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L.S. 4523Notes for Ethics in Commercial Law

Introduction

These introductory notes attempt to provide a bridge between some of those topics you might already havecovered, especially economics, I and ethics. It also seeks to place laws and regulations into some usable context.

How do laws and ethics relate to economics? Consider the following rather simple scenario:

Jane and Carol are neighbors. Each owns a cabin lying in a long valley. Jane and Carol especially love their sharedstream and its pond created by a beaver dam. However, the pond is small and contains a limited number of trout. Fora single owner, the pond can provide ample trout for a long time. For the two, it cannot. In fact, if each neighborfishes to her satisfaction, then the two will essentially dissipate the pond. The ideal, then, is for each to fish the pond

moderately such that it will provide trout for a long time. Some cooperative arrangement between the two mightachieve this. However, Jane and Carol both have a tendency to over fish, often when the other is away. If this activitycontinues, then it will dissipate the pond. For the purpose of discussion, assume that the following figure illustratesthe problem facing Jane and Carol with the shared pond.

Figure 1

Carol

Fish moderately Over fish

Jane Fish Moderately Ample fish for a long time Carol eats a lot of fish,including Jane's

Over fish Jane eats a lot of fish, Over fishing dissipates theincluding Carors pond. Both lose.

As Figure I suggest, if Jane and Carol cooperate (i.e. fish moderately), then each will have ample fish for a long time.If either defects (i.e. over fishes), then it will be at the other's expense.

Questions:

1. Why is there such an incentive for each neighbor to over fish? Suppose we can calculate the payoffsassociated with the neighbors' decisions to cooperate or defect. Do these payoffs help explain the incentiveto defect?

Carol

Cooperate Defect

Jane Cooperate 3,3 " -6,6

Defect 6, -6 -3,-3

xIf you haven't taken an economics course, please don't worry. Economics is neither a prerequisite of this course noressential to your ability to understand the concepts we cover.

2. What would you propose the neighbors do to foster mutual cooperation? Will your plan work? Why or Whynot?

3. How important are variables such as information and power in these cases?4. To what extent is LAW a means to insure cooperation?

Law As a Leviathan

Law might be the most obvious vehicle for resolving the problems confronting our neighbors. Strong legaland regulatory institutions can assign rights, establish responsibilities and enforce these rights and liabilities in casessuch as ours. Looked at in this fashion, law operates as a necessary creator of social order. If we are all rationalmaximizers, then we will often do things that affect others adversely. To some extent, then, we need enforceable lawsboth to protect us from other's decisions and to reign us in when our own decisions might create problems for others.Among the eighteenth century moral philosophers, Thomas Hobbes was most adamant about the importance ofgovernment and legal institutions - a "Leviathan" - capable of creating order among us humans whose lives hedescribed as "solitary, poore, nasty, brutish, and short. ''2 Hobbes argued that our self-interested, competitive andglory-seeking ways constantly put us at odds with each other and that the only a Leviathan, a strong monarch, forexample, can create sufficient order to overcome a "state of nature" in which competition and even anarchy prevails.

Whether we continue to exist in a "state of nature" for which law is a necessary barrier to anarchy is

debatable. However, we can all agree about law's importance as a creator or facilitator of order and stability in somecases. One need only look at those countries that lack the legal institutions to insure order to understand the

importance of an enforceable regime of laws. The former Soviet republics - including Russia - and some of theBalkan countries are good examples. Among the reasons provided by potential investors for not assuming significantfinancial risks in this region is the area's lack of strong legal regimes capable of protecting their investments.Currently the region is dominated by black markets, organized crime and an unstable political and legal climate.Citizens of this region might suggest the need for Hobbes' Leviathan.

ls a Leviathan all we need?

Is a stable legal and regulatory regime enough? So that they can realize the jointly maximizing state, Janeand Carol may each be willing to compromise with the other and cooperate. But how can each be sure that the otherwill cooperate? What if each neighbor agrees to cooperate, appears to be tree to her word, but is secretly over fishingwhen the other is away? If the two neighbors had not only agreed mutually to cooperate, but had formed a contract tothat effect, then each could use the law as a means of enforcing their arrangement. Contracts are not risk-free, but, by

providing a Leviathan-like regime in which the recognition and enforcement of certain agreements is a central part ofa legal system, can play an invaluable role in facilitating market economies. In the context of dilemmas like thatconfronting Jane and Carol, a legal contract elevates considerably the odds of a mutually cooperative solution.

Why Do People Obey the Law?

Assuming law provides the path toward a cooperative solution for Jane and Carol, one must wonder why;that is: why do people like these neighbors obey the law? Before we go further, what do we mean when we say "obeythe law?" Does this mean simply that people comply with the letter of the law? Or, does it mean that they alsocooperative with the spirit of the law? For example, you must decide whether to market a product that complies withall federal and state safety requirements. Will you do so even if you know of some problems with the product notgoverned by those regulations? What about environmental regulations? Let us suppose that chemicals A and B arebanned by federal regulation, but that chemical AB is not. You produce AB and know that it is at least as harmful aschemicals A or B. Do you produce and sell AB? What about inane regulations? Do you obey them, even thoughthey make no sense?

According to Hobbes, people obey the law (i.e. comply with it) because they must; i.e. because the Leviathancan back up its rules with force of some-kind. Tom Tyler would call this the.deterrence theory of legal obedience) !Jane and Carol will honor their legal commitment because each is rationally aware of and deterred by the legalconsequences of breach. In general, the deterrence theory posits that laws must contain sufficient incentives ordisincentives to encourage rational actors to act appropriately or not to act inappropriately. Therefore, to deter the

2 From THOMASHOBBES,THE LEVIATHAN(1651).3 TOMR. TYLER, WHY PEOPLEOBEYTHELAW 4-5 (1990)

commission of a crime, the combination of penalty and probability of being caught must exceed or at least be equal toany benefit realized from the commission. Rational polluters will choose to pollute if the expected value of pollutionis positive; i.e. where the economic benefit of polluting exceeds the expected costs of noncompliance. 4

Tyler's study strongly suggests that this deterrence theory is incomplete as an explanation for legalobedience. In fact, he concludes that we often obey law for moral reasons (he calls this the normative theory of legalobedience). In other words, people tend to obey law because they think it is the right thing to do, even in cases wheredisobedience is rationally preferable and not inconsistent with the actor's own ideas about law. Tyler's normativetheory is related to Reed et. al.'s (your textbook authors') "rule of law," which, according to your authors, makes lawsworthy of obedience because they square with a societies' conception of fairness: laws "are generally and equallyapplicable. ''s

Questions: Which of these theories makes more sense to you? Why?

Does Law Provide the Answers to Ethical Questions?

The answer, as you may guess, is MAYBE. In general, laws and ethics do overlap, and legal obedience isoften viewed as a rather minimal means of acting ethically. However, there are three reasons why law may notprovide the answer to ethical dilemma. First,

Extra-Legal Norms and Ethics

We have already established that Jane and Carol might use legal contract as their means to achieve acooperative solution. A strong regime of contract law certainly can facilitate two parties' maximizing efforts. But, dowe actually know many neighbors who have dealt with their potential problems in this way? The answer is no. Mostneighbors, even those like Jane and Carol, seem to get along without having to resort to law? How and why does thishappen? It is quite possible, perhaps even predictable, that two rational, maximizing people will choose to cooperate,despite the fact that defection appears to be a dominant strategy. This is so because Jane and Carol are neighbors whomust deal with each other every day and whose choices on one day will affect how each reacts on successive days.Game theorists would state that Jane and Carol are engaged in a repeated play rather than a single-iteration game.Each neighbor must evaluate his/her choice based not only on the payoffs for that iteration but for the long-termconsequences of that choice. Even rational maximizers will understand that mutual defection over the long-termresults in a "race to the bottom" in which both neighbors lose. Over time, our neighbors might establish a relationalexchange for which cooperation rather than defection is the prevailing norm.

The evidence supporting the creation and maintenance of relational exchanges supported by cooperation isoverwhelming. Two studies are worth noting. In his book Order Without Law: How Neighbors Settle Disputes, 6Robert Ellickson documented the 6ooperative norms that dominate the ranching and farming communities in ShastaCounty, California. There, cooperation among neighbors settles virtually all stray cattle and fencing issues despiteapplicable laws that present competing norms. Elliekson also questioned whether law is the focal point for partieswho must settle their disputes and found that the farmers and ranchers in Shasta County often did not know, or hadsignificant misunderstandings about, the law and that they rarely depended on the law to settle their problems.

Some thirty years earlier, Stewart Macaulay studied the dynamics of a supplier- manufacturer relationshipwhen competing documents presented potential contract problems for the parties. 7 Macaulay's work focused on whatwas then a relatively new law, the Uniform Commercial Code (UCC), and its effect on commercial dealings. Hewanted to determine whether the UCC's section governing competing printed forms (i.e. Buyer's printed purchaseorder and Seller's printed acknowledgement) accomplished the section's goals of facilitating contracting. He foundthat the parties dealt with their potential disputes in a decidedly non-contractual (and non-UCC) manner.

The types of relationships like those documented by Ellickson and Macaulay dominate both private and publiclife. Whether called relational exchanges, the product of enlightened or long-term self interest, or some other label, we

4The costs of noncompliance would be equal to the product of the expected penalty or fine if detected and theprobability of detection. David B. Spence, The Shadow of the Rational Polluter." Rethinking the Role of RationalActor Models in EnvironmentalLaw, 89 CAL. L. REV. 917, 920-21 (2001).50. Lee Reed et al., Textbook at 3.6 ROBERTELLICKSON,ORDER WITHOUTLAW:HOWNEIGHBORSSETTLEDISPUTES(Harvard Univ. Press 1991).7 Stewart Macaulay, Non-contractual Relations in Business: A Preliminary Study_ 28 AM. SOC. REV. 55-67 (1963).

understand that cooperation can become the norm in prisoners' dilemma-type problems like those confronting Jane andCarol.

By simply extending these ideas to a fL'm, we can understand the necessity for forging and maintaining strongand cooperative bonds with our customers, vendors and others. For those of you interested in Supply-Chain Management,these types of bonds are both important and supported by strong empirical research. Businesses engage far more often inrelationship-building, multiple-transaction activities than in discrete transactions for which some type of defecting strategymight be appropriate. In fact, it might be useful to try to identify those commercial activities that one can defensiblydescribe as "one-time games" for which defection would be an appropriate strategy.

Often Extra-legal Norms Supplant Formal Rules.Why is this So?

In a law course such as this, it is important to place law into some perspective. While law is a particularly important

part of the business environment, it is important that we understand that laws - including formal organizational rules,bylaws etc. - are not as dominant a part of our lives as some might want us to believe. Just as Macaulay's subjects avoidedthe law in settling their problems, most ofns do the same.

There probably have been few occasions in your lives in which you had to invoke formal laws. You may also notethat humans often create their own norms that substitute for those of orgamzations or activities. You may have observed,

for example, the manner in which cars exit a parking lot after a football or basketball game. They tend to line up in theparking lot waiting to enter a public street. While those already on the street enjoy the right-of-way, they usually willallow an exiting car to enter the street. One by one the "street cars" allow the exiting cars onto the street, notwithstandingthe laws that would allow the street cars to ignore the exiting cars. Why does this happen?

How Do Ethics Relate to This Discussion?

Our discussion about relational exchanges - relationship building - provides a convenient transition to our coverage

of ethics. At this point, we know that even rational economic actors will choose to act cooperatively in order to sustainrelationships. This suggests that ethics and economics are not necessarily antithetical. Acting ethically - for example,dealing fairly and honestly with customers and vendors - tends in most cases to enhance a ftrm's commercial position.There is also strong evidence showing that acting unethically- for example, engaging in bribes or price fLxing-- will havean adverse effect on the fLrm.

When businesses embrace ethical values because they believe that acting ethically will serve the economic interestsof the ftrm, then they are practicing instrumental ethics, i.e. they believe that acting ethically is good for the fn'm. Forthem, ethics are instruments for fostering the firm's economic interests (Instrumental ethics are closely related to, butdifferent from, utilitarianism, a moral philosophy that encourages behavior that creates desirable ends. Both areconsequentialist, but instmmentalism chooses firm value as its intended end. Utilitarian chooses overall social good). Inour two cases, we have already established that our parties - Jane and Carol - might actually choose to act cooperativelybecause it is in their interest to do so. They are practicing instrumental ethics.

Today most fu-ms use instrumental reasons to justify their adoption and enforcement of Codes of Ethics. Supportersof instrumentalism argue that if businesses act more ethically because they embrace this insmamental view, then suchjustification is defensible. Critics claim that instrumental ethics are intellectually indefensible and offer three reasons fortheir claim, s First, they argue that acting ethically does not always advance an economic interest. In fact, sometimes firmsand individuals must choose between ethical behavior and economic ends. Claiming a congruency between ethics andeconomic gain, the critics argue, is disingenuous. If acting ethically and economic gain are antithetical in a given situation,then insmamentalist, the critics suggest, will choose economic gain because ethical behavior will not yield their desiredoutcome, i.e. the instrumental basis for ethical conduct does not exist. Second, critics of instrumental ethics argue thateconomic advancement or a higher firm value are components of, not synonymous with, social good, which they believe isthe only appropriate justification for ethical behavior. Finally, embracing instromentalism creates a potential divergencebetween the goals of the firm and those of its agents/employees. If an employer, say Enron, uses instrumentalism as itsjustification for acting ethically and for insisting for ethical conduct from its employees, then the employees mightrationally assume that instrumental ethics should inform their own professional decisions, even when their self-interest andthat of their employer are different. An employee might ask: Why can't I be instrumental like my firm?

8 Dennis P. Quiun & Thomas M. Jones, An Agent Morality View of Business Policy, 20 ACAD. MGMT. REV. 22(1995).

Those who support non-instrumental business ethics believe thatethical behavior represents an end itself, i.e. actingethically needs no instrumentalbasis. Non-instrumentalists are generally regarded as deontologists, those who advancecategorical and universal rights and duties that represent their own ends. Emmanuel Kant,the founder of deontology,argued that rational people are capable of recognizing and embracing what he called categorical imperatives, universalrules of behavior. Among his most important roles are the following:

A rule of conduct is appropriate if it would be accepted universally.

Humans should be treated as ends and not as means to some end.

One can predict the ongoing intellectual battle between supporters of insmunental ethics non-instrumental ethics,especially among the academic community. However, the real battles are occurring every day in corporate board rooms,during international contract negotiations, among small fuans that are trying to survive andwith business people who mustoften choose between individual and organizational gain. It is within this last category thatyou might find yourself. Letusturn now to individual ethics.

What About My Own Professional Behavior?

In a study examining the ability of their former students to cope with their new jobs, 9two authors found that theirformer students had a hard time dealing with on-the-job ethical problems. These former students insisted that life "in thetrenches" is a bit different from the more comfortable environments in the classroom. The following are some of theirconclusions.

1. When confronted with on-the-job demands that were ethically questionable, theywere often told "JUST DO IT."

2. Four "organizational commandments" dominated their supervisors' professionallives.

*Performance is what counts: MAKE YOUR NUMBERS.

*Be loyal and show us you're a team player.*Don't break the law.*Don't over-invest in ethical behavior.

3. Too often, it seemed that the companies' formal ethical standards and codes madelittle difference.

4. Senior executives seemed to be out of touch - at least according to their actions -with the operations of an ethical organization.

Whether you will face ethical issues similar to those "in the trenches" depends upon two things: 1) whether you aresensitive to such issues and 2) your professional environment. Most of you will want both to act ethically and be perceivedas an honest employee. If you are indifferent about ethics, please consider at least the instrumental reasons noted above foracting ethically. If you care about ethical conduct and hope to work in an environment conducive to this sensitivity, thenthe ideas listed below will be useful to you.

• At this point in your professional lives, you should likely view the distinction between instrumental and non-instrumental ethics as academically important, but one that does not demand an urgent choice. In fact, an instrumentalbasis for ethical behavior will probably work for most of the ethical problems you or your firm will face.

9 Joseph L. Badaracco, Jr. & Allen P. Webb, Business Ethics." A View From the Trenches, 37 CAL. MGT. REV. 8-26(1995).

• It is worthwhile to consider your own "ethics code" now. Do you have a moral threshold for your professionalconduct? If so, what are its main tenets? Using private markets as both the relevant operating environments and

underlying bases for these rules, Quinn and Jones offer four ethical ideals for the firm or individual.

Avoid Harming Others - One premise of a market-based decision is that rational choices will tend not to harm others.When your managerial decisions tend to affect others adversely (i.e. have a spillover or negative externality effect), thenyou should review these consequences critically. If others are harmed by your behavior, then you should reconsider.Harm in this case can be physical or non-physical. Examples of non-physical harm would be that adversely affecting anindividuals reputation or her fundamental rights as a citizen (free expression, equal treatment etc.)

RespeetlndividualAutonomy - Individual autonomy is central to a market economy. It represents each person's right tochoose freely. This includes the right to choose whether to enter a market, how to operate within it, and when to leave thatmarket. Once that person makes a choice, she may reap the benefits but must also accept the responsibilities associatedwith them. Respecting this autonomy means that we recognize this basic right, but also that we understand both thecomponents and consequences of free choice. The two most important components of free choice are information andpower. Individuals need information to make reasoned choices and cannot choose fi'eely in cases of extreme powerasymmetry. One thesis seems best to capture the idea of respecting individual autonomy: A person who possessessuffTcient information and power has the right to make choices from among legal alternatives and both to reap the benefitsand suffer the consequences of that choice.

Avoid Deception - Effective markets operate on the assumption that the information available to buyers and sellers isaccurate. Misrepresenting relevant facts creates misinformation and causes market failure.

Honor Agreements- Agreements (Contracts) are the market's basic building blocks. Market buyers and sellers dependon each other to do as their contracts require. One should note, however, that honoring agreements does not alwaysrequire an actor to do as an agreement states. For example, if doing so will fundamentally harm the actor, then honoringthe agreement in such a case may also harm the other contracting party. In such as case, honoring the agreement maymean apprising the other party of the potential harm and working together to maintain the working relationship.

Why Specific Ethics Rules?

In short, because they work. You may take them or leave them, but simply ask yourself this question: Do theyprovide clear to relatively clear answers to the types of ethical problems you may face on the job? I think the answer isyes. While neither I nor Professor Knapp can look over your shoulder and tell you what to do, we can provide youintellectually and morally defensible rules that provide answers to ethical questions. It's up to you whether you choose toapply them or not.

Chapter 20

LLEWELLYN'S REALISM AND THE UCC

Karl Llewellynwas amongthelegal realists(LegalRealismwas a jurisprudentialmovementthat beganin the early 1900s) whoclaimedthatcommerciallawsshouldoften mirrorcommonpracticesbythosewho routinelyform andcarryout commercialtransactions.As thechiefdrafter of the UCC, Llewellyninsistedthatthe proposedlawnot onlymake uniform,modernize,simplifyand clarifycommercial law. He alsourged the commissionersto recognizetypicalcommercialpracticesand to incorporatesome ofthose practicesintothe Code. You'llseemanyexamplesof Llewellyn'srealisminthe Code,

UCC ARTICLES:

•Art. 1 - Introduction & definitions•Art. 2 - Sale of Goods

•Art. 2A - Lease of Goods•Art. 3 - Negotiable Instruments

•Art. 4 - Bank Collections & Deposits•Art. 4A - Electronic Fund Transfers

•Art. 5 - Letters of Credit•Art. 6 - Bulk Transfers

•Art. 7 - Documents of Title•Art. 8 - Investment Securities•Art. 9 - Secured Transactions

OUR COVERAGE (THE BIG PICTURE) -

•Sellers and Buyers (sale and lease of goods, digital products etc.) - Contracts Law: CommonLaw, UCC, UCITA (Uniform Computer Information Transactions Act) - The sales contracts we'llexamine are an important first step for our coverage. We'll focus on contracts involving the saleof goods, but will occasionally examine leases of goods and sales of digital properties likelicenses. The key here: Our coverage will begin with a focus on contract law- typically thecommon law, UCC and a tiny bit of UCITA.

•Assignees or Holders of Commercial Paper - Inserting some kind of commercial paper into thecontracts noted above adds another important party to the transaction and,possibly, somedifferent laws: Negotiable Instruments Law (Art. 3); Bank Collections and Deposits (Art. 4);Electronic Fund Transfers (Art. 4A). For now, simply consider the consequences of a seller ofgoods etc. accepting a promissory note in payment for the subject matter sold (Do you remembersigning both a contract and promissory note when you financed your car?). What if that sellersells that promissory note to a third party such as a finance company. A good share of ourcoverage in this area will be to define the rights of that third party, especially regarding Holder inDue Course (HDC) status. A third or subsequent party who holds a negotiable instrument maybe an HDC. HDC's are important because they are virtually super plaintiffs, capable of enforcingnegotiable instruments against signers who may have valid contract defenses.

•What if the Seller or another party finances the purchase of goods or othersubject matters?These are Secured Transactions (Art. 9). Of course, they're contracts, butare differentbecause personal propertysuch as a car, furniture or even stocks or bondsare offered as IIsecurity. If, for example, you financed your car with 1_ Bank, then in return for the money loaned

!

to you by the bank, you actually give the bank a security interest in the car(i.e. the car iscollateral). How these security agreements arise, are "perfected"and enforced are among theitems we'll cover in Article 9.

•What if the buyer/debtor can't pay debts as they become due? Often, this means the debtor willuse bankruptcy laws to deal with this crisis. We'll pay particular attention to liquidation andreorganization principles in the bankruptcy laws.

ARTICLE 2 COVERAGE

Article 2 governs sales and contracts for sale of goods. Article 2A applies to leases and contractsto lease goods. Goods (2-105) - all things moveable at the time of identification for sale exceptfor money, investment securities (stocks, bonds) and things in action (intangibles such aspatents, rights to money etc.). A sale of goods (2-106) is the transfer of title to goods from aseller to a buyer for a price. A lease of goods (2A - 103) is the transfer of possession, not title,from a lessor to a lessee for a price.

Article 2 governs contracts for the sale of existing or future goods (e.g: livestock to be born, cropsto be harvested and goods to be manufactured). What about digital products such as software?Are these goods? The NCCUSL has drafted and proposed to the states a new uniform actintended specifically to apply to software licenses. The Uniform Computer InformationTransactions Act intends to deal with these licenses in much the same way the UCC governstransactions involving goods. However, only two states, Virginia and Maryland, have adoptedUCITA, leaving most states to wonder how to treat software transactions. Currently, courts innon-UCITA states tend to treat shrink-wrap sSftware - i.e. that packaged in tangible form - asgoods. Click-wrap software - e.g. that available for downloading via the internet - is notpackaged in a tangible form and therefore does not meet the requirements under UCC 2-105.Frankly, the courts are struggling to agree on how to treat click-wrap transactions.

Key Definitions

Merchant (2-104) - Merchants are important actors because the Code holds merchants to ahigher standard of conduct in many cases (e.g. firm offers, goods faith). A merchant is a personthat deals in goods of the kind sold or otherwise by her occupation possesses skill or knowledgepeculiar to those goods. Are occasional sellers of cars merchants? Mechanics?

Good faith (1-201(19), 1-203, 2-103) - Actors in transactions governed by the UCC must act ingood faith (honestly); for merchants, good faith means in a commercially reasonable manner.

How do we determine the rights and liabilities of the parties should a dispute arise? Ofcourse, the specific, governing provisions of the Code will apply. But, so will the actions of theparties and the standards of the industry.

• Course of performance (2-208) - that performance in a current contract now in dispute.E.g. an installment K in which the parties have completed some of the performance -seller has delivered and buyer has accepted some of the installments. Very relevant indetermining the rights and liabilities of the parties if a dispute arises as to the conformityof a later installment.

• Course of dealings (1-205) - previous dealings (e.g. contracts )between the same twoparties. If they've dealt with each other in a certain, predictable manner in the past, thenwe should assume that those actions will govern how they should deal with each other ina disputed case.

• Usages,of,trade (1-205) - the standards or customs in the industry. What is the typical ,_percentage of spoilage when soybeans are shipped by train from Muskogee to Omaha?

CONTRACT FORMATION UNDER ARTICLE 2

[Note: The NCCUSL is constantlyupdating the UCC. These notes reflect theUCC without the proposed 2003 amendments. Until at least half the states adoptthese amendments, I deem them not applicable to our coverage. You will notethat I refer to them on occasion.]

Your textbook (West) emphasizes Article 2, but makes occasional references to 2A. I'lldo the same. We'll cover the basic rules of contract formation under Art. 2. Generally, the rulesin 2A mirror those in Art. 2.

It is also important to note that the UCC doesn't really revolutionize the rules ofcontracting. Rather, it supplements the common law rules based on some of the peculiaritiesassociated with contracts involving goods, standards and practices in the industry and goals ofclarity and simplification. UCC 1-103 states that general principles of law and equity (the basiccommon law rules) apply unless specifically displaced by a UCC provision.

The single most important difference between the Code and the common law is that theCode genuinely liberalizes and simplifies the common law principles. It is easier to form andperform contracts and to assert remedies under the Code than it is under the common law.

The Agreement

Remember, contracts are agreements, and, typically, these agreements break down intoan offer and an acceptance. It may be worthwhile for you to refresh your memory of contractingby reviewing the contracts chapters in West. Our goal is to identify and explain those Art. 2provisions that vary from or supplement the common law.

• 2-204 - Whether the parties have formed a contract depends not only on the formalitiesof offer and acceptance. If the parties words or conduct manifests the existence of a K,then a K exists (remember the duck rule?).

• What about electronic contracting? Electronic contracting may not include humanreview. If we form an agreement via email, then the conventional wisdom is that we'vefulfilled the requirements for contract, including those associated with documentation(Note: the Uniform Electronic Transmission Act enables parties to contract usingelectronic exchanges and signatures.). But, what if the supplier's and customer'scomputers interact with purchase orders and acknowledgments? Once would think thatsome human review is essential for the "mutual assent" of contacting to exist, and this,under current law, is generally so. However, under the revised UCC (2003 Amendments- not yet adopted by most states), this is not the case. Quoting 2-204(a) of the amendedUCC: "A contract may be formed by the interaction of electronic agents of the parties,even if no individual was aware of or reviewed the electronic agents' actions or theresulting terms and agreements."

• The only essential terms to contract formation under the Code are the subject matter(i.e. what goods?) and quantity (how many goods?). Price is not an essential term to Kformation (see 2-305). If the parties fail to agree on the price, then the price is thereasonable price. The Code also includes other "gap fillers": Code-provided terms if theparties fail to agree on these matters. (see e.g. 2-308 and 2-309 dealing with the timeand place of delivery).

• 2-205 - firm offers - If a g0..C.ECJD_makes a signed offer in writing that givesassurancesthatthe offeris openfor a prescribedor reasonableperiodof time,then the offer isirrevocablefor thatperiodof time. This variesfrom the common lawwhich allows theofferorto revokean offerat any time before the offeree's acceptance. Whether FAXedandemailedoffersbymerchantsare firm offers isan interpretiveissuefor the court.

• Acceptance (generally) - UCC 2-206 states that acceptance mayoccur in any mannerreasonableunderthe circumstances.What is reasonabledependsnot onlyon thecircumstancesin the presentcase, but also on courseof dealingsand usageof trade. 2-206 also deals with"Please ship ..." offers,i.e. buyers'purchaseorders that ask that theseller=pleaseship"certaingoods. When the offercallsfor the promptshipmentof goods,thenthe seller/offereecan acceptby 1) the promptshipmentof conforminggoods;2) thepromptpromiseto shipconforminggoods(noticehow thisvariesfrom thecommonlawrule regardingoffersto enter intounilateralKs);or 3) the promptshipmentofnonconforminggoodsunlessthe seller/offereepromplynotifiesthebuyer/offerorthat theshipmentis intendedas an accommodation.Thisthirdrule is certainlya departurefromthe commonlaw, butis basedon problemsspecificto thesale ofgoods. Number3)actuallydiscouragessellersfrom sendingnonconforming,no-risktenders bystatingthatsuchtendersare bothacceptanceand breachat the same time unlessthe sellerpromptlynotifiesthatbuyer thatthe seller is makinga nonconformingtender as anaccommodation. In such a case,the seller mustassumeall risksanddeliverychargesifthebuyerrejects the shipment.

• Acceptance (Battle of the forms) - The term, "battleof the forms,"is basedon thetypicalmethodof formingsalescontractsin a commercialsetting(inwhichboth partiesare merchants).When a buyerwantsto order goods,the buyer sendsthe sellera"purchaseorder,"a printedform which includesspacesto fill in thegoods ordered, price,quantity,shippingtermsand deliverydate. The setlertypicallyacceptswithanotherprintedform, an acknowledgement.The problem,of course,is thatthese printed formsrarelymirroreachother's terms,and, underthe common law, thisviolatesthe"mirrorimage" rule(the acceptancemustmirrorthe offer). UCC 2-207 tothe rescue(well, sortof). 2-207 statesthat a definiteexpressionof acceptancecommunicatedbyan offereewithina reasonable periodof time is an acceptance evenif it containsprovisionsinadditionto or differentfrom those statedinthe offer unlessthe offeree states thatacceptance is conditional upon the offeror's assent to the different or additionalterms. In thislattercase, the offeree's acknowledgementwouldbea counteroffer,not anacceptance. If there is an acceptancewithdifferentoradditionalterms,then these termsare merelyproposalsto the contractunlessbothpartiesare merchants. If botharemerchants,thenthe additionaltermsbecomepartof thecontractunless1) the termsmateriallyalterthe contract(typicalexample = arbitrationprovision);2) the offerexpresslylimits acceptanceto the termsstated in the offer;or 3) theofferor notifiestheoffereewithina reasonableperiodof time thatthe offerordoes notagree withthedifferentor additionalterm. [Note: I realizethat 2-207 is rathercomplexandwouldsuggestthat youapproachit likea system. See below:]

A Systematic Look at 2-207

Do we have competingforms between the parties?If no,ignore2-207. If yes, proceed.

Has theofferee definitelyexpresseda willingnessto acceptthe offeror'soffer?If no, stop. If yes, proceed.

Does the acknowledgementby the offereeincludeterms inadditiontoor,different_f_omlthose_injthe,offer_

If no, thenthere is acceptance(acceptancemirrorsoffer).If Yes, then proceed.

Does the acknowledgementstatethat acceptanceis conditionaluponthe offeror'sassentto the differentor additionalterms?

If no, thenthere is acceptance.

If yes, then there is no acceptance, this is a counteroffer.

If there is acceptance but with different or additional terms, thenwhat do we do with these terms? They're just proposals unlessboth parties are merchants. If both are merchants, then these

terms become part of the K untess:• they materially alter the K;

• the offer expressly limits acceptance to the terms of the offer; or• the offeror notifies the offeree within a reasonable time of offeror's objection to the

different or additional terms.

Consideration

Consistentwithwhatwe've discussed,the rules for considerationinsales Ks areessentiallythe same as for common lawKs. To forma K, each side mustgive consideration,i.e.give or promisesome benefitor detrimentto the other. However,the UCC does liberalize therules applicableto contractmodification. In general, partieswho wishto modifyexistingcontractsmustgive new consideration.UCC 2-209 statesthatthe partiesto a contractfor the sale ofgoodscan modifya contractifonly one sidegivesnew consideration.For example, if thecontractrequiresa buyerof deliveredgoodsto pay the contractpricewithin30 days of delivery,but,the partiesagree after the contractthat the buyermayhave an additional30 days to pay(givingthe buyer60 daysto pay), thenthe extensionof the paymentdate - a contractmodification- is enforceableeventhoughthe buyergave no new considerationfor the seller'spromise.

This liberalizationof considerationrulesis yet anotherexampleof the drafters'willingnessto incorporatelawsconsistentwithindustrypracticesintothe UCC.

The Writing Requirement (Statute of Frauds)

You'll recallthat the Statuteof Fraudsrequiresthat certaincontractsbe written,otherwisethey are unenforceable(voidable). 2-201, the UCC's statuteof Frauds requiresa writingfor salesKs inwhichthe priceis $500 or more. (2A-201 requiresa writingfor leases of goods in whichtheK price>_$1000). In itstypical spiritof simplificationand _iberalization,the Code recognizesthree exceptionsto the writingrequirement:

• legal admission. If the party againstwhomenforcementis soughtadmits in judicialpleadings,discoveryor in court that a contractexists,then a K isenforceable, despitethe absenceof a writing.

• Specially manufactured goods - if the oral K calls for the seller/lessorto mfg. goodsspeciallyfor the buyer/lessee,thenthe oral K is enforceableassumingthe goodscouldnot reasonablybe sold/leasedto anotherparty andthe seller/lesseehas begunthemfgingprocess.

• Partial performance- not surprisingly,a buyer/lessee isresponsiblefor payingthe Kpriceto the extentthat the buyer/lesseehas acceptedgoods,evenwhen the contractisunwritten. Partial performancemay also bindthe seller/lessorto delivergoodsto theextentthat eitherhas acceptedpaymentfrom the buyer/lessee.

• Confirmatory Memoranda - Generally,to meet the minimumrequirementsof the

Statutes of Frauds, the writingmust include at least the signature of the person againstw_om enf0rcement is sought. That is, if two parties agree orally, then one sends awritten and signed confirmation, then the sender, not the receiver is bound. However, 2-202(2) states that between merchants, a| writing in confirmation of an oral contract thatbinds the sender shall also bind the receiver, if the receiver has reason to know theletter's contents and doesn't object within 10 days of receiving the confirmation.

Parol I extrinsic evidence

Parolor extrinsicevidenceis evidencethatattemptsto vary fromor add to the provisionsof a writtencontract. Firstrecognizedat commonlaw, the parol evidence rule holdsinadmissiblethe parties'agreements, negotiationsetc. thatoccurredbeforeorcontemporaneouslywiththesigningof a writtencontractif the agreementsetc. alter, modifyorcontradictthe writtenK.

The Codegenerallyagrees withthiscommonlaw rule, butalso liberalizesitto someextent. 2-202 statesthat a personmay testifyaboutcourseof performance,courseof dealingsand usageof trade if suchtestimonyclarifiesunclear provisionsinthe writing. 2-202 alsoallowsa partyto testifyabout consistent additional terms (i.e. the party'stestimonycan modifythewrittenK, but can't alter or contradictit). However, if thewrittencontractstatesthat it is intendedto be thecompleteand exclusivestatementof the contract'sterms,then thetraditionalcommonlaw rules apply•

Unconscionability

The conceptof unconscionabilityisn'ta perfectfitfor our coverageof contractformation,butwe mustcover it nonetheless. UCC 2-302 (2A-108) statesthat a courtmay voidan entirecontractor simplyeliminate a provisionof thatcontractif the courtdeterminesthat the contractorprovisionis unconscionable,i.e. =shockstheconscienceof the court." ,Typically,a contractorprovisionis.unconscionableif.1).there isgrosslyunfair bargainingpowerbetweenthe parties,2)one party has no meaningfulchoiceof options,and 3) thecontractor someprovisiontherein.

• takes advantageof numbers1 and 2_ Now considersoftware licenses• Softwareproducersusestandardforms for theirlicensingagreements,and you, the licensee,typicallyhave nosay aboutthe contentsof these licenses. Essentially,a licenseemusteither take thelicensingagreementas it isor choosenotto purchasethe license. Are thesetake-it-or-leave-itstandardslicensesunconscionable?

Title and Risk of LossChapter 21

Our coverage of the Code's title and risk of loss rules represents an important departurefromboth thecontractformationruleswe just finishedandany businesslaw-relatedsubjectyou'vecovered. Those of youwho have hada coursein Real Property Lawunderstandthesignificanceof title. Title is importantin ourcoursetoo. For us, however,when titlepasseswillbe less importantthan whether it does. Our discussionswill focuson passageof riskof loss.

Why focus on risk of loss?

The draftersof the UCC choseto separate the rulesfor riskof lossfrom thoseof passageof title. That is:underthe UCC, titleand riskof lossrulesare verysimilar, but not identical.Underthe UCC's predecessors,the UniformSales Act andthe commonlaw, riskof losspassedto a buyerof goodswhen titlepassedto the buyer. Titrerules,however,were based on someratherfragile principlesandwere fairly arcane. The draftersunderstoodthatrisk of losswas, byfar, the mostimportanttitle-relatedissuefacingsellersand buyersof goodsand thereforechoseto separatethe concepts. Figure 1 providesa general overviewof titleand riskof loss.

Figure 1Passage of Title and Risk of Loss

General

Passableof Title Passage of Risk of LossWhen does passage of titlematter?. 1)Claimsof buyer'screditorsi.e. the buyer must usually When does passageof risk of lossmatter? In

have titlebeforehis creditorscan assert a any case inwhichthe goodsare damaged orclaim to thosegoods. 2) Taxation- typically, destroyed- whether in transitto the buyer, in ataxes don'tapplyto the buyer's goodsuntilhe warehouseor someother situation.

hastitle.UCC rulesgoverningpassage of risk of loss: 2-

UCC rule governingwhen titlepasses:2-401 509, 2-324, 2-326, 2-510(less important) (very important)

The parties' agreement can control passage of_ The parties' agreement can control passage of.title, risk of loss,

How does Identification of goods affect title and risk of loss?

Identification is an important concept under Article 2, but is probably a pretty mysteriousconcept to you. So far, we know that identification is a key part of the definition of goods: allthings moveable at the time of identification for sale ... We haven't discussed yet the importantrole this concept plays in several performance issues, but, for now, should understand thatneither title to nor risk of loss for goods can pass to the buyer unless the goods are identified.

A working definition for identification is:when the goods are separated from orrecognized as the subjects of the seller's and buyer's sale and purchase of goods. (see 2-501)For existing goods, the parties can actually agree on the time of identification. With noagreement, then identification happens at the time of contract if the goods exist at that time andthe parties designate the goods. For example, if you and I agree on the purchase and sale of mytruck that you've just test-driven, then identification happens at the time of our agreement.Otherwise, identification happens when the goods are designated as those destined for thebuyer. The seller or a warehouseman may physically separate or mark the goods for the buyer.

Risk of loss and title don't typically pass upon identification, but the buyer does acquireboth an insurable and special property interest in the goods. An insurable interest gives the "

buyer a legal right to insure the identified goods (even if the goods are still in the seller'spossession). We'll talk more about the special property interest later.

A Digression: A typical sales transaction: Rights of the buyer and seller

Before we address the actual rules for passage of title and risk of loss, we shouldexamine generally what happens in a typical sales transaction and the respective rights of theseller and buyer. First, when title and risk of loss pass to the buyer depends on how thetransaction is going to unfold. Figure 2 identifies the possibilities.

Figure 2How will the parties complete the sales transaction?,

1. A third-party carrier will deliver the goods to the buyer. The emphasis is on "third-party."Federal Express, UPS, train, water-borne vessel etc. (not the seller's or buyer's vehicles)

2. Delivery.is to occur" without movement of the goods. The seller has stored the goods in athird-party warehouse and the buyer is to obtain title and risk of loss while the goods remain at

the warehouse.

3. All other situations. E.g. the seller will deliver the goods to the buyer. Buyer will pick up the9oods, etc.

We will explore the rights of the parties to a sales transaction more fully later, but an overview ofsome of these rights will help us understand some of the title and risk of loss rules we're about tocover. (Figure 3)

Figure 3Seller's and Buyer's rights in a Sales Transaction

(General)

Seller's ri_lhts Buyer's rightsSeller has a limited right to cure a non- With some exceptions:Buyer has the right toconforming tender of goods (see 2-508) inspect the goods before accepting and paying

for them (2-513)Buyer has the right to reject a non-conforming

tender of goods (2-601 + several othersections)

At some point, the buyer will likely accept the9oods (2-606)

In limited cases, the buyer may have the rightto revoke acceptance of 9oods (2-608)

Passage of Title

UCC 2-401 includes the rules for passage of title. Remember that goods must beidentified for title to pass to the buyer. Generally, the passage-of-title rules mirror those forpassage of risk of loss. There are some limited exceptions - e.g. in Figure 4, item 1. - 2-401 'IIdoesn't distinguish between merchant and non-merchant sellers. Otherwise, you may assumethat title and risk of loss pass at the same time.

Basic Risk of Loss Rules

Figure 4 and UCC 2-509 provide the risk of loss rules for virtually all, non-breach cases.These are important - I will hold you strictly responsible for them!

Figure 4Risk of Loss Rules (no breach)

If the sales transaction provides _The risk of loss passes to the buyer.In shipment K s, when the seller delivers thegoods to the carrier (see refinements in Figure

1.-Shipment using a 3d party carrier 5); in destination K s, when the carrier makesa tender of delivery to the buyer at the

destination.

2. That goods will stay in the warehouse in" According to the contract, if the goods are'which the seller stored them, but that buyer will, identified; when the buyer receives a document

assume title and risk of loss (i.e. delivery w/o of title (e.g. warehouse receipt); OR whenmovement of goods) bailee (warehouseman) acknowledges buyer's.

right to the goods:3. any other means of delivery other than Upon receipt of goods by the buyer if the seller,

stated in 1. or 2. above (e.g. Seller delivers to is a merchant; upon tender of delivery of goods.Buyer or Buyer picks up from Seller) by seller if the seller is a non-merchant.,

Figure 5 provides more details about the distinction between shipment and destinationcontracts in Figure 4, number 1.

Figure 5Shipment versus Destination Contracts

'Shipment Contract Destination Contract.A shipment contract requires A destination contract requires

Definition ,the seller to get the goods to the seller to get the goods to.the carrier, at which time the. the carrier and to pay thebuyer assumes the shipping costs of shipping the goods to

costs, the destination.Unless course of performance

The Code favors shipment K or course of dealings implies as. Therefore, if the parties destination K, the parties must.agree to use a carrier, but explicitly agree on a.

include no shipping term, the destination K.. e.g.s: FOBExamples contract is a shipment K. destination: FOB Buyer. FOB

Other e.g.s: FOB. FOB Buyer's city. Ex ship (goodsshipping point. FOB Seller. must be unloaded at buyer's

FOB Seller's city. FAS (seller port). No arrival, no sale •is obliged to get the goods (destination K and if goodsalongside the water-going don't arrive, the K is •

vessel). CIF or C&F.. COD. discharged ).

4Special Risk of Loss Rules

Sales on Approval and Sales or Return are special sales because the buyer has theright to return conforming goods to the seller (see 2-326). Accordingly, these special situationsrequire different risk of loss rules. In a sale on approval, the buyer is taking the goods primarily

for personal or household use, If the goods meet the buyer's expectations, then the buyer willretain the goods and pay the contract price. If not, the buyer has the rightto return the goods tothe seller. In general, the seller retains both title and risk of loss during theapproval period.Conversely, in a sale or return, the buyer's goal is to resell the goods. In such case, the buyerassumes both title and risk of loss during the "return" period_

Consignment sales are similar to sales or return, but differ based on the assumption thata consignment is an agency relationship in which the consignor retains titleto the goods..Like a.sale or return, the consignee has the ROL while the goods are in the consignee'spossession. However,while the consigneepossessesthe goodsand attemptsto sell them, theconsignee'screditorshave a claim againstthosegoodsunlessthe consignedgoodsare statedtobe held on consignmentorthe creditorsshouldreasonablyassumethat thegoodsare so held.

The Effect of Breach on Risk of Loss (see UCC 2-510)

One wouldpredictthat breachmighthavea significantimpactonthe riskof lossrules.So far, ourassumptionshave been thatthe goodsare damagedor destroyed,but that eitherthecontracttermsor Code provisionswouldallocaterisksconsistentwith usageof trade ideals.Breachchangeseverything. Predictably,,thebreachingpartyis subjectnotonly to otherside'sassertionof the Code's remediesbutalso mustacceptthe riskofloss forgoodsdamagedordestroyedafter the breach. Figure6 identifiesthree specialriskof lossrulesoccasionedbyaparties'breach. Numbers 1. and 2. addresscasesof Seller's breach. Number3 addressesBuyer's breach. [Please refer to Figure 3 regarding the rights of the parties in a salestransaction.]

Figure 6Risk of Loss if a Party Breaches

1."If the tender of delivery is so nonconforming that the buyer has the rightto reject that tender,.then the risk of loss remains on the seller until cure (by the seller) or acceptance (by the buyer):2. If the buyer rightfully revokes acceptance of goods, then the risk of loss is on the seller to the

extent of any deficiency in buyer's insurance.3. If the buyer repudiates or otherwise breaches the contract before ROL passes to him, then, as,to identified and conforming goods, the ROL is on the buyer to the extent of any deficiency in the

seller's'insurance coverage.

Sale of Goods by Non-owners

As the introductionto thischapter states,our coverageof titleemphasizeswhether asopposedto when title passes to the buyer. We are now ready to talk aboutwhether it is possiblefor a sellerto transfera greater interestin goodsthan whathe has. Pleasetake a momenttoconsiderthat question. Your intuitionwilllikelytell you thata se//erof goodscan transfer nogreater interest in the goods than what the se//erhas. Generally,this is correct. You shouldprepare yourselves,however,for some exceptionsto thisrule.

Considerthe underlyingreasonsfor rulesdirectedat thisarea. First,we want toencouragesales of goods. Placingrestrictionson the seller'sabilityto transferand the buyer'sabilityto acquire titleis antitheticalto this ideal. When you purchasegoodsat any retailstore,you simplyassumethat youwill leave withtitleto thosegoods. Second, wealso wantstronglytodiscouragetheft. Allowingpossessorsof goods- includingthievesand theirtransferees - totransferbetter interestsinthosegoodsthanthey have encouragesboth theftand acceptanceofgoodsby fences (a fence is a personwhoknowinglypurchasesgoodsfroma thief). Youwillnoticethat thesetwo principlesare countervailing.If we adoptrulesthat fosterthe free transferoftitle, thenwe may encouragetheft. If we undulylimitthe abilityof sellerstotransfer goodtitle,then we may discouragesales. The provisionsin UCC 2-403 attemptto balancethe interestsof

encouraging sales and discouraging theft. You can decide whether the drafters succeeded in thefollowing two provisions.

• Voidable Title. A seller with voidable title has the power to transfer good title to a goodfaith purchaser for value. Note first that the seller, in this case, has the power, not theright, to transfer good title. When a person has the power to do something, then thatperson may affect other's rights, but also may be held legally responsible for that action.In this case, the seller with voidable title can transfer good title, but can also be held liableto someone else. A seller has voidable title if he acquired goods by a) deceiving histransferee about his identity; b) paid by a check that was later dishonored; c) was to payfor the goods with cash, but hasn't paid for them yet; OR d) fraud. In all of these cases,the person who transferred the goods to the seller did so intentionally; i.e. the seller didn'trob the transferor, burgle the goods or buy them from a thief. One may argue, therefore,that the transferor assumed a share of the risk in this case based on her (the transferor's)decision to interact with the seller. In other words, the voidable title provision places theburden on the transferor, not the good faith purchaser, to deal with the seller. Cloakingthis seller with voidable title means two things: 1) he can transfer good title to a good faithpurchaser for value; and 2) he is legally liable to his transferor for not only the purchaseprice of the goods but also other damages arising from his wrongful conduct.

• Entrusting goods to a Merchant. A person (the entruster) who entrusts goods to amerchant gives that merchant the power to transfer all the rights of the entruster to abuyer in the ordinary course of business (BOCB - 1-201(9) - a good faith purchaser forvalue from a merchant). Think about this one for a while. First, BOCBs cannot alwaysassume they will receive good title when they purchase from a merchant. If the merchantis a thief or a fence, then the merchant has the power to transfer the rights of a thief, i.e.void or no title. On the other hand, if a person with title entrusts goods to a merchant(willingly transfers possession of goods to a merchant - e.g. takes stereo into dealer forrepairs; consigns goods etc.), then.the merchant can transfer the entruster's rights, in thiscase title, to a BOCB. This entrustment provision attempts to balance interests and isbased primarily on the risks assumed by any title holder who entrusts to one who deals ingoods like those entrusted. If a merchant rightfully, negligently or maliciously sells thosegoods, the BOCB receives title. In such a case, the entruster's only recourse is againstthe merchant.

Consider these two examples:

1. You take a very valuable, family-heirloom watch to the jewelry store for repairs. Thejeweler negligently sells your watch to a customer. You later trace the watch to thatcustomer and pursue an action to get the watch back. Will you succeed? Explain.

2. You rent a covered stall at a marina on Lake Murray. The next day you store yourboat in that rented stall. The marina operator, who also sells and services boats likeyours, sells your boat to a customer. You now bring an action to repossess yourboat. Will you succeed? Explain.

,! - •

6ha?_r 2_1- No_

J

Performance of Sales ContractsBreach and Remedies

Chapter 22

introduction

In Chapter 21 we examined performance issues related to title and riskof loss. In thischapter, we will look at typical performance issues in sales contracts and the remedies availableto the parties in the event of breach.

Performance of Sales Contracts

Recall our general coverage of the rights of the parties in a sales contract. Figure 1(identical to Figure 3 in your title and risk of loss outline) identifies these rights.

Figure 1Seller's and Buyer's rights in a Sales Transaction

(General)

Seller's rights Buyer's rightsSeller has a limited right to cure a non- With some exceptions, Buyer has the right toconforming tender of goods (see 2-508) inspect the goods before accepting and paying

for them (2-513)Buyer has the right to reject a non-conforming

tender of goods (2-601 + several othersections)

At some point, the buyer wiil likely accept the9oods (2-606)

In limited cases, the buyer may have the rightto revoke acceptance of _loods (2-608)

1. Buyer's right to inspect the goods - typically, a buyer has the right to inspect thegoods before paying for them. A reasonable inspection provides the buyer theopportunity to determine whether the goods conform to the contract. There are twoexceptions to the buyer's right to inspect before payment: COD (collect on delivery),in which the buyer must pay immediately upon delivery of the goods; and paymentagainst documents of title, in which the contract requires the buyer to pay when a billof lading or warehouse receipt is delivered. That a buyer must pay for the goods inthese two cases before he inspects does not preclude his ability to reject the goods.In COD and payment against documents cases, payment does not necessarilyrepresent acceptance of goods.

2. Rejection by the Buyer - Of course, the buyer will have the right to reject "non-conforming" goods. However, whether a tender by the seller is so nonconformingthat the buyer has the right to reject the entire tender is an important issue. We beginwith the Perfect Tender Rule, 2-601 : Unless otherwise agreed, if the goods or tenderof delivery fails in any respect to conform to the contract, the buyer may 1) accept theentire tender; 2) reject the entire tender; or 3) accept the conforming units and rejectthe rest. Don't allow the Perfect Tender Rule to mislead you. It has manyexceptions: 1) =unless otherwise agreed" - the parties may explicitly (in the contract)or implicitly (e.g. course of performance, course of dealings, usage of trade) agree onsomething less than the perfect tender rule. For example, if the buyer has typicallyaccepted tenders exactly like the one in dispute, then course of _.ealin,qs.will likelyrequire the buyer to accept this one. 2) Good faith - for merchants, good faithrequires that they act in "a commercially rea_Qnable manner." Arguably, attempting

to reject an entire shipment because a small percentage of the units arenonconforming may not be commercially reasonable. 3) installment Ks - 2-514treats each installment as a separate tender for the purpose of determining thebuyer's right to reject. If an individual installment is substantially non-con,forming,!hen the buyer may re!ect lh:al installment. The buyer may not reie¢_ the entirecontract unless a defective installment substantially im,r,=i,_ th9 t,p!U__nf th_ _ntir_contract. For example, a buyer will likely have a better chance of rejecting an entirecontract if the first installment is substantially nonconforming. If the buyer hasalready accepted five installments, but the sixth is substantially non-conforming, thenthe buyer could not reject the contract. 4) defect in manner of delivery -no.___nconformitvis to th_ manner of deliverv, not the goods, then the buyer may rejectthe shipment only if =material loss or delay occurs" as a result of the norlc:onformity.For example, if the seller uses a different carrier or the goods arrive a day late, thenthe buyer could not reject unless he can show that these deviations from the contractcaused him material loss or delay. 5) Seller's ability to cure - Even if the buyer h_sLhe riqht to reject a tender, the seller reserves the riqht to cure - i.e. send aconforming tender with no adverse legal consequences - _ there is still time leftunder the contract to cure; or b) if the seller reasonably believed that the buyer wouldaccept the tenaer, Dut the buye_es not. Please notice the redundancy in b. First,

•if the seller reasonably believes the buyer will accept the tender, then the buyer maynot be able to reject because of course of dealings or some other "unless otherwiseagreed" possibility. Second, even if the buyer does attempt to reject, he must stillgive the seller an opportunity to cure in this case.

3. Acceptance by the buyer - Under 2-606, a buyer accepts goods when she 1)manifests a willingness to retain the goods as tendered (e.g. expresses acceptance,pays for the goods except in COD or payment against documents cases); or 2) failsto reject within a reasonable period of time; or 3) deals with the goods in a mannerinconsistent with the seller's ownership of them (e.g. sells the goods). Under 2-607,acceptance of the goods means 1) the buyer must pay for the goods according to thecontract's terms; 2) the buyer can no longer reject the goods; AND 3, if he hasn'tpreviously assumed the risk of loss. the buyer assumes it upon acceptance.

4. Revocation of acceptance by the buyer - Typically, acceptance of the goods bythe buyer is commercially final, i.e. this places the burden on the buyer to completehis side of the agreement. However, UCC 2-608 allows the buyer to revokeacceptance of goods if 1) the buyer discovers a defect in the goodsi_airs.the value of the qoods, but only if the buyer could not have discovered thisdefect upon inspection; OR 2) the buyer has accepted the goods upon reasonablebelief that the seller would cure, but the seller fails to do so.

Additional Performance Provisions

1. Excuse of the seller because of Impossibility of performance or CommercialImpracticability - Although the common law and the UCC are very reluctant toexcuse a party's performance, both will do so, but only under extreme circumstances.UC._C2-615 will excu_ a seller's performance if 1) some event occurs Rfter contractperformance that renders the seller's performance impossible or commerciallyimpracticable: AND 2_ the seller could not reasonably have foreseen the event at thetime,of_contra_.You_ll,re_all,in',o_r'coger_ _e"of'th'e'E_lst6r-n Aii'lih_e's_and "il___. ............... gGulf Oil case that the court would not excuse Gulf Oil, even after the OPEC oilembargo significantly raised the market price for oil and caused Gulf to lose a greatdeal of money in its contract to provide jet fuel for Eastern.

2. Anticipatory Repudiation I Right to Seek Adequate Assurances of Performance- Under 2-610, an anticipatory rej_udiation is a repudiation of

3

b_efore they become,due. For example, if the seller tells the buyer that the seller willnot deliver the goods in two weeks consistent with the agreed shipment date, thenthe seller has anticipatorily repudiated the contract. Not surprisingly, a_repudiation is a material breach of K. However, NR s must be unequivocal, i.e. clearstatements of a parties refusal to perform when performance is due. Ofte.._either by his state.ment_ nr r_nnd_,,"t,@n,,ivnr,_f_q i _ nive_ the nlhAr qJ_worry, but doesn't anticioatorily reoudiate. Under 2-609, if a party has reasonaf_P..grounds for insecurity because of the other,sides statements or conduc.t J.b.eoM.b.einsecure oarty may demand n writing that the other side provide :___tlrRnt_ nfperformance consistent with the K. If the reeeivino oartv dnf=_n't nrnvide thn_p.assurances within a reasonable period of time not to exceed_3._insecure party may treat that failure as a reoudiation of the K. Two e.g.s: 1) th_=w_ - a seller who equivocates when asked if he's going to deliver thegoods as promised; or 2) the "cash short" buye( - seller learns that the buyer isn'tpaying bills as they become due. In both cases, the insecure party has the right todemand assurances of performance. No assurances = repudiation.

L,,(if__ An International Sale of GoodsV

Although we don't emphasize international sales / leases of goods, it would be worthwhilefor us to examine how these contracts might prompt different issues and rules• In Chapter 21 (p.407), West provides a general guide to these contracts, emphas'z'ng the part'es use of letters ofcredit• West correctly states that letters of credit represent the seller's and buyer's hedge againstsomething going wrong. Sellers desire letters of credit to increase the probability of payment forconforming tenders; buyers desire the letters to increase the probability that the seller's tenderconforms to the contract; In other words, distance and unfamiliarity can influence performance.

An international sale of goods may also prompt different risk and loss and title provisions.However, the UN Conventions for the International Sale of Goods (CISG) provisions for passageof risk of loss and title are very similar to those in the Code, especially in contracts involving

carriers and delivery without movement. _ I'_ re_,p:)_3{lole._ £-ov _'_r_v_-OF" C.,I_ _'7

Breach of Sales Contracts

Based on the Perfect Tender Rule, one may assume that any performance that deviatesfrom perfection is breach. Of course, that is not the case; in fact, the rule has so manyexceptions that you must conclude that a seller or buyer who substantially performs is likelyentitled to contract performance from the other side. So, when is there a material breach of asales contract that would provoke the remedies discussed in this chapter? In general, there arethree types of material breach: anticipatory repudiation; total non-performance when it is due; orsubstantial non-performance. In a sales context, substantial non-performance applies if a buyerrightfully rejects or revokes acceptance of goods (in such cases, the seller has materiallybreached) or when the buyer wrongfully rejects and refuses to pay for goods (in such case, thebuyer has materially breached).

Remedies in Sales Contracts

If you note a strong resemblance between the remedies for sales contracts and those forthe other types of contracts you studied in the Legal Environment course, then you're right.Article 2 remedies in many ways mirror common law remedies. Predictably, the differences arisebecause of 1) peculiarities of contracts involving goods, and 2) Llewellyn's penchant forliberalizing the Code to make it simpler and more modern and to integrate typical commercialpractices. You'll also detect a real symmetry between the seller's and buyer's remedies. Figure2 provides a general view of the parties' remedies in the event of material breach. For ourpurposes, material breach by the seller would include anticipatory repudiation and buyer's rightful

4

rejection or revocation of acceptance of goods (assuming the buyer has the right to reject theentire contract performance). Material breach by the buyer includes anticipatory repudiation,failure to pay for delivered goods, and wrongful rejection.

Figure 2Seller's & Buyer's Remedies

In the Event of Material Breach

Seller's Remedies Buyer's RemediesBuyer's insolvency - 2-702 Seller's insolvency - 2-502

Liquidated Damages - 2-718 Liquidated damages - 2-718Resale damages - 2-706 Cover Damages - 2-712 - J_w_'E.w" _C._

Market damages - 2-708 Market damages - 2-713 _o_-_ wig. _ le..Action for the K price - 2-709 Action for goods - 2-716 _oow_ '_1 _,

Seller's Remedies _ro _e_'- _rwe _q_

1. Buyer's insolvency- If the seller delivers goods on credit to an insolvent buyer, "to ¢3_oY%_k I_u_eYthen the seller has the right to reclaim those goods within 10 days of buyer'sreceipt of them. It is important to note that the seller's claim inthis casesupersedes that of buyer's other creditors.

2. Liquidated damages - If the contract explicitly states the seller's damages in theevent of the buyer's breach, then that "liquidated damages" provision will apply ifthe agreed-upon measure reasonably approximates the actual measure of

seller's damages, p-L_'l_l-_'./ _v_a_eJ v_il} Y_,_- _-._ e_v3(-_',.ce_ (-_V_'-( _,v_. \

3. Resale damages - In a commercial setting, the seller will typically attempt to "}'O0 hi_-- V'I)resell the goods after the buyer's breach. If the seller reasonably resells thegoods (see 2-706(2)), then the seller may recover damages based on theContract price - Resale price + any incidental damages arising from the breach.2-710 defines incidental damages as any commercial reasonable chargesincurred by the seller in stopping delivery, transportation, storage and/orattempting to resell the goods.

4. Market damages - If the seller doesn't resell or makes reasonable efforts to doso and fails, then the seller has the right to recover damages based on theContract price - market price (measured at the time and place of delivery) +incidental damages.

5. Seller's action for the Contract Price - You may recall that the common law- allows the remedy of specific performance in very limited cases. The most• typical example would be a buyer-plaintiff requiring a breaching seller in a

contract for the sale of real estate to specifically perform - i.e. to turn over thedeed. The Code liberalizes specific performance by making it available to boththe seller and buyer. The seller may specifically enforce a K- i.e. bring an actionfor the K price - in two cases: 1) the obvious: to the extent that the buyer has

accepted goods; and 2) if the seller has made reasonable efforts to resell ,_identified goods and fails.

You will note a consistent theme in numbers 2-5 above: each of these seller's remediesattempt to realize the plaintiff/seller's expectations; i.e. to place the seller in the position hewould have realized had the buyer performed according to the contract.

5

Buyer's Remedies (note Buyer'sexpectationremedies in2-5 below)

1. Seller'sinsolvency- If the goodsare identifiedand the buyer haspaid at least partofthe contractpricefor the goods,thenthe buyer,by tenderingthebalance of thecontractprice,has,consistentwith hisspecialpropertyrightarisingfromidentification,the rightto claim the goods. In fact, the.buyer'sriqhtto the ,qoodssu__persedesthat of the seller'sothercreditors.

2. Liquidateddamages - If thecontractexplicitlystatesthe buyer'sdamages in theevent of the seller'sbreach,then that=liquidateddamages"provisionwill applyif theagreed-upon measure reasonably approximates the actual measure of buyer'sdamages.

3. Cover damages - If, after the seller's breach, the buyer covers - reasonablypurchases substitute goods - then the buyer may recover damages based on theCover price - Contract price + incidental + consequential damages. UCC 2-715defines the buyer's incidental and consequential damages. Incidental damagesinclude any commercial reasonable charges arising from inspection, receipt,transportation, storage or.covering the goods. Consequential damages tend to bebuyer-specific in the Code. They include any additional expenses/damages borne bythe buyer because of the seller's breach. However, to recover consequentialdamages, the buyer must demonstrate that the seller could reasonably haveforeseen their possibility at the time of the contract. Examples include lost sales fromother contracts, lost production arising from not receiving a necessary machine, etc.

4. Market damages,- If the buyer doesn't cover or tries, but fails, todo so, then thebuyer has the right to recover damages based on the Market price (measured at thetime of breach andplace of delivery) - Contract price + incidental + consequentialdamages.

5. Buyer's action for the goods - The buyer has a right to recover the goods if 1) thegoods are unique or 2) if the goods have been identified and the buyer has madereasonable efforts to cover, but fails. Obviously, the buyer's ability to recover thegoods depends both upon their existence and the seller having retained them. If theseller has sold the goods to someone else, then the buyer cannotclaim the goodsfrom that third party.

good canI. Inherev_i_,jL,%v_iqt_c(a tCnOiV)

Warranties & Product LiabilityChapter 23

INTRODUCTION (IT'S ALL PRODUCT LIABILITY)

This coverage deals with an important question concerning the sale and purchase ofgoods: What happens when a defect in the goods leads to personal injuries, property damage, orother types of damages for a purchaser, member of her family or even an innocent bystander?We read about cases like this all the time. Currently Merck is defending a multitude of lawsuitsaimed at holding the company responsible for injuries allegedly arising from Merck's sale ofVioxx. Many of us have heard or even joked about Stella Liebeck's claim that McDonald's too hotcoffee caused her terrible injuries (Want to learn more? Here's one look at the _McDonald'sCoffee Case). I suspect most of us have confronted problems with things we've purchased -cars, computers etc. - that just don't seem to work like they're supposed to work. What thesecases have in common is that they all represent claims by plaintiffs who contend that a product"damaged" them in some way. In fact, all these cases fall under the heading of PRODUCTLIABILITY.

It is important to understand that products are sometimes defective and that there areremedies available to those damaged by defective goods. Things can get a bit complicated,because some of these remedies are available under the UCC and others arise from tort law. For

our purposes, here's a handy way of distinguishing UCC from tort cases involving defectiveproducts. Typically, ;tort law appfies to cases in which a defective product causes personalinjury andor property damage, and the UCC applies in what are commonly called productdisappointment cases; i.e. cases in which the product simply doesn't work like itssupposed to work.

The following sections deal with product liability, first product disappointment cases, forwhich UCC warranties are appropriate, then personal injury/property damage cases, to which tortlaws apply.

WARRANTIES UNDER THE UCC AND PRODUCT DISAPPOINTMENT

Warranties - in sales and leases - represent another departure from your commonassumptions about contracts. While they are certainly contract-related theories, warrantiesprovoke performance issues that are different from those you've covered so far. Like always, wewill focus on sales warranties (although warranties for leases are very similar to those for sales).To place warranties in some context, remember our coverage; of performance, including that ofacceptance of goods and revocation of acceptance. You'll r_._all that:revocation of acceptance isoften referred to as a post acceptance remedy, i.e. an atypical remedy allowed after a buyerhas accepted goods. Breach of warranty is also a post acceotance remedy, but unlike revocationof acceptance, in which a buyer has a right to reverse the tra_saction (i.e. give the goods backand get back the purchase price), breach of warranty is more of a post acceptance, expectationremedy, in which the buyer can recover damages based on Lhe difference between what thegoods are worth as warranted and what they're actually worth.

Generally, warranties are explicit or implicit contract terms that provide buyers post-acceptance remedies in those cases in which either the titleor product quality is defective. Wewill focus primarily on warranties of quality, both express w_lrranties and implied warranties.

EXPRESS WARRANTIES (of quality - 2-313)

0ExpressJ,wan:a 0ties,[ar.iselbecau selof_statem ent s;!_'omises'or" descriptions,m ade,',or, •models or samples shown, by the seller. Specifically, 2-3" 3 states:

Any affirmati¢;1 of fact or-promise;De.;cription;

Sample (just like tl'e purcha:,ed goods), orModel (a representatiL'n of the Jurchased goods)

2

made or shown by the seller to the buyer which becomes a part of the basis of the bargaincreatesan expresswarranty that the goodsshallconformto the affirmation,promise,description,sampleor model.

Sellersneedn'tuse wordssuchas "guarantee"or =warrant"to establishexpresswarranties,but mustbe sufficientlydefinitein theirassertionto lead a reasonable buyerto believethat the goodswillconformto the seller'sstatements. Simple opinions(=thiscar drivesreallywell";=it'sbeen a greatcad") or"puffingof wares"("the car is inA1 condition!").arenot expresswarranties. Statementsof fact, however,can be. For example,statementslike "this car has8000 actualmiles"or=thecar hasn'tbeen wrecked"do create expresswarranties. The keytowhetherthe buyer'swordsor actionscreate expresswarrantiesiswhether they become part ofthe basis of the bargain. Basisof thebargaindoesn'tnecessarilymean that the buyer mustrelyon the seller'swordsor actions,but doessuggestthat a reasonablepersonwouldassume that

the goodswillconformto buyer'sassertionsmade or samplesormodelsshown.

How does the Parol (extrinsic) Evidence Rule relate to Express Warranties?

Of course,expresswarrantiesarise onlyif the buyercan prove them. The ParolEvidenceRulecan certainlyaffect the buyer'sabilityto prove thatthe seller made statementsorusedsamplesor modelsto encouragea purchase. For example, if the writtencontract doesnotincludestatementsmade bythe sellerbefore the parties signedthe document,then the buyer'seffort to testifyaboutthosestatementsdependson whetherthey are admissibleunder the ParolEvidenceRule. The good news for the buyer:2-202 liberalizesthe rule a bit. For example,oralstatementsmade by a seller before thepartiessigna writingare admissibleif they are consistentadditiona/terms. Assuminga purchaseagreementstatesnothingaboutwarrantiesordisclaimers,the seller'sstatementswouldbeconsistentadditionalterms. However, if thewritingincludesa warrantydisclaimer(suchas an "as is" provision),then the seller'scomments wouldbeinconsistentwiththewriting. Remember,however,that if the contractstatesthat it is theexclusiveevidenceof the parties'agreement, thenthe buyerwillbe unableto testifyabouttheseller's statements.

You shouldalsorecallthat a buyermay testifyaboutcourseof performance,courseofdealingandusage of trade, notwithstandingthe Parol EvidenceRule. These may, but likelyrarely, supportthe buyer'sassertionof an expresswarranty.

What about statements, promises, descriptions, samples or models made orshown after contract formation?

One mightwonderwhethera sellercan make an expresswarrantyafter the partieshaveformed a contract. The answer is: YES! Statementsetc. m;_de_afterthe contract can become:partof the basis of the bargain based on the Code's modification principles, 2-209. Remember,bilateral consideration isn't necessary to modify a contract for the sale of goods. Therefore, onecan view statement made by a seller after contract formatior, as modifications, not requiringconsideration from the buyer. Obviously, the buyer must pr¢_vethe statements, and another rule,the Statute of Frauds, may also affect such cases. If the oric_nalcontract falls within the Statuteof Frauds, then a modification of that contract would have to be written.

IMPLIED WARRANTIES

As their name suggests, impliedwarranties arise because the law, in thi:_case the UCC,

"=i ' t1_states,that_tbey_accompanyso_sales,_ not,becauselofJexph¢_t_statementsLetc._'oYa_e_seller_,Wewill examine two implied warranties of quality, merchantability _mdfitness, a rel=_tedconcept,state lemon laws, and the implied warranty of title.

Implied Warranty of Merchantability (2-314)

When merchants sell goods, they impliedly warrant that the goodsare merchantable. Tobe merchantable, goods must be fit for the ordinary purposes for which theyare typically used,pass without objection in the trade, or be of average or better quality. In general, this means that,when the sellers are merchants, their shoes must be fit for standing and walking; their runningshoes must be fit for running; their two-ton trucks must be fit to haul loads of up to 2 tons; andtheir food must conform to the eater's reasonable expectations.

A Digression: State Lemon Laws

State Lemon laws'offer protection to new car purchasers who havemade reasonable,efforts but failed to remedy problems with their new cars. These are not warranties, and LemonLaws do not appear in the Code. However, they offer similar, Code-like protection.

Most states lemon laws are the same: they offer a new car purchaser the right to returnthe car and receive the purchase price back if the car is defective and the buyer has made,reasonable efforts to get it repaired. The buyer must notify her dealer of thecar's defects within'the first year of her ownership, accept all reasonable effort by the dealer to'repair the car andcomply with any contract or manufacturer requirement of arbitration or mediation. If all theseefforts fail, the buyer has a right to receive the price paid for the car when she returns it.

Implied Warranty of Fitness for a Particular Purpose (2-315)

The implied warranty of fitness for a particular purpose arises whena buyer relies on theseller to choose goods that conform to the buyer's purpose. For the impliedwarranty of fitness toexist, the seller must know that the buyer is relying on the seller to sell goods that are consistentwith the buyer's particular purpose, and the buyer must actually rely on theseller's expertise inchoosing such goods. The particular purpose can vary from finding a sophisticated cooling fanfor a zoo's marine mammal exhibit to choosing appropriate hiking shoes for a trip up Pikes' Peak.This latter example also reveals the interrelationship between the implied warranties of fitnessand merchantability. To be merchantable, hiking shoes must be fit for hiking. However, toprovoke the implied warranty of fitness, the seller would have to know that the buyer was relyingon the seller to find shoes that would be appropriate for a more ambitious hike - up Pike's Peak,and the buyer would have to rely on the seller's choice. You may also havenoted that the typical_sellermaking the implied warranty of fitness !s a merchant; ,i.e. one who possessskill or expertiserelating to specific goods.

Implied Warranty of Title (2-312).

When they sell goods, sellers impliedly warrant that the buyer will take good title and that,the goods will be unencumbered by any infringement (copyright, patent etc.)or security interest(see Article 9). It may be useful to place the I/W of title in a familiar context: the sale of goods bynon-owners. If a seller has the power to transfer title, then the buyer acquires title. However, ifthe seller does not have that power, then the rightful owner has the right to repossess goods fromthe buyer. In this latter case, the buyer would have the right to recover thepurchase price + otherdamages from the seller because the seller has breached the I/W of title. One other note: theseller can disclaim this implied warranty by using any language to lead a reasonable buyer tobelieve that the warranty doesn't accompany the sale. However, the disclaimers of quality inUCC 2-316 (see next section) will not workl Typically, a seller would have to state thatthere is no warranty of title. And, you may recall that one cannot be a BOCB if she purchases

goods from a pawnbroker.WARRANTY DISCLAIMERS (2-316)

It seems almost contradictory that the Code recognizes this assortment of warranties, butalso allows sellers to disclaim them. If warranties are so important, then whygive sellers thisdisclaimer power? The answer is a bit more complex than tt'¢isexplanatio,1suggests, but the bestway to explain this apparent contradiction is to rely on basic contract principles, especially a

central concept in contract law: freedom of contract. While the Code mayimpose impliedwarranties by operation of law, the parties should be free to agree about whether or to whatextent warranties accompany the sale. You will note that the Code does itsbest to balance thesecompeting interests.

Disclaiming Express Warranties

Although 2-316 tends to "beat around the bush" on this issue, here'sthe deal:'A seller.CANNOT disclaim a proven express warranty. This is the only sensible interpretation of theCode. :Ifa buyer can prove that the seller made an express warranty, but the seller can prove the,existence of a disclaimer, then the contract includes conflicting provisions. ,In such case, thedisclaimer will work against implied, but not express warranties.

Disclaiming Implied Warranties

• A seller can disclaim theJ/W of merchantability but must usethe term."merchantability" in a conspicuous disclaimer; e.g. "Seller disclaims the I/W ofMerchantability..."

• A seller can disclaim the I/W of fitness, but this disclaimer must be conspicuous.

, _;_v_ _) A typical warranty disclaimer will read: "Seller disclaims anyand all warrantiesc_O,_._, including the impliedwarranty of merchantability and fitnessfor a particularpurpose." You will note that this typical disclaimer mentions "fitness" even

_PJ_ .__j(v'_' though 2-316 doesn't require this. For sellers, it just makes sense to disclaim

_8;'-__ _. _.V_e._.__" specifically those I/W s that would otherwise accompany thesale.• A seller can disclaim all implied warranties by including contract language such

_as:These goods are sold =ASIS" or "WITH ALL FAULTS." Actually, any termsthat would lead a reasonable buyer to believe that I/W s don't accompany thesale will work. These two specific terms are the most common.

OTHER WARRAN'f3r ISSUES

A non-exhaustivelistof otherissuesthatmay arise in warrantycasesfollows.

• Notice - 2-607 statesthat, to assert any of the Code's warranties,a buyer mustnotifythe "seller"(thedefendant- see privitybelow).withina reasonabletimeafter discoveringa defect_ This is a categoricalrequirement;i.e. no notice= nowarrantyremedy.

_Of_'-i-_eed _ _(-.v_ow • Statute of Limitations - To assert a warrantyaction, thebuyermust file hislawsuitwithin4 years(5 years inOK) of the timethegoodswere delivered toO Y-- _ P# the buyer:

• Privity- You may recall from your coverage of comracts that privity of contractmeans party to the contract. In general, privity identifies who can be a plaintiff ordefendant in a breach of contract case. In warranty cases, privity, under 2-318,includes buyer plaintiffs and.seller defendants. Other potential plaintiffs includemembers of the buyer's household ar'd guests of the buyer. However, in productdisappointmentcases (i.e. cases with no personal injuries,orproperty damage),the typicalplaintiffisthe buyer. In m(,ststates,potentialdefendantsincludetheactualsellerand oftenthe manufactu,er.

• Damages -,Damages ina breachof warrantyactionincludeexpectationdamages+ incidentalandconsequentialdamages. Expectationsdamages = the

5

difference between what the product should be worth as warranted (typically theK price) - the value of the goods, given their defect. You'll recall that 2-715defines incidental and consequential damages and that a buyer cannot recoverconsequential damages unless the seller/defendant should reasonably haveforeseen their potential at the time of the contract. Finally, just as they candisclaim implied warranty liability, sellers can limit or totally eliminateconsequential damages if the contract includes a conspicuous provision that

doe,soMagnusson-Moss Act - This is a federal sta!ute that regulates writtenwarranties aimed at consumers. Selldrs aren t obliged to make express, written

[ ,v _. " " -/.warranties, but if they do, then M-M applies. For our purposes, you should know

\ 0_1_ / that ifa seller makes a written warranty, then that seller cannot disclaim implied

'x ' _ werranties."_DUCT LIABILITY / PERSONAL INJURIES AND/OR PROPERTY DAMAGE

Warranties are important because product disappointment cases are often far from trivial.Defective products can cause manufacturing facilities to close, crop failures or a total loss ofpotable water because of a faulty valve in a cities' purification plant. You will note, however, thatwarranties can often fall short in providing remedies; especially as they apply to consequential,damages.. In fact, it was, at least partially, the shortcomings of warranties that spawned modernproduct liability law. As you know by now, the term, "product liability," actually describes bothproduct disappointment and personal injury/property damage cases. However, for the balance ofour coverage, I will use the term only as it relates to the latter cases.

First and foremost, you should understand that tort law generally governs the types ofproduct liability cases involving personal injuries and/or property damages. We turn then to tort

law. PrOpel- Ua_tli_ ve_; _DI>6_0v_1 I_qj_ _ovn vl0w c_Kinds of Torts

Figure 1 illustrates the three different types of torts: intentional, torts based on negligenceand torts based on strict liability. All of these are relevant in product liabilityactions, so youshould have a basic understanding of each.

Figure 1

Torts Based on Plaintiffs Obligation to Prove Defendant's Fault

,Intentional Torts Ne_lli_lence "Strict Tort LiabilityRequires Proof of Malice or Breach of a Duty to act Liability imposed without proof

Intent Reasonably of fault

Two fallacies often arise from illustrations like that above. First, grouping torts like thissuggests that one can discreetly choose from among the three. Actually, the gradations of tortare far greater than Figure 1 portrays, There are, for example, varying degrees of negligence, i_o"r- (,1-I-e90__1.1Second, the figure seems to be a continuum based on the defendant's level of fault; i.e. the leftside, intentional torts, suggests more fault than the middle, negligence. This is a bit misleading.Actually, consistent with Figure 1's title, ,the_continuum'has,muchlmore,to,do.withlthelp!aintiffis" "_.burden of proof. It's much higher for intentional torts than for negligence or strict liability. Theburden-of-proof description also helps us understand strict liability. Strict liability is not liabilitywithout fault; it is liability without having to ro_ fault. In strict liability cases, the plaintiff canrecover against a defendant without having to demcnstrate that the defendant acted intentionallyor negligently. Why is this important to us? Becau.. e strict liability applies to a good share of

Joimf _ 58veral bi_loili_/ " whe_m_c i_ a _]_o_p o_-_teFe_e_t'_ e.ac_qi3re_po_ibl6 eo_.a t_;,+ oF f_ 4a_gef, b_¥ t_ pl_.imti fK: camcolleo_

C_llcq-l_ral _o_-ce. : _,vO'rl_vS co_f) 7o_ c_ S]-ill re.CovCw_q_z cow,_v_a_n I_ z

o_-_e_}- side'. F,.,_-,i-l-ive_ d a:-je5product liability cases. Over the last forty years, no area of private law has changed so

• remarkably, affected product manufacturers and sellers so significantly or motivated as manycalls for major reform as personal injury, product liability laws. Although the reasons for thesealmost revolutionary developments are very complex; a brief history lesson offers some insightsabout the current state of product liability law.

Who Should Pay for Product Injuries?

Towards the end of the 1950s, state courts and legislatures were struggling with thisquestion. ProduCt liability law, like virtually all areas of private law,was at that time (and actuallycontinues to be) state law. Although there were certainly differences among the state productliability regimes, most states allowed plaintiffs who were:injured bya defective product to pursueeither negligence theories or breach of warranty theories against the defendant, the productseller. One might conclude that negligence, a tort, was a fairly predictable theory in thesepersonal injury cases. Warranties, on the other hand, seem more applicable to thedisappointment cases discussed in the introduction. However, the Uniform Commercial Codespecifically states that warranties shall be available 'in all product liability cases, including thoseinvolving personal injuries and/or property damages.

In:most:cases;.plaintiffs:did:noLfare weltwith:eithernegligence or warranty theories. Itwas difficult for plaintiffs to prove negligence in many cases, especially against productmanufacturers whose operations were usually far away from the plaintiff. In many product liabilitycases, the manufacturer could demonstrate that its quality control methods were exceptional andthat no one should judge it negligent simply because a single product left its production floor in adefective state. No manufacturer, the defendant would claim, can insure that its products areperfect.

Warranty cases also posed problems for the plaintiff. Although they were strict liabilitytheories - i.e. the plaintiff did not have to prove negligence or any kind of fault against thedefendant - warranties posed different problems for plaintiffs. The first of these problems wasprivity. Many states applied strict privity standards to the plaintiffs' warranty cases againstmanufacturers. This meant that the plaintiffs could not pursue a warranty action against amanufacturer unless the plaintiff purchased the product directly from that manufacturer. Whilemany states relaxed this vertical privity defense allowing the plaintiffs to bring warranty casesagainst manufacturers, most states extended warranty theories to only product buyers andmembers of the buyer's household. Non-buyers who were damaged by a defective product couldnot pursue a warranty claim against the product seller. This came to be known as the horizontalprivity defense.

The UCC also limited the effectiveness of warranty provisions because of the Code'sstatute of limitations, allowance of disclaimers and notice requirements. The statute of limitationsfor warranty actions is four years from the time the product is delivered to the buyer. Warrantytheories, therefore, were not available to those plaintiffs injured by _.product purchased over fouryears before the plaintiff's injuries. Although some courts limited th_ ability of product sellers todisclaim warranty liability in personal injury cases, most courts extended the UCC's disclaimerprovisions to these cases. Finally, the Code's requirement that a warranty plaintiff provide noticeto a defendant so that the defendant can correct the problem posr,d barriers in many personalinjury, product liability cases.

Cloaked then with negligence theories that were hard to prove and warranty theories thatincluded many barriers, plaintiffs often found themselves bearing :he costs of defective products,at least until the case of Greenman v. Yuba Power Products. Yo,Jwill note in this case thatGreenman brought a breach of warranty action against Yuba Power Products.

_reenman v. Yuba Power Product.%Inc.

377 P.2d 897 (Cal, 1963)OPINIONBY: TRAYNOR \

OPINION: Plaintiffbroughtthisactionfor damagesagainstthe r_,tailerandthe manufacturer of a

?

Shopsmith, a combination powertool that could beused as a saw, drill, and wood lathe. He sawa Shopsmith demonstrated by the retailer and studied a brochure prepared by the manufacturer.He decided he wanted a Shopsmith for his home workshop, and his wife bought and gave himone for Christmas in 1955. In 1957 he bought the necessary attacl')ments to use the Shopsmithas a lathe for turning a large piece of wood he wished to make into a chalice. After he had workedon the piece of wood several times without difficulty, it suddenly flew out of the machine andstruck him on the forehead, inflicting serious injuries. About 10 1/2 months later, he gave theretailer and the manufacturer written notice of claimed breaches of warranties and filed acomplaint against them alleging such breaches and negligence.

After a trial before a jury, the court ruled that there was no evidence that the retailer was negligentor had breached any express warranty and that the manufacturer was not liable for the breach ofany implied warranty. Accordingly, it submitted to the jury only the cause of action alleging breachof implied warranties against the retailer and the causes of action alleging negligence and breachof express warranties against the manufacturer. The jury returned a verdict for the retailer againstplaintiff and for plaintiff against the manufacturer in the amount of $ 65,000. The trial court deniedthe manufacturer's motion for a new trial and entered judgment on the verdict. The manufacturerand plaintiff appeal. Plaintiff seeks a reversal of the part of the judgment in favor of the retailer,however, only in the event that the part of the judgment against the manufacturer is reversed.

Plaintiff introduced substantial evidence that his injuries were caused by defective design andconstruction of the Shopsmith. His expert witnesses testified that inadequate set screws wereused to hold parts of the machine together so that normal vibration caused the tailstock of thelathe to move away from the piece of wood being turned permitting it to fly out of the lathe. Theyalso testified that there were other more positive ways of fastening the parts of the machinetogether, the use of which would have prevented the accident. The jury could thereforereasonably have concluded that the manufacturer negligently constructed the Shopsmith. Thejury could also reasonably have concluded that statements in the manufacturer's brochure wereuntrue, that they constituted express warranties, nl and that plaintiffs injurieswere caused bytheir breach.

The manufacturer contends, however, that plaintiff did not give it notice of breach of warrantywithin a reasonable time and that therefore his cause of action for breach of warranty is barred bysection 1769 of the Civil Code. Since it cannot be determined whether the verdict against it wasbased on the negligence or warranty cause of action or both, the manufacturer concludes that theerror in presenting the warranty cause of action to the jury was prejudicial.

Section 1769 of the Civil Code provides: "In the absence of express or implied agreement of theparties, acceptance of the goods by the buyer shall not discharge the seller from liability indamages or other legal remedy for breach of any promise or warranty in the contract to sell or thesale. But, if, after acceptance of the goods, the buyer fails to give notice to the seller of the breachof any promise or warranty within a reasonable time after the buyer knows, or ought to know ofsuch breach, the seller shall not be liabletherefor."

Like other provisions of the Uniform Sales Act, section 1"r69deals with the rights of the parties toa contract of sale or a sale. It does not provide that notice must be given of the breach of awarranty that arises independently of a contract of sale between the parties. Such warranties arenot imposed by the sales act, but are the product of common-law decisions that have recognizedthem in a variety of situations. It is true that in many of these situations the court has invoked the

of warranties,(_iy. Code,§§ 1732 ,_1,735)in,defining.the,defendant,s.liability tllsa es actdefil_!tionsbut it has done so, not because the statutes so required, but because they provided appropriatestandards for the court to adopt under the circumstances presented.

The notice requirement of section 1769, however, is r,ot an appropriate one for the court to adoptin actions by injured consumers against manufacturer_ with whom they have not dealt. "Asbetween the immediate parties to the sale [tile notice requirement] is a sound commercial rule,

.designed to protect the seller against unduly delayed claims for damages. As applied to personalinjuries, and notice to a remote seller, it becomes a booby-trap for the unwary. The injuredconsumer is seldom 'steeped in the business practice which justifies the rule,' and at least untilhe has had legal advice it will not occur to him to give notice to one with whom he has had nodealings." It is true that in Jones v. Burgermeister Brewing Corp., 198 Cal.App.2d 198, 202-203[18 CaI.Rptr. 311], [**'7] Perry v. Thrifty Drug Co., 186 CaI.App.2d 410, 411 [9 CaI.Rptr. 50],Arata v. Tonegato, 152 CaI.App.2d 837, 841 [314 P.2d 130], and Maecherlein v. [*62] SealyMattress Co., 145 CaI.App.2d 275, 278 [302 P.2d 331], the court assumed that notice of breachof warranty must be given in an action by a consumer against a manufacturer. Since in thosecases, however, the court did not consider the question whether a distinction exists between awarranty based on a contract between the parties and one imposed on a manufacturer not inprivity with the consumer, the decisions are not authority for rejecting the rule of the La Hue andChapman cases, supra. We conclude, therefore, that even if plaintiff did not give timely notice ofbreach of warranty to the manufacturer, his cause of action based on the representationscontained in the brochure was not barred.

Moreover, to impose strict liability on the manufacturer under the circumstances "ofthis case, itwas not necessary for plaintiff to establish an express warranty as defined in section 1732 of theCivil Code. A manufacturer is strictly liable in tort when an article he places on the market,knowing that it is to be used without inspection for defects, proves to have a defect that causesinjury to a human being. Recognized first in the case of unwholesome food products, such liabilityhas now been extended to a variety of other products that create as great or greater hazards ifdefective.

Although in these cases strict liability has usually been based on the theory of an express orimplied warranty running from the manufacturer to the plaintiff, the abandonment of therequirement of a contract between them, the recognition that the liability is not assumed byagreement but imposed by law, and the refusal to permit the manufacturer to define the scope ofits own responsibility for defective products make clear that the liability is not one governed bythe law of contract warranties but by the law of strict liability in tort. Accordingly, rules defining andgoverning warranties that were developed to meet the needs of commercial transactions cannotproperly be invoked to govern the manufacturer's liability to those injured by its defective productsunless those rules also serve the purposes for which such liability is imposed.

We need not recanvass the reasons for imposing strict liability on the manufacturer. They havebeen fully articulated in the cases cited above. The purpose of such liability is to insure that thecosts of injuries resulting from defective products are borne by the manufacturers that put suchproducts on the market rather than by the injured persons who are powerless to protectthemselves. Sales warranties serve this purpose fitfully at best. In the _resent case, for example,plaintiff was able to plead and prove an express warranty only because,he read and relied on therepresentations of the Shopsmith's ruggedness contained in the manufacturer's brochure. Implicitin the machine's presence on the market, however, was a representation that it would safely dothe jobs for which it was built. Under these circumstances, it should not be controlling whetherplaintiff selected the machine because of the statements in the brochure, or because of themachine's own appearance of excellence that belied the defect lurking beneath the surface, orbecause he merely assumed that it woutd safely do the jobs it was built to do. It should not becontrolling whether the details of the sales from manufacturer to retailer and from retailer toplaintiff'swife were such that one or more of the implied v,arranties of the sales act arose. (Civ.Code, § 1735.) "The remedies of injured consumers ougi'!t not to be made to depend upon theintricacies_ofthe law of sales." To establishthe manufa¢_urer.'.sab ty, t-was sufficient thatplaintiff proved that he was injured while using the Shop_mith in a way it was intended to be usedas a result of a defect in design and manufacture of whi_;hplaintiff was not aware that made theShopsmith unsafe for its intended use.

The manufacturer contends that the trial court erred in refusing to give three instructionsrequested by it. It appears from the record, however, th=_tthe substance of two of the requested

9

instructions was adequately covered by the instructions given and that the third instruction wasnot supported by the evidence.

The judgment is affirmed.

By adopting a product liability theory that embraced the most desirable elements ofnegligence and warranty, Greenman revolutionized the plaintiff's case. Likewarranty, theGreenman theory was based on strict liability, in this case strict tort liability, but like negligence,this strict liability theory was unencumbered by privily, disclaimer or notice defenses and had atort-based statute of limitations: two years from the time of injury.Within fifteen years of this decision, virtually every state had adopted strict tort liability principleslike those first applied in Greenman, but all states, including California, hadalso refined the rulessomewhat. State courts, for example, had to recognize and apply defenses, not addressed inGreenman. The two defenses most typically adopted by the states were product misuse andvoluntary assumption of the risk of know product defect. Courts generally regarded productmisuse as a misuse by the plaintiff that could not reasonably have been foreseen by the productmanufacturer or seller. Voluntary assumption of the risk of a known product defect requires thatthe plaintiff both have objective knowledge of a product's defect and undertake to use the productnonetheless. We will discuss these two defenses in more detail later. Fornow, the followingtables, Figures 2 and 3 summarize respectively the plaintiff's prima facie case of strict, productliability and the two traditional defenses available to the defendant.

Figure 2Plaintiff's Prima Facie CaseOf Strict, Products Liability.

[Note: this isa generalizationonly. Itmay vary somewhatfromthe rulesof a particularstateat that time.]

Plaintiff Must Prove: Explanation1. thatthe defendantalloweda defectiveproductto Applies to any person/entityin the distributivechain,leave !ts place of business, including the manufacturer, manufacturer of some

component part, wholesaler or retailer. Does notapply to casual sellers like you and me.

2.that the defect rendered the product Rarely poses a barrier to the plaintiff's case. If the_unreasonablydangerous, plaintiff is seriously injured, fact finders might take

this for 9ranted.3. that the defective product caused the plaintiff's Based on actual andproximate causation in tort.injuries

10

Figure 3

Defenses to a Strict, Product_Liability Claim

(circa. 1975)

This is an absolute defense, i.e. if the defendant canprove product misuse, then the plaintiff loses.

=Product Misuse -Product misuse is any use of the product that couldnot reasonably be foreseen by a product seller.Can you think of any such uses? What aboutspeeding while driving? Driving under theinfluence? Using a car battery to pound a nail into aboard?

,Voluntary assumption of the risk Also an absolute defense. While not difficult toof a known product defect understand, how often does it arise?

Current Issues in Product Liability Law

Greenman and its influence provide the antecedents for our understanding contemporaryissues involving product liability law. One can predict that a regime similar to that describedabove would produce far more successful outcomes for plaintiffs than the previous negligenceand warranty regimes. This was so much the case that many refer to the period:between_1963and:=1980 as the:_P-roduct:tiability:Revolution;," and most of those so referring are less thanenthusiastic about that revolution. Rroduct sellers were_especially adamant in their_protestsabout the current state of product liability:laws. They protested the:b§_icidea of-a st-rict:.li._l_ilitytheory;the:availability of_defenses.numerousother problems with thecurrent_regime,.and:eyenthe;fact:that the;states, not the federal'government, werezgoverning this area. The fotlowingannotated outline - with sections introduced with key questions - provides a general overview offour important areas of reform that product sellers have aimed at a product liability regime likethat illustrated in Figures 2 and 3.

What does strict fiability mean in design, packaging and labeling cases ?

You will recall that one of the problems with applying negligence rules to product liabilitycases was that plaintiffs often could not carry their burden of proving the product seller's fault.One of the policy decisions inherent in Greenman and the more pro-plaintiff strict tort liabilitystandard was that the plaintiff did not have to attribute that defect to the defendant's negligence;rather she would have to demonstrate only that the product was defective. This was especiallyimportant in those cases in which the defendant could prove that its quality control standards metor exceeded any legal duty owed under a negligence rule, Of course, no quality controlperformance can eliminate all possibilities of a defect, but demonstrating that it met it legal dutymeant that the manufacturer was not negligent. The application of strict tortliability to thesecases underscored the policy decision to place_the_costs_ef_defecti_erproducts_enrpr_ldct4sellers Iinstead otbuyer because product:s"dll_i_'a_b_tter;economic_poSition _t_h_lO-dses"occasioned by theirsale ofa defective product. According to Ronald Cease, product sellers canassume these costs for less than product buyers.

While strict:tort:might:be anappropriate remedyfor what came to beknown.as,manufacturing defects, i.e. defects arising from the manufacturing process, the remedy posedreal interpretive problems in cases involving design,:packaging:and:l_:belingdefe_cts, often

ll

referred to as generic defects. They are generic because a finding that one product is defectivelydesigned, packaged or labeled represents a finding that every one of these products is defective.The Ford Pinto, Dalkon Shield, Vioxx and asbestos cases provide sobering case studies aboutthe astronomical toll such a finding can take on a product seller.

Exacerbating this problem was the fact that courts struggled to understand what applyinga strict tort standard to generic defect cases actually meant. Does it mean that a product isdefective if the defendant can make it safer? If so, one might argue that all products arepotentially defective. Does it mean that the design, packaging and labeling must be reasonable?If so, this would seem to create a negligence standard.

.Although states still haven't embraced uniform standards for generic defects, most haveadopteda hybrid negligence-strict tort standard for such cases in which the plaintiff must provethat a product's design, packaging and/or labeling fails the reasonable expectations test. In other_vords, a,plaintiff must:demonstratethatthe design; :packaging or labeling does:notmeet.thereasonable expectations:of one who purchasesor:used the_producL_

Why shouldntt:other-forms:of plaintiff's misconduct at least.comparatively reduce:theplaintiffl-s:recove_ry?

In Figure 3, you will note that both of the =traditional" product liabilitydefenses areabsolute. If the defendant can prove either product misuse or voluntary assumption of the risk ofa know defect, then the defendant prevails. What may not be obvious is that these defenses tendrarely to be raised successfully. Consider, for example, what kinds of conduct by the plaintiffrepresent unforeseeable misuse, especially in light of the following facts.

Daly was legally intoxicated as he drove his GM car ona Los Angeles freeway. Because of his intoxication, his

car went out of control and ran into a concrete embankment.When the car hit the embankment, the driver's-side dooropened and Daly fell out of the car. Daly died as a resultof his injuries. Later the evidence revealed that Daly wasnot wearing his seat belt and that the latch on the driver's-side door was defective. Had the latch not been defective,

Daly would not have fallen out of the car and wourd_ikelyhave suffered only minor injuries.

Would you consider Daly's misconduct unforeseeable misuse? voluntary assumption ofthe risk of a known defect? Perhaps the better question is: Why should fact-finders be required toanswer questions such as these? Most would agree that both Daly's misconduct and thedefective door contributed to his injuries. The problems with the two traditional defenses becomeevident in this case. First, some might consider Daly's misconduct foreseeable, therefore notwithin the meaning of product misuse when used as a traditional defense. Second, the twodefenses are absolute and therefore do not consider those cases in which both the plaintiff andthe defective product contribute to the plaintiff's injuries.

Once again, the states have tried to address this problem, but have done so in differentWays. Many have applied comparative fault to these types of cases, but have been ratheruneven about the types of misconduct to which comparative fault applies. Others, like California,have applied a pure form of comparative fault to all types of plaintiffs' misconduct in such cases.Finally, others, such as Oklahoma, continue to apply the two traditional absolute defenses in such

cases. _lI

Are there other substantive points for reform?(How's this question for keeping the number of ?s to 4?)

There are several issues about which state courts have struggled and fi)r which productsellers have suggested the need for reform. Here ;ire the four most important.

12

• Statutes of Limitations - Product sellers claim that 1.hetwo-year (from the time of injury)statute of limitations allows plaintiffs to pursue actions based on their use of old orsometimes very old products. The general aviation industry claims to have been veryhard hit as a result of this law because plaintiffs have often brought actions againstcompanies such as Cessna and Beachcraft for defects the plaintiffs claim exist in planesthat are meant to last for a very long time. In response to this, several states haveadopted what are called statutes of repose for durable (tong-lasting) products. Thesestatutes limit the availability of product liability cases by limiting the time of filing suchactions based on the time a new durable product was first delivered to a purchaser.Congress has also responded by adopting a special statute of repose for general aviationaircraft.

• Non-manufacturer defendants _-Those in the distributive chain who are notmanufacturers claim that they are not legitimate product liability defendants because theyhad nothing to do with the product defect. Many states have adopted laws stating thatplaintiffs can sue only manufacturers unless they can show either that i.) the retailer,wholesaler contributed to or had reason to know of the product's defect or iL) themanufacturer no longer exists or cannot bexeached as a defendant.

• Collateral Sources of Recovery- Product liability defendants also argue that a plaintiff'srecovery should be reduced because of their recovery from other sources such as fromworkers' compensation. Those injured on the job are entitled to workers' compensation,but may also have a product liability case against the seller(s) of the product they wereusing on the jobi

• Damages, especially Punitive Damages - Damage awards in tort cases tend to becontroversial in many cases, but have become particularly bothersome to productmanufacturers, largely because they have such "deep pockets." Of course, ,plaintiffs canrecoverpunitive damages in product liability cases only if they can show malice or intent _by the defendant: However, product sellers claim that the lack of limits for such awardsallow some to be far in excess of what might be appropriate.

Should Federal law Govern this a/ea?

Although this question is a bit beyond the scope of this course, it is an important one,especially in light of over twenty years of attempted federal product liabilityreform by Congress.While Congress has been successful in adopting a few band-aid =reforms" (e.g. the statute ofrepose for general aviation noted above), it has failed comprehensively to regulate this area.Those who argue for federal reform claim that product sellers need a uniform body of productliability rules so that they can compete internationally against competitors who must comply withless rigorous product liability regimes. Opponents of federal reform argue that significant federalpreemption in an area like product liability- an area that has historically been governed by thestates - would be an unprecedented incursion by the national government into a state-regulateddomain. The debate continues.

•

_-.47',e4v,la,rv_v_-ie_ CF_Nt_olbe_.4i4c_Dimed

oisc_a_>i%...

ctoeswt-have % sa,/ "giiness"

Damages-- _c__io_ _ I_ci4e_tal * co_seqw_Hal

Co_. . rrx_s_ vae _egeesb_ _o, seller

_5_7 o _' ] tao _vo_ oF #a_l+req_iv& proof _ irl-fecrl- ,bvea_c_of- dt_'_ +h I

2! -

Chapter 24Introduction to Negotiable Instruments

Welcome to Negotiable Instruments Law! This is new material for most of you. Don'tworry too much about this. There's nothing magic about these things, nor is the law applicable totheir creation, transfer and enforcement difficult. However, there is one important differencebetween the rules applicable to negotiable instruments and those for contracts and sales:negotiable instruments law tends to be more categorical. That is - the rules for determiningwhether a piece of paper is a negotiable instrument and whether the person who wants to enforceit is a holder leave little to the imagination. Knowing these rule, therefore, is certainly as criticalas knowing those in Article 2; however, if you have mastered the rules, thenyou should be ableto answer these questions without determining whether someone acted, for example, "in acommercially reasonable manner."

WHY DO WE HAVE DIFFERENT RULES FOR NEGOTIABLE INSTRUMENTS?

One might assume that basic rules of contract would govern the use of all commercialpaper - contracts, negotiable instruments, letters of credit, financing statements, mortgages etc.In fact, because contracts are virtually always the underlying reason people use commercialpaper, contract law applies directly or indirectly to these transactions. The inspiration for differentrules governing negotiable instruments is the holder in due course (HDC), and the bulk ofArticle 3 deals with whether a person possessing some form of commercial paper is an HDC.

Assignees of Contract Rights to Money

When a person has a contract right to receive money, she can sell that right to someoneelse: The best example of this is when a firm factors (sells) its Accounts Receivable to a financecompany. The seller is an assignor of a contract right to money, and the finance company is anassignee. The assignee has a right to collect that money if the assignor has that right. In otherwords, the assignee of a contract right to-money stands in the legal position of his assignor. If, forexample, the person owing the money - the debtor - has the right to withhold payment to theassignor, then the debtor has the right not to pay the assignee. In such case, the assignee'sclaim would be against his assignor.

Consider the case of Fielder's Oil, a local gasoline jobber (wholesaler) who suppliesgasoline to twenty fast-food/gasoline stores in the Norman area. Typically, Fielder's allows itscustomers thirty days after delivery to pay for gasoline, and, in the interim between delivery andpayment, Fielders claims the right to future payments as accounts receivable. Fielder's may sella share of these accounts receivable to Invest Bank. When payment is due, Invest will seekpayment from the debtors, the Norman stores. Invest's right to payment is the same as that forFielder's, and generally, Invest, the assignee, will receive payment when it's due. However,suppose that Fielder's delivered lower-than-agreed octane gasoline to some of its stores and thatthese stores didn't discover this problem until twenty-eight days after the delivery. Fielder's hasagreed to correct the problem, but cannot do this by the payment date. In this case, thedebtor/stores have a right to withhold payment; i.e. Fielder's has breached. Invest, the assignee,has no right to payment from these stores that received the bad gasoline because Fielder's, thebreaching seller, has no such right. [Note: Let's remind ourselves that in many cases 1)Fielder's will correct the problem as quickly as possible because 2) Fielder's has beenselling to these same stores for a very long time and wish_:s to retain goodwill; therefore,3) the stores may actually agree to pay for the forthcoming good gasoline before it arrives,

Fielder's may reduce the price and/ordefer its buyer_,' obligation to pay and, in eitheror 4)case, make good on its contract with Invest.]

Holders in Due Course

So far, we recognize that assignments o; rights to mo_ey are typical and are governed bystrict contract rules that grant the assignee the seine rights to ,he money as those held by the

assignor. Let's consider another value associated with the ability to transfer these rights -promotion of commerce - and the importance of this furtherance-of-commerce ideal. Privatemarket economies need firms like Invest and other financial institutions andthe cash flow thatthey encqurage. 'Fielder's needs cash NOW. Invest has the cash, but wants some assurancesthat it will get what its bargained for. What if we had some legal mechanismthat genuinelylubricated financial markets by eliminating some of the risks faced by thosewho purchase rightsto money? Wouldn't this encourage the transfer of commercial paper? I hope you answer YES!Well, negotiable instruments do just that because'transfereesof these instruments, like Invest,,can become holders in due course. If Invest had purchased negotiable 30-day drafts or notesfrom Fielder's, taken by proper negotiation, paid value, and acted in goods faith without anyknowledge of defenses, then Invest would have been an HDC andwould have been able torequirepayment from the debtors despite their ability to revoke ac_ceptanceagainst Fielder's.The debtors only claim in such a case would be against their seller, Fielder's, not Invest.

Just as it is one of two principles inspiring the Sale-of-goods-by N0n-owners rules inArticle 2, promotion of commerce is the reason we recognize HDCs, With one importantexception at the end of our coverage, our focus in Article 3 will be: 1) Howdoes one become aholder in due course? and 2) What are the rights of an HDC? You will soonnote another parallelwith our section on sales by non-owners. Just as good faith purchasers forvalue or BOCBs don'talways take good title, I+IDCdon't always win!! Of course, we want to protect HDCs, but we mustbalance their interests against other important goals. In fact, we will see later that an interveningtheft of a negotiable instrument often has the same effect as a theft of goods. Stay tuned.

OUR COVERAGE

We willfocuson thecreationand rightsof an HDC. Afterthat, wewill take a little time toexamine the rightsof all the parties to negotiableinstruments:makers(of notes),acceptors(ofdrafts), drawers(of drafts) andindorsers(of notesor drafts). Fornow, wewill examinetherequirementsnecessaryto becomean HDC and the firstof these requirements.

"l ,, u^_.}( r Eor one to become an HDC, she must:_I _.1 b'Y "_'_ \ ,, Possess a negotiable instrument (see 3-104 et. seq.).

_p/_e'_ _" _ • Be a "Holder" (see 3-201 et. seq.) , _,0,o\__ &yE/ V" _ ° Have taken for value, in good faith, without knowledge ofany defenses etc. {D (-,.P)

oyo'_O_ "t THE REQUIREMENTS FOR NEGOTIABLE INSTRUMENTS

_) :3 ..... -_ Every day, business people confrontexamples of commercial paper. If you ve signeo a_. ^_:_(V_ I_" lease, check, purchase agreement, credit card form or any other printed document, you ve signed\v,_ _a_) commercial paper. Negotiableinstruments are specific examples of commercial paper. The form

" requirements for negotiable instruments allow potential transferees to discern whether the paper<isnegotiable and, therefore, whether they can be HDCs of that paper. UCC3-104 sets out therequirements, but before we examine them, let's look at some examples.

A Promissory Note

principalamount: $ 30fl_O0 Date: 3ept. 15r 1995

FOR VALUE RECEIVED, the undersignedherebyjointlyandseverallypromise topay to the order of

Fidelity Federal Savings and Loan the sumof .30tO00 Dollars ($), togetherwith interest

thereonat therate of 7.5 % perannum on the unpaidbalance. Saidsum shallbe paid in the

followingmanner:

Beginningon October1, 1995, and then on or before the firstday of eachsucceedingmonth throughSeptember1, 2015, borrowsagree to pay installmentsof Twohundredeightdollarsand thirtyfourcents($208.34) to FidelityFederal S&Lorsubsequentlawfulholders.

NI paymentsshan befirst appliedto interestand thebalanceto principal.This notsmay be prepaid,at any time, inwhole or inpart,withoutpenalty.

This noteshall be at theoptionof any holderthereof be immediatelydue and payableupon theoccurrenceof any of the following:1) Failureto make any paymentduehereunderwithinon or beforeitsdue date. 2) Breachof any conditionof any secudty interest,mortgage,loan agreement,pledgeagreement orguaranteegrantedascollateralsecurityfor thisnote. 3) Breach of anyconditionof anyloan agreement, secudtyagreementor mortgage, if any, havinga priodtyover anyloan agreement,securityagreement or mortgageon collateralgranted, in whole or inpart, as collateralsecurity for thisnote.4) Uponthe death, incapacity,dissolutionor liquidationof any of the undersigned,or anyendorser,guarantorto suretyhereto. 5) Upon thefilingby any of the undersignedof an assignmentfor thebenefitof creditors,bankruptcyorother formof insolvency,or bysufferinganinvoluntarypetitionin bankruptcyorreceivershipnotvacated withinthirty(30) days.

In the event this noteshallnot be in default and placedfor cellection, thenthe undersignedagree topay all reasonableattorneyfees andcostsof collection.Paymentsnotmade withinfive (5) days of

due date shallbe subjecttoa late chargeof ]0% of saidpayment.All paymentshereunder shallbe made to suchaddressas may from timeto time be designatedbyany holder.

The undersignedand all otherpartiesto thisnote,whetheras endorsers,guarantorsor sureties,agree to remain fullybounduntilthis noteshall be fullypaidand waivedemand, presentmentandpretestand allnoticesheretoand furtheragree to remain boundnotwithstandinganyextension,modification,waiver, or otherindulgenceor dischargeorrelease of anyobliger hereunderorexchange,substitution,or releaseof any collateralgrantedasseeudty for this note.No modificationor indulgenceby any holderhereof shall be bindingunless in writing;and any indulgenceon any oneoccasionshallnot be an indulgencefor any otheror futureoccasion.Anymodificationor change interms, hereundergrantedby any holderhereof, shallbe validand bindingupon eachof theundersigned,notwithstandingthe acknowledgementof any of the undersigned,andeach of theundersigneddoes herebyirrevocablygrantto each of the othersa powerof attorneyto enter intoanysuchmodificationon theirbehalf.This noteshall be construed,governedand enforcedinaccordancewith the laws of the State of Oklahoma.

_'m _c_oo_ SuzanneRazook

Be_ower Bo_ower

This note is an unconditional promise by the makers (Razooks) to pay a fixed

amount of money ($30,000 + stated interest, payable in installments), payable at a

definite time (240 installments, beginning on October 1, 1995) and payable to the order of

Fidelity Federal S&L.

A Check

Nim Razook 2059I t II CurmudgeonLaneNorman, OK 73019325-5529

Dale 3-17-05Pay tothe orderof O'Conl_[['s lrlsh_b $ 300o

rI_'rtydollarsand"q l OG....................................................................................................... Dollars

First Bank of NormanNorman, Oklahoma 73070-7777

For Meals- nogreen beer _im _azoo_

A check is a demand draft in which the drawer (Razook) orders the drawee (First

Bank):topay a payee (O'Connells). In the context of 3-104, checks are unconditional orders

to pay a fixed amount of money ($30.00), signed by drawer, payable on demand and payableto the order of O'Connells.

A Trade Acceptance (source: Clarkson et al. West Business Law, 10thed. p. 481)

Tulsa. Oklahoma March15 2007

To D&F Clothiers,Inc.

On June 15, 2007 Pay to the Order of MidwestemStyleFabrics

-FiftyThousand and no - Dollam $- 50,000

The obligations of the acceptor hereof arise out of the purchase of goods from the drawer. The drawee mayaccept this bill payable at any bank or trust company in the United States which drawee may designate.

Accepted at Blackacre,New York on March 15. 2005

Payable at Bankof Blackacre

Blackacre,New York MidwestemSMe Fabrics

Buyer's Signature D&F Clothiers,Inc.

ByAgentorOfflcer _TotlI Smi_/ V.P. By J'oe J'o_e,._¢ /o/'es.

.A trade acceptance is an unconditional order (draft) by a drawer (Midwestern/Joe

Jones) directed at the drawee (D&F/Tom Smith). The drawer (typically the seller in acontract for the.sale of goods) is ordering the drawee (typically the buyer) to pay thepayee (Midwestern) at a definite time in the future. Notice that,the drawer and the payeeare the same "person." Notice also that, for-this instrument to work, the drawee must,"accept" it. While this may seem mysterious to you now, it will not be after we cover theliability of acceptors later. For now, please note that a trade acceptance meets therequirements for negotiability under 3-104. Now we can examine these requirementsmore thoroughly. Figure 1 sets out the requirements for negotiable instruments andsome explanations.

Figure 1

,_legotiabie Ir_struments 3-104 Requirements

Requirement ExplanationNothingon the papercan makeit subjectto

or governedby the termsof anotheragreement or someone'sperformance.The paper can allude toor be "as per"

another agreement. Identifyingcollateral'Unconditional; securing the payment or fundsfrom which it

will be paid is also OK. A term such as_"subject !o all implied orconstructive "_ '_A}_ '_IUO_A$ )

conditions is also OK (because all neg./ _VlCLCeJ3_lv'_instruments are subject tothese conditions)"P_romiseor order. ,Promise =Notes;Order = draft _ t_o._ -_ _i (._1

Money must be a lawfulmedium of e..X_'_pIc o-F,_,exchange. Fixedamount- general rule: _Y_,.c}-i_ a CPeC_should be able to ascertain paper's value

,Topay a fixed amount of money by examining it. Fixed orvariable interest --,._._ I

is OK. Installments are OK. Acceleration\ ....clause and amount includescosts off) r_,Y--d.._ n3-_vu_v_ev'_r

collection & attorney fees" OK./ r_oYc.If the paper doesn'tspecifyadefinite time _P_._iva _ I C.for payment, then it is likelydemand paper

(i.e. payable upon presentment). To bepayable at a definite time, the paper must

state that it is payable on or before a stated,Payable at definite time or on demand ,date. Extension dates OK: if holder can

extend, date needn't be specified; if makercan extend, date must be specified.

These are "the:magicwords ofnegotiability." They're:notonly required,

cPayable to order dr to bearer but also influence further negotiation. Ingeneral, the paper must bepayable to the

"_V3e._ WOYO{5 l_YOr_o-_C -_r_KL_'_-CV- orderofX, to Xor his order,or to bearer. If

2,_1"I i'_ _paperis payable to the orderof bearer, it'sbearer paper. If it's payableto cash, it'sbearer paper.

_heiMaker, isithe,promisor._0_aj_lp_E. The_l_the_persoh'_d_denng_-'*_f"d rawee_to

Signed by the Maker or Drawer pay in a draft. Please use the termspropedy.

This is not an exhaustive coverage, but will probably get you by. P_ease refer toyour text for additional coverage.

Chapter 25Transfer of Negotiable Instruments

Holder in Due Course

In our quest to create and define the rights of a holder in due course, we must examinehow properly to transfer negotiable instruments such that our possessor is a "holder." Onecannot be anHDC without being aholder. In general, one becomes:a holder by cl;)taking by_proper.execution (i.e. a payee is a holder);c2):taking:by negotiation (subsequent possessors canbe holders); or;3) possessing:'_bearer" paper. These are not self-explanat0ry concepts, so don'tbe alarmed if you're somewhat puzzled now. At this point, please note: ordinary transfers ofcommercial paper - e.g. contracts, negotiable instruments etc. - cloak the transferee with at leastthe status of "assignee." Although ordinary assignees (like Invest, our purchaser of accountsreceivable in Chapter 24) aren't HDCs, they can enforce their contract rights in most cases.However, HDCs can enforce negotiable instruments in virtually all cases. The last part of thisoutline addresses how a holder becomes an HDC.

HOLDER BY PROPER EXECUTION

If I write a check to O'Connells and deliver it to an O'Connells employee, then O'Connellsbecomes a holder of that check. In other words, proper:execution:of a;negotiable:instrument.enables a named payee to become a holder. {lf-there:is:no named'_ayee, but:the instrument ispayable.to bearer; then any:possessor:of-that instrument-.evena thief -_is-__h61der_From thesetwo statements, you should infer two things: 1) Being a holder doesn't make you an HDC! In fact,,generally:payees are not HDCs because they've dealt directly with the maker or drawer and knowof potential defenses (HDCs must have no notice of defense). Later we'll discuss how holdersbecome HDCs. 2) Even now, you should sense that bearer paper is:risky. While thieves ofbearer paper certainly can't be HDCs, they can be holders. This will become more meaningfullater when we examine HDC creation and status.

HOLDER BY POSSESSION OF BEARER PAPER

,Any_possessor of bearer paper, including a thief, is a holder. Although the fullconsequences of this statement may not be evident now, you may already have some feel for the iconcept and riskiness of bearer paper. For example, did you ever wonder why retailers whoreceive checks immediately stamp the back of the check with a "for deposit only':, as opposed toa simple signature, indorsement? As we will discuss later, such a statement protects the retailerin the event the checks are stolen.

HOLDER BY NEGOTIATION

By definition,:negotiationJs the trad_fe¥ (Sf_ r_gotiable:instrument in such a way:that the.transferee becomes a holder. As we've already seen, negotiation isn't the only way one canbecome a holder. However, negotiation is especially important because subsequent transferees- those who take the instrument after execution - typically take by negotiation. Like the rules fornegotiable instruments, those for negotiation are categorical and crucial. In fact, any_breakin,the chain of negotiation such that a possessor.is:not _.holder eliininates_the:potential forany subsequent possessor to be_an:HDC/H

The categorical rules for negotiation depend on whether the paper is bearer or orderpaper. The rules and some applications follow.

ql• Onecan.negotiate bearerpaper.by=simply_deliveHng that paper_to

,the transferee.

• Onecan negotiate:orde[ppper.onlyby:indoi'=sing and:defii/ering the,paper to the transferee.

You will note that the three examples of negotiable instruments in your notes for Chapter24 - the promissory note, check and trade acceptance - are payable "to the order of" namedpayees. These, therefore, are all examples of order paper, and each requires an indorsementand delivery for proper negotiation. So, if Fidelity Federal S&L wants to negotiate the promissorynote, it must indorse that note and deliver it to its transferee, Second Mortgage. By doing this,FFS&L has properly negotiated the note, and 2dMort has become a "holder" of that note. If,however, the note had been payable to bearer (e.g. =wepromise to pay bearer" or =wepromise topay FFS&L or bearer" etc.), then FFS&L could properly have negotiated the note to 2dMort bydelivery alone - no indorsement would be necessary.

Indorsements and their Effect on Subsequent Negotiation

That a negotiable instrument begins as order or bearer paper doesn't mean that it retainsthat:characteristic throughout its life. How one indorses a negotiable instrument affects its statusas order or bearer paper.

Blank and Special Indorsements

There are several different types of indorsements, but the two most important are blankand special indorsements. A:blank indorsement consists simply of the indorser's (transferor's)signature_ When you put your name on the back of a paycheck before depositing it, you areplacing a blank indorsement on the check. A-special indorsement identifies the indorsee(transferee) and includes the indorser's signature. For example, if I have a paycheck payable tomy order, but wish to cash it at Buy For Less, then a special indorsement might look like this:

PayBuyForLessNimRazool_

Whether an indorsement is blank or special - all indorsements must be one or theother - determines how one further negotiates the paper. Two more rules:

• A_blank indorsement converts orderpaper to bearerpaper andallows bearer paper to retain its status as bearer paper.

• A special indorsement coverts bearer paper to order paper andallows order paper to retain its status as order paper.

Don't make this more complicated than it is! These categorical rules are important, butare easy to apply. For example, assume that Henry Cheeseman, makes a check payable to theorder of Nikki Nguyen. Nikki negotiates to Haeran Park, who negotiates to Vivian Chou, who thennegotiates to Linda Matsuhara. The back of that check mi$1htlook like this:

Pay to Haeran Parl_

Nik_i 9_guyen[Note: This is a special indorsement. TO negotiate the check, Haeran must indorse and deliver it

because a special indorsement allows order paper to retain its status as order paper.I

Haeran Park[Note: This blank indorsement converts order paper to bearer paper.]

Pay to L/nda MatsuharaVivian Chou

[Note: Vivian didn't have to indorse this paper to negotiate it. However, her special indorsementconverted bearer paper back to order paper, if I.Jnda wants further to negotiate the paper, she

must indorse and deliver it to her transferee.]

3

Our in class exercise using special and blank indorsements will helpyou understand andapply these rules.

R_-st_ictiveIndorsements

By definition, a;restrictive indorsement purports to limit the furtheLtransfer of a;negotiable instrument.. For example,

PayonlyHaeranParViki 9guyen

at least suggests that Haeran Park will be the last transferee of the paper and that he mustpresent the check for payment. The:Code discourages restrictive indorsements like this bystating that such indorsements typically do not restrict further transfer or negotiation. IfHaeran Park wishes further to negotiate the paper, he may do so, and subsequent possessorscan be holders. The Code limits the application of restrictive indorsements because it wishes toretain the negotiable intent of the executing party - the maker or drawer. If they were willing to bebound to further transferees, then why should a holder down the line be ableto restrict this?

There:is-oneimportant:exception to the:r01ethat restrictive_indorsements:donot limit:the_,further_negotiationof negofiable:instruments_ if:one:indorses a check

For Deposit Only ',I

/Vim Razook ;j

,then the indorser,-Razook;-is-li_itir'_gfurther:negotiation:to.the c!t]eckcollection process. Banksand check clearinghouses can properly negotiate the check within that process, but no one elsecan be a proper holder of the check. At this point, you should be prepared to draw two importantconclusions: 1) simply indorsing your check in blank is risky because that blank indorsementconverts the check to bearer paper, and a thief- i.e. a possessor of bearer paper - can be aholder (can possibly transfer to an HDC!!); and 2) a "for deposit only" indorsement protects apayee or subsequent holder of a check from this prospect because this restrictive indorsementlimits negotiation of the check to the collection process.

Qualified-Indorsements

,_:qualified:indorsementamounts to a disclaimer:of the indorser's liability:under 3-415. Ign_general;an-indorser promises to pay on the instrument that she indorsed ifa holder presents theinstrument for payment;:but the Maker (note) or Drawee (draft) refuses to pay. An:indorsement;

NimRazook

Without_recourse

_effectivelydisclaims this liability. However,_.atransferee for value of ordet_paper has-the rightto the unqualified indorsement of the tFansferor. Therefore, if the paper is order paper inRazook's hands, then his transferee for value needn't accept the qualified indorsement.

A FINAL COMMENT

In our typical case, one executes a negotiable instrument in paymentfor something. Theholder of that instrument has taken by proper execution and wishes further to negotiate the paper.That holder and her transferee understand that negotiation is crucial because the transfereewants to become a holder and, ideally, an HDC. The rules for negotiation are simple andcategorical. One negotiates order paper by indorsement and delivery. Onecan negotiate bearer

4

paper by delivery alone, although she can indorse that paper if she wants. The manner ofindorsement, as we've seen, affects how properly to negotiate the paper further. Finally, abreakdown in negotiation breaks the chain of negotiation. In such a case, no subsequentpossessor of the paper can be a holder. So,_ifyou possess order paper, and someone steals that.

'-paper from you and forges your indorsement, then that theft breaks the chain of negotiation andno subsequent possessor can be a holder. This is so because a forged signature is whollyinoperative as that of the person whose name is signed. No proper indorsement - Nonegotiation.

HOLDER IN DUE COURSE

Ouraim has been to create and determinethe rightsof an HDC. So far, we know that an,HDC-mustpossessa negotiableinstrumentand be a "holder."_Fora holderto be an HDC, she,musttake the negotiableinstrumentfor value, in good faith and without notice of anydefenses (See UCC 3-302). Let me again remindyouof the similaritybetween theserequirementsandthoserequiredto becomea gfp for v and BOCB. The followingsubsectionsdiscusstheserequirementsmore fully.

Takingfor Value

One cannotbe an HDC unlessshe paysvaluefor thenegotiableinstrument; Under UCC3-303, one gives value only to the extent that she has actual/y performed the agreedconsideration. As you'llrecall, one mustgive considerationto forma contract. To-become an'_HDC,however,one mustactuallyperformthe consideration- i.e. executorypromises(promisesmade, but notyet performed)are consideration,butare not value under3-303. For example, if Ipromiseto pay you$900 for a note payablein sixmonths,I haven'tgivenvalue. And, if I learnofsomedefense associatedwiththe note before I actuallypay the $900, then I can't be an HDCbecauseI haveknowledgeof defense before I meet the value requirement.

,Valueneedn't behind,money- i.e. it can be any performed consideration; however,occasionally a question arises about the extent to which a giver of value can enforce as an HDC.Ingeneral; the agrded and performed consideration must bear some reasonable re!ationship tothe actual value of the negotiable instrumenL For example, if I've paid the agreed considerationof $400 for a $1000 note, then, one might argue, I haven't given sufficient consideration and maybe able to enforce as an HDC for up to, but not above, $400. You may also note that myagreement to pay only 40% of the face amount of the instrument suggests that I may know aboutsome defense that provokes me to pay such a modest amount.

One also gives value by 1):paying with a negotiable instrument (e.g. actually giving anote or check in payment for the n.i) or 2)by canceling an existing debt. If, for example, I cancela $900 debt you already owe in return for your transfer of the $1000 note, then I have given valuefor the instrument.

T_kih-_i_ Go0d Faith.

,Goodfaith means-honestyin fact. Ingeneral, a holdertakes a negotiableinstrumentingoodfaith if she has actedhonestlyinall aspectsof the acquisitionof the negotiableinstrument.As statedabove, especiallydeep discountssuggestproblemsinthe n.i.'s transferand raisedoubtsabout the transferee'sgoodfaith. Also, thosewho acceptn.i. s from businesseswhohave recordsof questionablebusinesspracticesmay lack the essentialgoodfaith necessarytobecome an HDC. 9i

TakingwithoutNotice-bf Defenses etc.

To become anHDC, onemust not knowor have reasontoknow ofany defense that a,party to the instrumentmay beable to assert, These includeany contracting defenses or notice,that the instrument is overdue, has been dishonored, has an unauthorized signature or has been

altered, For example, assume thatMary signs a one-year note in payment for a car shepurchased from Peter. Peter negotiates the note to Harvey who pays valuefor the note, butknows that Mary is experiencing difficulties with the car and has filed an action to revokeacceptance of the car under the state's Lemon Law. In this case, Harvey cannot be an HDCbecause he has knowledge of Mary's, the maker's, contracts defense against her seller andHarvey's transferor, Peter•

,Generally, we charge the holder with notice =f,any reasonable personwould be aware of.the.defenses listed above: For example, if any re'asonable person might detect a possible forgeryor alteration or know that the paper is overdue by looking at the face of the instrument, then thatholder has notice (or at least reasonable knowledge of) of that defense andcannot be an HDC•

CanPayees be HDCs?

Typically,NO!:,Payeestypically.dealdirectlywithmakers and drawers'and are thereforeknowledgeableaboutpotentialdefensesetc. However,considerAlex andSally's case above•Supposethat the payee, Paul,operatesa legalgamblingestablishmentandacceptsthe notesignedbyAlex andSally in paymentfor Alex'sgamblingdebts• Byacceptingthe noteasexecuted,Paul, the payee, becomesa holder. Notice thatPaul has dealtdirectlywithAlex, butnot Sally,who is simplythe cosignerof the note. In thiscase, it is possiblefor Paul, the payee,tobe an HDC, against Sally, theco-makerof the note. Sally'sdefense, fraudin the inducement,isa personaldefense; Paul may enforcethe paperagainstSally as an HDC. [Note: if gamblingisillegalunderapplicablestate law,then bothAlexand Sallycouldassert thereal defenseofillegalityagainstPaul. Of course,then Paul wouldhaveAlex's legsbrokenetc.]

• ,4

RIGHTS OF AN HDc " ' " ; ,

Now that we've created our HDC, let's discuss his rights. An H_DCtakes a negotiable'instrument ¢) free fromother's_laim_ to the instrument (i.e. an HDC has superior title to theinstrument); and 2) free from all personal defenses of those with whom theHDC has not dealt

_dit;ectly• While 1) is self-explanatory, 2) requires some explanation. Personal defense are to bedistinguished from real defenses, defenses assertable even against an HDC: A brief look atpersonal and real defenses and accompanying issues follows.

THE SHELTER PRINCIPLE

Guess what? Sometimes holders who do not meet the requirements for being HDCs canstill assert the rights of HDCs. Cool huh? The shelter principle is largely based on contracts law:an ordinary assignee stands in the legal position of her assignor. The principle states:_a:holderwho takes a negotiable instrument from / after ah_HDChas th_i_h'tS_gf an HDC. If, forexample,Paul, in the facts above, is an HDC and negotiatesthenot_-tdTim, who takes ingoodfaithandwithoutnoticeof defenses, butpays nothingfor the instrument,thenTim 1) can't be anHDC becausehe didn'tpay value for the note,but2) acquires the rightsofan HDC becausehistransferor,Paul, was an HDC.

If youthinkabout it, the shelterprinciplereally isn'tthat revolutionary.Inthe facts above,Paul, as an HDC, couldcertainlyhaveenforcedthe paperagainstSally (butperhaps not AlexbecausePaul dealt directlywithAlex) had he (Paul) presenteditto Sally forpayment• Whyshouldn'tPaul'stransfereesenjoy the same rightto enforce? In fact, manyjustify the shelterprinciplebasedon the fact that it makes paper highlymarketableinthe handsof an HDC (frankly, J

I think.this isquestionable.because.we.don't.knowPaul isan HE)Cuntil someoneraises'thatissue and we litigate to see if he's right).

4_

Chapter 26Rights of a Holder in Due Course &

Liability of Parties to a Negotiable Instrument

These notesfocuson two things. First, itexaminesthe rightsof a holderin duecourse,especiallythosedefensesthat onecan assert againstan HDC. The secondaryintentof thiscoverage isto determinewhat itreallymeansto he a makerof a note,acceptorof a draft,drawerof a draft or indorserof a draftor note.

Personal Defenses

Personaldefenses'- i.e. d_fe_se_h_t effectiveagainst=nHDC - includebasiccontracts.defenses_(e.g,failureof consideration,failureof performanceetc.) and a fewother defensesdiscussedbrieflylater. Notethat an;HDCmustnot:have dealt directly_withthepe_n asserting,the:defenses. In otherwords,,if_an:HDChas:dealtdirectly=with.thatperson,then the HDC is_subjectto.that person'sdefenses. This is consistentwith our assumptionsaboutHDC status.Typically,an HDC is not a partyto the originaltransaction,but rather is a goodfaith payerofvalue for a negotiableinstrumentusedin that transaction.

Real Defenses

HDC's are powerfulparties, but not invulnerable.PublicPolicydictatesthat HDCs besubjectto some defenses. Real:defensesinclude:;

* MiK6rityor other fdrms Ofi_cai_i6ityrecognizedby statelaw;• Illegalityof the underlying:transectionfor whicha n.i. is givenas payment;

• F_-udin theexecution(leadsa partyto signa n.i.withoutknowingwhat she'ssigned);• Dischargeinbankruptcy:proceedings;

• Forgery;-I=_t _• Alteration.

"These realand personaldefensesare notquite as simpleas they appear. For example,fraud:in:the:inducement,as opposedto:fraudin:the execution, isa personal,not a real, defense:FPaudih_theinducementoccurswhena personkrn_vinglysigns:anegotiableinslz_ment;bullsinducedtodo sobecause of someone'sfraud;_If, for example, Alexir=duccshis wife Sally to co-sign a promissorynote basodon Atox'spromisethat the payee is one of hisbusiness creditors,but actually the payeo opuratosa legal sportsgamblingoperationand Alexispaying debtsbasedon lostbats, then Sallyis the victimof fraud in the inducemenL An HDC of tJlatinstrumentis notsubjectto Sally'spersonaldefense,fraudin theinduc_,mcnt Fraudin tho executionis ram andbased on onesigninga negotiableinstrumentwithout knowingor havingreasonto knowwhathe's signed. You may notethat all of the.real defensesare fairlyrare and basedon strongideasof publicpolicy- they are notthe typicaldefensesthat ariseagainstHDCs.

Fr_4 _, -H_ E_¢c,_o_ i $ alw_o,s. i_po_,_it:,le.. "to S_c_IIF_.II_/ cJalv_ - H: ,/o_

TheF:FC'sHDCRule -_ [Fit- w,=_$ (_ <lv_o-P_pj_ t;I,v_a_P_ _ _;o_o_¢_._TheFe_l_raI-TradoCon_dssio_lhasessent_a|lyeliminatddHDCstatus n consumer credit_' J:_._- :_O_-

tTansact_ot_.NI caramercialpapor used:i_:coi_umer-cn-_dit4]'ansac'dons---transactionsinwhich _o_.,lro ._|_v_c°nsumers*a-._-,_purchasing_/¢financi-ng'f°r'----_Pe_--s°_l---,,i'._h°useh°ld_u'-%e.--must'include_a_--.,_.-_, _ _ __-,.._ _- • ststcmen-t, ia(- 'ql_alerting,subsequ_'_"_e_s of,_"_ _r__,te,the,lbg _tB, c'l_dfn-_sand_defer_sestt_t a consumer/signormighth_ve (the st,_uam_r_t8pWasr_on p._ i,_We_ BL).Whon youmad the statement,youwill realize that any transferee.of-paperwithsuchlanguage:wilLrlotbecome:an.HDC.-

The FTC's adopteditsHDC Rule after studies revealedthat Ioo manyunscrupuloussellerswere requiringconsumerbuyersto signnegoti-,yJoleh_sttumcmts,especiatlytim_ notes, andthen sellingthat paper_to01irdpartieswho oftenbecame HDCs. Consumerswere havingto pay

HDCs for bad goods or services, and often they could not assert remedies against their sellersbecause the sellers would move, shelter their assets etc.

LIABILITY OF THE PARTIES

In this brief section, I will discuss the liability of the principle parties tO a negotiableinstrument. Although some of the terms may be new, the underlying concepts are pretty basic.

First, we'll discuss four parties to a negotiable instrument: maker, accepter, drawer andindorser. Each of these parties has either primary or secondary liability. Makers,ofinotes, andAcceptors.of, drafts have,primary liability. A_personwith primal,liability must pay.uponpresentment of the instrument to them. If the instrument is payable some time in the future, thenpresentment must beat that time. ,Drawersandlndorsershave.secondarpliability. ®newithsecondary liability isn!t obliged to pay until the instrument has been presented for payment,dishonor has occurred and the secondary party is notified of that dishonor: Figure 1 identifies theparties to a negotiable instrument, sets out the type of liability they assume and provides anexplanation.

Figure 1

Party Type of Liability Explanation O_'\'_ _,_

Amakerpromises topay the payee or any(subsequentholderupon presentment;i.e.

whenthe holderpresentsthe notefor V_P_,_Maker (promisorof a note) - Primaw payment. Obviously,ifthe note is "time" .1¥/%_

pPa_,li._t_,aj _ _ paper, thenthe presentermustwait untilthat ._t'_'/_ --,_ O_

time.,An_acceptorof a draltassumesprimarily q_lr_

,liabilitywhen they promiseto pay on a dra4t; _V"'__Onlya drawee can be an acseptor. If, for d Vt'___,..I \_'example, I writea checkpayable to you, take -- .. \_'Y Ithe check to my bank,and ask the bank to _1 ocertifythe check,thenI am asking the ' _1_,,,drawee/bankto acceptthe check; i.e.

,Accaptor(a draweewho promiseto pay onthatcheck. The bank ispromises Primary: notobligedto certify,but if it does, then it is

to pay ona draft) promisingto pay youor any subsequentholderwhen you presentthe check forpayment. A betterexampleis the ttadaaccet_tan_ We willdiscussitin class.When youwritea check,you're a drawer.Whether youknowitor not, you are notobligedto pay on thatcheck unlessa holder

! presentsthe check forpayment, the draweeDrawer (of a draft) " Seconda_ bank(your bank) refusesto pay, and the

¢1_ ,¢=m_,¢_ ,ill _, _ holdernotifiesyouof the dishonor.A,personwho indorsese n.i. is obligedtopay on,theinstrument- note or draf_-butonlyafterthe holderpresentsthe instrument,forpayment(to the makerof the note ordraweeof the drafl);the nJ. is dishonoredand the presenternotifiesthe indorserof the

Indorser(ofa note ordraft) 9econda_< ,dishonor. Remember,an indorsement_U'io_trrC=;_u_ (quaifiei:l=i_ldoraement) I_relievesthe indorserof this secondaryliability. . -

_ <,ow'1¢5ac.,-Hv_

So, considerthese examples.

1. Marionsignsa 90-day notepayableto the orderof Penelope. Penelopeindorsesthenoteandtransfers itto Henryetta. When the noteis due, Henryettapresentsthe notetoMarionfor paymenLbut Marionrefusesto pay. Henryettanow hasa claim againsttheprimaryparty,Marion,basedon his refusalto pay,and againstPenelope,the indorserwith secondaryliability,assumingHenryettapromptlynotifiesPenelopeof the dishonor.

2. You drawa checkpayableto the order of Olive Oil. Olivedepositsthe checkinto hercheckingaccount,but findsout later that yourbank hasdishonoredthe check becauseofinsufficientfunds. Olive'sbank removesthe creditto heraccount,leavingOlive to dealwith the problem. Olive'sonlyrecourseisagainstyou, the secondaryparty. Yourobligationas a secondarypartyarises becauseOlive presentedthecheck for payment,itwas dishonored,andshe notifiedyouof thatdishonor.

Primaryandsecondary liabilitiesare examples.ofsignature liability, i.e. liabilitybased _0w_.ai

on a person'sdecisionto signas oneof the partiescitedabove. You shouldknow that anyone _ra_3_Ya.l_ill'--l_whotransfersa n.i. forvalue also makes transfer warranties to his transferee. Ingeneral, the•transferorforvalue warrants 1) that he has and isb'ansferringpropertitle tothe n.i;;2) that all thesignaturesare valid(i.e. there are noforgeries);3) that there are no materialalterationson then.J.;and4) the transferorisn'tsubjectto any defensespossessedbyotherpartiesto the n.i.Even those whoproperlynegotiatebearer paperbydeliveralone make thesewarranties andcanbe held legallyresponsiblefor theirbreach.

Pa,/ec.

pyim. Liat_

-) Pae8

[ /1"

I

I _ •

'_, Checks and Electronic Transfers: BankCollection_-and DepositsAlso: An Integrative Forgery & Alteration Exercise

Chapte@

INTRODUCTION

Checks are negotiable instruments and are therefore governed by the basic rules ofnegotiable instruments law. However, a check is a specific type of draft in which the relationshipbetween the drawer and drawee- the drawee is always a bank or_some otherfinancial institutionJiS an important and well-developed area of law. For most of you, ATM anddebit cards havedisplaced checks as more efficient means of transacting business. Checks nonetheless continueto be important, especially in commercial settings. While ATM and debit cards are not negotiableinstruments, they have one important characteristic in common with checks: they rely on a well-defined legal and contractual relationship between a depositor and her bank. This relationshipand some of the variations it provokes are the focus of these notes.

DEPOSITORS AND BANKS

When you set up:a checking account or acquire anATM or debit card, you arecontracting with the bank. ,You are the creditor, and the bank is the debtor. Essentially, you:and,the bank are agreeing d );that the bank will direct payments acc0rding to your orders; and:2) willcollect on checks.you deposit into your account. It is important to note, however, that yourcontract with the bank is supplemented by a fairly comprehensive body of law; i.e. the UCC -especially Articles 4 and 4A - governs a good share of this relationship. The brief explanation forthis regulatory incursion into the bank-customer contract is that the stakes are high and that a

• , . \ ,.

coherent, balanced and uniform system of bank collections and deposits actually stabilizes the

monetary environment• _v_v_ eY "-) ?a,tec.The Legal Relationship _(_-_ ( Ho,,_e_a¢_ )

I

/

,Drawer-- ........... Drawee '_Customer ................. Bank _r,_We P_

The most important provision governing the relationship between the Drawer and Drawee ' Ph_mda_:_of checks is UCC 4-401. It requires the drawee/bank to honor all properly payable items. Ingeneral, a check is properly payable if the drawer has completed and executed it either to a (_avl'Jr .S_e H_C

payee, herself, bearer or cash (recall that a check payable to cash is considered bearer paper). _av_ _. _-_- _0_The following rules further define the rights and liabilities of the drawer.drawee.

1. An underlying assumption is that the,drawer maintains funds in her account I ) ; -_heq

.sufficient to pay on drawn checks• If the drawer's account contains insufficient ,_id 30 _'_-.F_I_I 7,funds, then the bank may either dishonor the check or pay despite the overdraftand charge the drawer's account.

2. The drawee bank is neither a primary nor secondary party to the check• In otherwords, a payee or holder cannot sue the bank for its refusal to pay on a check

_ _ I _--unless the bank has accepted(certified)the check. (_6'J tOe(.OW_ _. _1(-(ff._ _"OY._3. If a bank wrongfully dishonors a check - i.e. refuses to pay on a check supported'

by sufficient funds - then the bank is liable to the drawer for compensatory and

"_W,5 !_ _ _oe6v_ re._ _CCc_ consequential damages•

_( -H,_c (_3_iCV _ C"WP-¢_._4. A bank is not obliged to pay on an old(stale) check. The bank may consider anycheck dated over 6 months ago as stale and refuse to pay, or it may honor the

_,.._ct_ ,./o_ _a_ _-_v (5_ check if done in good faith. If the bank discovers a stale check, itwouid bewise

(-Ph£. IoawV- ov o(cv.( _-_P_,l'__ to notify the drawer and ask whether it should pay on the instrument. [Note: A

stale check does not typically relieve the drawer of liability on the underlyingtransaction that provoked the check. That is: if you receive a check for $70 froma friend who purchased CDs from you, then your failure to present the check forpayment within 6 months doesn't relieve your friend from contract liability to you.]

5. Abank has the legal right to pay on postdated checks before the date indicated,unless-thedraw_-n-6tifies the bank of the postdate before the check is paid.,

6. The drawer has the right to stop payment on:a check_ An oral stop paymentorder is effective against the drawee bank for 14 days. A written stop paymentorder is effective for 6 months and can be renewed. If a bank fails to honor astop payment order, it must recredit the drawer's account and is potentially liablefor damages.

Electronic Funds Transfers

That we spendless time on EFTs shouldnot diminishtheirimportanceto you. In fact,mostof youhave chosenATMs and/ordebitcardsas preferablemeans ofpayment. In essence,we spend lesstime onthese paymentsystemsbecausethey provokefewer problems,especiallywith collections and deposits. "Ehe:absence:of:a:paper:trail:and:the:accompanying:intermediarybanks_financia_:instituti_ns:means:that:the:pr_cess:_f:c_llecti_n:and:dep_sit:is:m_re:e_icient:andmandates:less:law. EFTs have some problems with tracking and proving collections anddeposits, but many view these methods as far better than check system. The key is tounderstand that the relationship between you, the holder of a debit card, and the bank is exactlythe same as if you had a checking account, except the rules are contracted because of theabsence of paper and the accompanying issues of that paper's transfer both within and withoutthe collection process.

`T:her-e_are_s-_me:specia_:rules:f_r_when:a:debit:card:is:_st:_r:st_en;:these:tend:t_:_imity_ur_iabi_ity_assuming_y_u_a_t_resp_nsibiy:and:reas_nab_y_given_the_cirdu_t_6c`_s_If=yourccardis:lost:or=stolen;:then'-your=financial:responsibility_for~the:card:cannot-exce_-d:$50-_-s-_6_in_0unotify;yoUr_bank:within:two:days:of:learning:of:it..Your liability cannot exceed $500 if you don'tnotify your bank.

CHECK DEPOSITS AND COLLECTIONS

_.Co._!ec_l o _f_ Drawer :==> PayeeU

L_l_t'(_Ce_ $ Depository Bank (_,t_eP__,'3_a_)

Drawee _ Intermediary InstitutionPayor Bank

When a drawer writes a check, she typically does so as payment forsomething. In the(somewhat crude, I'll admit) illustration above, the drawer delivers the check to a payee. Whilethe payee may present the check for payment or for deposit at the drawer's bank (the drawee),the more common situation is for the payee to have an account at a different bank and to depositthe check there. We're now talking about two accounts - that of the drawer with her bank, thedrawee, and that of the payee and his bank, the depository bank. When thepayee deposits the.._drawer's check, the depository bank "provisionallycredits":the payee!s account: A_provisionalcredit-is not final andmay:be-reversedJf the:drawee/Payor refuses to pay (dishonors) the check.Unless there is direct relationship between the Depository and Payor banks, theJDepository;bankwill*transferorhe'check4to_amintermediary_bank=which_willrdirect*themheck4to_th_Pa-_. T,beintermediary_bank_may_beacheck`c_earingh_use_a:Eedera_:ReserveBank_r_just_an_ther_bank_In any case, the intermediary bank will also provisionally credit its transferor's account. Final.

,settlement occurs when the drawee/Payor bank decides to pay on-the check or to dishonor,Obviously, adecision by the drawee/Payor to pay will "firm up" the provisionalcredits for all the_,institutions inthe collection process, tA:decisien:to:dishonor=the:check:means:that:the'provisionalcredits:will:be:reversed.-:)

T.here:are:time:rules,for._each.-of=the:baeks:in:the:coltection:process:to=make;a,decision.about:whether'-to:pay:l:provide:a:final:credit:on:a:check:or:to:dishonor.Eor,"onus" checks - i.e.checks:presented:by_-a:payee:direct_y:t_:the:drawee_P-ay_r:bank;:the:bank:must:decide_na_y:bythe:_pening:f_r:busin_s_s:_n:the:sec_nd:business:_day:aft_r-the:payee:pres_nted:the:check_Eor,_-n_themEchecks_the:bank:(dep_sit_ry:_r:intermediary):m_st:take:acti_n:_n:the:check:bymidnight:of--the:next:banking:day_following:the:banking:day:on:which:that:bank:received:thecheck. If, for example, the depository bank receives a check on Tuesday afternoon, it has untilWednesday at midnight to pay or dishonor the check. If it takes no action by the midnightdeadline, the bank must pay on the check.

Recently, Congress adopted and the Federal Reserve System implemented what arecalled "Check:21._rules,,allowing:banks:to:clear:chdcks:_e_--quickly,typically on the same daythat they are presented at the depository bank for payment..Instead:of:having:to-.send:the:actual.check:thr_ugh:intermediary_bank_:t_:the:Pay_r-_(Drawee):bankT`the:dep_sit_ry:bank:can:sendanetectronic:photograph:of:the:check:to:the:P_ayor,."Fhe:Payor:can:make:the:decision:to:pay:orcnot_qui_k!y;zof_the:same:day:of its_de-p-_it. If you're interested, then see Basics for Check 21.

Why Check:21-?. It removes:the±float;"-'that:time:between:when:the:drawer:executes>(writes and delivers to the Payee) the.check:and:when:itls:actually-paid. The"good old days"when the drawer could write a check on Friday, knowing that he won't deposit the funds to coverthe check until Monday, are basically over.

FORGED AND ALTERED CHECKS

The following exercise involving forged and altered checks will serveboth to bolster yourunderstanding of the bank and customer relationship, but also to reinforce some principles ofnegotiable instruments law. Regarding the latter, remember three importantpoints from ourcoverage of negotiable instruments:cl)a:break inthe chain of negotiation (_.g. a:forgedindorsement of order paper)eliminates the possibility of holder status for anyperson who takesafter that break - i.e. anyone who takes after a forged indorsement of orderpaper cannot be aholder; in fact, that person doesn't have title to the instrument;:2) forgery is real defense; and 3)

,material alteration is a real.defense;Now, consider fourdifferent "improprieties"_concerningchecks:

1. a forged check(which, of course, includes the "drawer's" forged signature);

2. a:forgedindorsement on a check;

3. amaterially altered check (e.g. the amount is changed); and

4. ,ap:unauthorized completion on a check (e.g. the drawer allows the payee to completethe check and the payee does so, but in an unauthorized manner).

We will cover each of these cases. In each, we will ask two questions:

1. If the drawee/payor bank pays on the check, does the drawee havethe right to chargethe drawer's account?

2. If the drawee refuses to pay on the check (e.g. dishonors because the drawer stoppedpayment on the check), then can the presenter recover against thedrawer?

Four cases and two questions ought to yield eight answers. The following table presents thecases, questions and answers. The table offers fairly superficial explanations at times; therefore,your attendance for this lecture is very important.

I

=.

Forged and Altered ChecksArticles 3 and 4 Questions and Answers

_ Forged, _ _ UnauthorizedForged Check. _ ,Indorsement on Materially; Completion of_

(signature) ,Check Altered Check ,CheckNO - The checkisn't NO - Althoughthe YES, BUT ONLY AS YES - an

"propedypayable" drawersigned the TO THE ORIGINAL unauthorized1. If the Drawee under4-401. Under check,a forged TENOR (amount) completionis notthe

pays onthe check, Art. 3, no personis indorsementbreaks OF THE CHECK. same as a matedalcanit charge the_ liableon a negotiable the chainof holders. The Drawee cannot alteration,because

Drawer's account? instrumentunlesshis No subsequent charge the Drawer's the drawer hassignatureappears person,includingthe accountfor the allowed anotherto

thereonandan drawee bank, is a altered amount. _ complete theunauthodzed holderor has title. _ instrumentand mustsignatureis Because of this, the D__I.EP,/_.5-_ assumethe dsk of an

inoperativeas thatof check isn'tpropedy _ unauthorizedthe apparentdrawer, payable,and the _ completion. The

drawer may require _ check, as completed,_dit thedrawer's, the bank to recredit _. is propedy payable

account, his account, by the bank.YES - the drawer is

NO - Again, a person NO - the presenter YES - but only as responsible for the2. If the:Drawee_ is not responsibleon tookbya forged the the original unauthorized

refuses topay on a negotiable indorsement. She tenor of the check, completleo and mustthe check, can the instrumentunless his has neither holder The drawer is not pay accordingto thatpresenter recover signatureappears statusnortitle. Likely responsiblefor the completion. O1

against the Drawer? thereon. Even if she will absorbthe altered amount, course,presenter is HDC, loss if shedealt Recall that forgeryis presenterknew or

Drawer is protected directlywith the a realdefense, ha_rR_(_n to knowby a real defense, forger, usableeven against of the unauthorized

Fov_er_/ i S a YP-_I an HDC. co_.mpletion_thenthis

One additional note before we proceed. Nothing in the table above relieves a person of

liability if his own negligence substantially contributes to the forgery or alteration. Therefore, if'

you know your checkbook is lost or stolen and do nothing about it, then you're potentiallyresponsible for what happens thereafter. At the very least, you could have notified your bankabout the loss or the theft, but did nothing. In such a case, the bank should be able to charge

your account.

There you have it! As an integrative exercise, forged and altered checks remind us ofsome Article 3 rules and how they relate to the Bank - Customer relationship. Before we move

on, consider (or remind yourself of) the effect of forgery and alteration of other negotiableinstruments. For example, a note with the maker's forged signature is ineffective against the

apparent maker; i.e.,forgeryJs a real defense., ,The same is true about a material alteration. Themaker may be liable based on the original tenor of the item, but not on the altered tenor. Finally,

doesn't this exercise lead you to believe that unauthorized completion is a personal, not a realdefense?

/ ,t.00

DaW6 Not'ft. { FrH¢)

$

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With a_ £_r_ed _checr._ ...........

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Secured TransactionsChapter 29

INTRODUCTION

In our coverage of secured transaction, you will learn the basic vocabulary for, thepurpose and typical set-up of, and a few of the statutory priorities arising within, suchtransactions. As you read Chapter 29 and these course notes, think about how securedtransactions might tend to integrate sales and negotiable instruments law.

SECURED TRANSACTIONS: DEFINITIONS AND TYPICAL TRANSACTIONS

Definitions

L/_'_PC_U_ a contract in which a creditor obtains a security interest in

/30_- jk/lj_- the debtor's_"-epe.rsonalproperlY'in return for value - the extension of credit - given to a

_j debtor. The creditor is called the secured party; the debtor is called, well, the debtor; the"t_ L).___1'3DI) I property subject to the security interest is the collateral; and the contract between the securedparty and debtor is called a security agreement. At common law security agreements haddifferent names depending on the transaction. These included chattel mortgages, conditionalsales contracts and pledges. You needn't worry about the first two of these; however, pledges -in which the secured party actually takes possession of the collateral during the pay back period -have survived and continue to thrive in contemporary commercial transactions.

Typical Transactions

Secured transactions typically involve two p,..;:.ies:the secured party and the debtor.However, the transaction often includes an important third party, who may not be a party to thesecured transaction, but has a stake in the transaction nonetheless. Here are some examples.

1. Two-Party Secured Transactions - When:a,bb-_F_fin-aKc-es_the_purchase:ofcpersonal.property- e.g. goods - directly with :her s-elle?,-thenthe partie.fi ha_e.entered into a:,securityJagreement_in..which the:selle_:is_the secured party:and the buyer is the.debtor:During the pay back period, the buyer/debtor is likely paying installments directly to herseller/secured party, and the sold goods are the collateral. If the buyer/debtor defaults,then the seller may recover the collateral to satisfy the buyer/debtor's debt. This is alsoan example of a purchase money security interest. These are important and will beaddressed in more detail later.

SELLER .................. BUYERSECURED PARTY ....... DEBTOR

[SOLD GOODS ARE COLLATERAL]

Another two-party possibility would be a case in which a lender like a bank makes a loanto a debtor, but requires the debtor to give the lender a security interest in personal propertyduring the pay back period. For example, 1't Bank loans Grace Slick $10,000, and in returnGrace gives 1= Bank a security interest in two of her patents with a licensing value of$20,000/year.

BAN_ .CUSTOMER _1SECURED PARTY ....... DEBTOR

[PATENTS = COLLATERAL]

2. Three-Party Transactions- When the buyer finances the purchase of personal propertysuch as inventory or equipment for his business with some party other than his seller, forexample 2d Bank, then you have what amounts to a three-party transaction. The buyer

is the debtor; 2d Bank is the secured party; and the seller, while not a party to thesecured transaction, is significantly involved in the overall transaction because the buyeris relying on the secured transaction with 2d Bank to purchase goods from the seller. Inthis case, 2d Bank acquires a purchase money security interest in the inventory orequipment because 2d Bank is providing the debtor the purchase money so that thedebtor can purchase goods.

SELLER --- GOODS ....... = BUYER-DEBTOR

2D BANK/SECURED PARTY

[The inventory or equipment is the collateral.]

CREATING AND PROTECTING A SECURITY INTEREST IN COLLATERAL

There are two very important questions associated with secured transactions, and theseform the basis for a good share of our coverage. The first is: How does the secured party acquirea security interest in the collateral? This initial goal of a secured party is to secure his interest inthe collateral. By doing so, he has protected his legal interest against the debtor. The second, asimportant goal for the secured party, is to protect his security interest from others' claims.Acquiring a security interest in collateral against the debtor is important; however, others mayalso assert rights against that collateral. It is important, therefore, for the secured party to protectthis claim against the debtor's other creditors. The acquisition by the secured party of a securityinterest in collateral is called attachment. The protection of that security interest from others'claims is called perfection. To understand secured transactions, you must understand both ofthese concepts.

Attachment

Attachment secures the secured party's rights against the debtor. Attachment typicallyrequires three things:

1. a written security agreement signed by the debtor and describing the collateral such

that one can identify that collateral. Exception to the writing requirement: if the i_ -H_--secured party takes possession of the collateral - this is a pledge - then an oral ,,_ c_P_-_v"S _P-.&_"agreement will suffice. [Note: typically the parties use a written security agreeme_ with _y_-tC)fp_.3"(-a pledge.] The description of the collateral may be very specific (see, for example, thesample security agreement below) or general, but, as stated, must describe the collateral.Acceptable descriptions include: equity certificates (e.g. stocks) identified by number,durable equipment identified by make, model and number, "all of thedebtor's inventory","after-acquired inventory or equipment". Note how general the last two items are - theystill identify the collateral, therefore meeting the Code's requirements.

i

A Sample Security Agreement

March 29, 2007

Duane Debtor, 304 Crescent Avenue, Portland, Oregon 90909 (hereinafter called "Debtor")hereby grants to Creative Finance, Inc., 513 Mt. St. Helens Street, Portland, Oregon 90909(hereinafter called the "Secured Party") a security interest in the following property(hereinafter called the "Collateral")":

a 2007 Ford F-150 Pickup Truck VIN FP4320B9071 and a 2005 Cadillac Seville VINGM6789C1205

to secure payment and performance of obligations identified as follows (hereinafter calledthe "Obligations"):

Debtor is to make monthly installments to the Secured Party of one thousand five hundreddollars beginning on April 1, 2007 and on the first day of each succeeding month throughMarch 1, 2008.

Default in payment or performance of any of the Obligations or default under anyagreement evidencing any of the Obligations is a default under this agreement. Uponsuch default, Secured Party may declare all Obligations immediately due and payable andshall have all the remedies of a secured party under the UniformCommercial Code.

Duone Debtor Crea_ Fi_Debtor Secured Party

By. By $i_ _,rs,

2. the secured party must give value. Once again, we're confronted with the concept ofvalue, but in this case, value means consideration. Typically, a secured party gives valueby extending or promising to extend credit to the debtor.

3. the debtor must have rights in the collateral. This usually means ownership rights. ___t..,..(_p_luY•For example, a bank/secured party that finances a retailer's/debtor's inventory does not _acquire a security interest in that inventory until the debtor has title to that inventory. S_"_- _vp__

Therefore, in a shipment contract between the retailer and his supplier, the title would _t_t_'l,-,v_,_-_ '_pass to the retailer when the supplier delivered the goods to the carrier.

Once attachment occurs, the secured party has secured his rights against the debtor, but _Y_" _r_must be concerned about securing his rights against others who may claim some right in the _e ,/-'_v _ ,'J-collateral. We turn then to perfection. , _n_rC_eS_

Perfection 0V_ "_

If a debtor defaults, the secured party becomes vitally interested in his ability to possessthe collateral to satisfy the debt owed by the debtor. Whether the secured party will accomplishthis goal depends not only on his claim against the debtor - obtained throughattachment - butalso on the secured party's rights to the collateral against those with competing claims. IPerfection represents the secured party's effort to protect his rights to the collateral againstothers' claims. Those of you who have studied real property law will recognize the similaritiesperfection has with the filing systems for interests in real estate.

We will discuss four methods of perfection: filing a financing statement, taking possessionof collateral, perfection by attachment as applied to purchase money security interests inconsumer goods and perfection applied to motor vehicles.

1. Perfection by Filing - a secured party can perfect his security interestby filing a financing statement. A financing statement must be written,contain the names of the debtor and secured party, be signed by thedebtor, and include a description of the collateral. Although I will notrequire that you know where to file - it actually varies from state to state- I should point out that the 1999 revisions to Article 9 establish rules forcentral filing for most financing statements - at the Secretary of State'soffice. This, of course, doesn't apply to fixtures - things affixed to realestate like central air conditioning units. Financing statements for theseare filed at the county clerk's office in the county where the fixture isaffixed.

2. Perfection by Possession - If the secured party takes possession ofthe collateral (as in a pledge), then the act of possession constitutesperfection.

3. Perfection of Purchase Money Security. Interests in ConsumerGoods - A purchase money security interest (pmsi) is a security interestin which the secured party finances the purchase of goods - consumergoods, inventory or equipment. The secured party in such a transactioncan be the seller of goods or a lender such as a bank that lends thedebtor money so that the debtor can purchase goods. When a securedparty finances consumer goods and takes a pmsi, perfection occursupon attachment - i.e. the secured party needn't file a financingstatement. [Note: of course, the secured party may file a financingstatement for pmsi s in consumer goods.]

4. Perfection of security interests-in motor vehicles - most states,including Oklahoma, require that a secured party place a written lienentry on the motor vehicle's certificate of title to perfect a securityinterest in that vehicle. A lien entry is simply a statement that thesecured party has a lien on the vehicle.

PRIORITIES I

As you might predict, sometimes courts have to deal with competing claims by creditors,including those between secured creditors. Here are some fairly straight forward priority rules.We'll discuss them more thoroughly in class.

1. Secured creditors trump unsecured creditors. If a debtor has defaultedand/or is in financial trouble, secured creditors have prior claims overthose whose claims are unsecured.

2. For competing secured, but unperfected claims, the first to attachprevails.

= 3. Perfected interests trump unperfected interests.

._For competing perfected claims, first to perfect.

A pmsi in inventory trumps an existing security interest in after-acquiredproperty if the pmsi security interest holder notifies the other security

/_ interest holder before the debtor takes possession of the inventory.

A pmsi in equipment or other collateral besides inventory trumps anexisting security interest n after-acquired property if the pmsi security

P i, aye

interest holder perfects within 10 days of the debtor taking possession ofthe goods.

7. A BOCB trumps any security interest holder in inventory even if theBOCB knows of the security interest.

SECURED PARTY'S RIGHTS UPON DEFAULT: Self-help versus State-imposed repossession.

4

f

I.!

iY_-teveS_ _v_ _v_er.S' CI31mZ

L.S. 4523.001Quiz I

Spring, 2007

41. Assuming each of the following statements is true, which is most relevant in determining whether an enforceable contractexists between a seller and buyer of goods?

-- a. The parties have nothing to document an agreement.b. The parties are both merchants.

d_AS of February 1, 2007, the parties had never dealt with each other before.On February 2, 2007, the buyer rejected a shipment of goods from the seller, claiming the shipment wasnonconforming.

*** On January 17, 2007, Slocum Sales, a retailer of home and garden supplies, received a purchase order from Byron Brisbane, alandscaper. The two parties had never contracted before. The purchase order was a general office form available at any businesssupply store. It stated, in part: "Please deliver no later than February 20, 2007, the following items (the items, quantities and pricesappear in the order) appearing in your January, 2007 catalog. The total price stated in the purchase order was $1289. Brisbaneincluded his email address on the form. Slocum received the purchase order on January 18. [Refers to Question 2_.. Please

_ assume that each numbered question is independent of all others, but relates back to these facts.]

,,_AOn January I8, 2007, Slocum sent an ema/I to Brisbane stating: "We will deliver accor,d,ing to your instructions."ppearing at the bottom of the email was the following statement in all capital letters: SLOCUM SALES RESERVESTHE RIGHT TO USE A THIRD PARTY CARRIER TO DELIVER ORDERS. SHOULD SUCH A CARRIER BEUSED, THE PURCHASER IS OBLIGED TO PAY AN ADDITIONAL I PERCENT OF THE CONTRACT PRICE ASA DELIVERY FEE." Assuming each ofthe following statements is true, which is most relevant in determining whether

a co_maqt exists between Slocum and Brisbane7_._ a.) Brisbane s purchase order form included a printed provision stating: "Acceptance is limited to the terms stated

herein."

b. Slocum uses a third party carrier for about 25% of its deliveries.el" Brisbane didn't scroll down far enough to see the third-party-delivery term.

..._d_" The third-party-delivery term obviously accompanies all of Slocum's email transmissions. I'_ tg _ '_'Ov_ _rovkg_t)v",,

_3/ 3. On 18, 2007, Slocum sent an email to Brisbane stating: "We will deliver according to your instructions."January

Appearing at the bottom of the email was the following statement in all capital letters: "SLOCUM SALES RESERVESTHE RIGHT TO USE A THIRD PARTY CARRIER TO DELIVER ORDERS. SHOULD SUCH A CARRIER BE

USED, THE PURCHASER IS OBLIGED TO PAY AN ADDITIONAL I PERCENT OF THE CONTRACT PRICE ASA DELIVERY FEE." Assuming each of the following statements is true, which is meg relevant in determining whethera contract exists between Slocum and Brisbane?

b/_.f_b_._hBheThethird-party-delivery term obviously accompanies all of Slocom's email transmissions.

riab_,e's purchased order form included a printed provision stating: "Acceptance is limited to the terms statedrein.'

---_ c. Slocum's email included statement: "Acceptance is conditional upon buyer's consent to the third-party-a

delivery term."d. B. and c. and equally relevant.

L_. Assuming each of the following statements is true, which is most relevant in determining whether a contract existsb,etween Slocum and Brisbane?

8.¢__62,,_'_ lm,.x_ a. On January 30, 2007. Slocum emailad Brisbane stating that the delivery is on its way to Brisbane, that it variedr / _ from Brisbane's order and that Brisbane could accept it or not depending on its needs.

.Ci_-e.._gY_.6_.[A"_ b • The delivery by Slocum was so nonconforming that Brisbane had the right to reject it.

r_Dg_]_ 'IICV'_0_- _ On January 31, 2007, Brisbane notified Slocum that he rejected the shipment, was angry about it, and wask_../ considering suing Slocum.

_, 6.OvaA r._6__ d_ On January 31, 2007, Slocum emailad Brisbane stating that he was sony for Brisbane's inconvenience.

G/_Which of the following statertvants about unconscionability is_untrue?

To some extent, unconscionability restricts freedom of contract.

A contract or provision therein is unconscionable as a matter of fact, not law.• Typically unconseionability would apply to a contract or provision that ';shocks the conscience of the court.

. • . . • . ye _,Typtca y, standard contrac_.m which one party drafts he wrmen contract that the other s de can take or leaare not unconscionable. 5

*** On January 3, 2007, Sayers and Bathsheba orally contracted for the sale and purchase of a metal fabricator that Bathshebaneeds to upgrade her manufacturing operation. The contract price for the machine was $222,000; the delivery date was February

14, 2007; the shipping term was FOB Seller; and the payment term was net 30 (payment is due within 30 days of delivery). [Refersto Questions 6-7. Please assume that each question is independent of all others but refers back to these facts.]

"_6. On 4, 2007, Sayers sent an email to Bathsheba stating, "This note is to confirm your purchase of the ModelJanuary

41446 Prefabricator. The contract price is $222,000 ... (the other terms are noted in the email). Bathsheba received andread the email on that day. On January 20, 2007, Bathsheba learned of an opportunity to purchase a similar machine foralmost half the price. Assuming each of the following statements is true,which is most relevant in determining whetherBathsheba is contractually bound to Sayers?

The price for the similar machine is $125,000.• On January 2 I, 2007, Bathsheba notified Sayers that she no longer wanted to purchase the machine fromSayers.

_) Bathsheba and Sayers had never dealt with each other until January 3, 2007.Both Bathsheba and Sayers are merchants in regard to the machine.

.-- 7. Sayers delivered the machine to Bathsheba on February 14, 2007. Today, Bathsheba sought via email permission todefer paying the contract price for the machine until April 30, 2007. Assuming each of the following statements is true,which is most relevant in determining whether Bathsheba's request to defer payment until April 30 is part of her andSayers' contract?

a. Bathsheba and Sayers are both merchants.

___ Bathsheba and Sayers have never dealt with each other before.Today, Sayers consented to Bathsheba's request for an extension.Bathsheba is giving nothing extra for the extension.

hd.. All of the above.

Exactlytwo oftheabove. _.. -.,.5ell_"

9. Which of the fo ow ng statements best explains why a _ who ships totally nonconforming goods in response to a"please ship" offer has accepted and breached at the same time?a. Such a rule mirrors the common law rule.

Such a rule is consistent with principles associated with offers to form unilateral contracts.Such a rule discourages _.ye_ from shipping nonconforming goods without legal consequences.A. and b. above. _elte_

10. Wl._i_;h.,?fthe following statements provides the best description of how the UCC relates to the common law of contracts?( a. ) The UCC and the common law are the same except the UCC liberalizes many of the strict common lawprinciples.

/_ The UCC and the common law are the same except the common law is more liberal in dealing with theformation and performance of contracts than the UCC.

c. The common law of contracts is primarily commercial law while the UCC is primarily a regulatory law.d. The common law of contracts is primarily regulatory while the UCC is primarily commercial law.

'_ ]. Course o f performance:

. /.af is the performance by the same two parties in past contracts."jb_ Is the performance reasonably expected in the trade.t _ Is the future performance expected in a contract where the performance has not begun.

_ None of the above, .LJl2. In a contract in which Lowe's sells fencing to your neighbor and adds $450 to the contract price for installation of the

the UCC governs the formation and performance of the contract because this is a sale of goods.The common law exclusively governs the formation and performance of the contract because this is a cost pluscontract.

_/. The common law exclusively governs the formation and performance of the contract because this is a sale of/ what will become real estate.

d_" The UCC governs the formation and performance of the contract because this is a hybrid sales/service contract/ in which services predominate.

L.S.Quiz45232 2"_Last 6 Digits of OU ID

Please state and apply the applicable law.

On February 14, 2007, a third party carrier was to deliver goods to Buytronics, an electronics retailer located inWichita, Kansas. The seller was Shed Incorporated, whose manufacturing plant for the delivered goods was in

Colorado Springs, Colorado. The contract between Shed and Buytronics included the term, FOB Denver. S/----'--_61. (5 points) State the basic risk of loss rule, given the parties' contract and shipping term. _t_8

DOq,,'_b.

_ S_tl_v delivo_'_ A't_c-Dooc4__ JrV_ C_vrtOvj he_. i_ fre_-Fror_viS_

c_ _.osS. Iv_Vwi_ c_3cj o_ce. Sv___Alhc., oje.,-rS_-v_5_o_,_S "iv "D6mv6v_

)

2. (10 points) If the goods were substantially nonconforming and damaged or destroyed in txansit to Buytronics, who

would bear the risk of loss. Explain fully. _,/"_)_

wool4 'oe_ _l_ yo vt_._-_._ <eje_.cb _rv_er_q_ +m6_ Shed ImC.

c,_v-,sidere_ bvea_h _- cov_ac-b ) v-,s_ic,_ _e_>v_ +m_+ -ym_

J

_ ,t°S _ -v3 (10 points)If, on February5, 2007, " "B'_-" ,'_"_h ...."_" • hed told

shipment0of goods _ damaged_ordes_oyl_,dfm_ansit, whowould bearthe risk of loss? E_plain fully. " f._....,

/ L.S. 4523 - Quiz 3Spring, 2007

Multiple Choice: Please pencil in on your scantron the letter corresponding with the correct answer. There is only onecorrect answer.

*** On February 13, 2007, Barbara purchased a new name-brand, full-sized SUV from Stanley, a car retailer. Barbara was to usethe vehicle for her business as independent real estate broker. The purchase price of the SUV was $35,000, and the manufacturerprovided a standard wriRen, limited warranty of three years or 36,000 miles. On the 13±, the parties both signed a written contractfor the purchase and sale of the SUV. The contract identified the parties, provided the VIN number of the vehicle, stated thecontract price and included the following statement: "The contract between the identified parties is limited to the terms stated inthis document."

As part of the transaction, Barbara made a down payment of $12,000 and signed the following instrument:

February13,2007

TheundersignedpromisestopayStanleyMotorsor its orderthesumof Twonty-threethousanddollars($23,000)withannual interest jV, ca(o¢_ i)ciOVXg"\

ofsix percent(6%),thepaymenttobe as follows:BeginningonApril1,2007,andonthe firstdayof eachsucceedingmonththrough ./_¥Oy_ _p_/0_,.j_ O/March1,2010, theundersignedpronfisestopayStanleyMotorsorits orderthesumof sixhundredninety_dollarsandseventycentsl$699.70).

nie_ ,/tYro_']J ,-_,_ .^/c_,,

1. Aspercontracttopurchase. ,._(\"ff_'/61 if''_av

2. Subjecttoallimpliedandconstructiveconditions, x__x/ 3(O 0 vt_V"

BarbaraBabbia

%_ (Refers to Questions 1-7)^ . In this transaction:

_the vehicle manufacturer cannot be responsible for warranty because it is not in privity with Barbara.k.,/ Under federal law, the manufacturer would be prohibited from disclaiming implied warranties.

Stanley warrants that the car is merchantable.d. None of the above.

_2. If, in this transaction, Barbara, after accepting the car, discovers something substantially wrong with the SUV during theftr_./ear of ownership, then:

her remedies, if any, would be post acceptance remedies.

She would not be able to use a standard "Lemon Law."c. Her remedies would be against the manufacturer only, not Stanley.d. Exactly two of the above.

_. Assuming that, just before Barbara drove the car off the lot, Stanley told her (and Barbara can prove this) that she couldreturn the car no later than February 23, 2007, if she did not like it, then:

a. this statement could not be an express warranty because it occurred after the contract.

_ This statement wonld be inadmissible hi court because of the wording of the contract signed by both parties-c. A.andB.above.

d. None oftheabove.

4. The best label for the insmmaent above signed by Barbara is:

_.. check.

Draft.Note.

Certificate of deposit.

_> 5. The,.langnage noted hi 1. in the instrument above:

(a._) has no effect on whether the instrument is negotiable.

_1_ Renders the instrument conditional, but still negotiable.c. Renders the instrument conditional and therefore not negotiable.

xl( Means that the instrument does not include a definite amount.

6. The/_l:_nguage noted in 2. hi the instrument above.:( a._ has no effect on whether the instrument is negotiable."-b. Renders the instrument conditional, but still negotiable.

c. Renders the instrument conditional and therefore not negotiable.

_. Means that the instrument does not include a definite amount.

2

_'7. The above instrument signed by Barbara:/ ,a. is negotiable.

/K Is payable on demand.

Is a time instrument.Exactly two of the above.

April 1,2007

I promise to pay Seth Cyprus One Hundred Thousand dollars if Seth'$ horse, Citation, wins the Kentucky Derby in May, 2007.

BrutusBailey

-_ 8. The instrument above: _JO"_ _v_cov_;'_'iO_,"_]

_._ is a negotiable note.

Is a non-negotiable drain.

/_' Is a negotiable draft.Is a non-negotiable note.

z_. In negotiable insmunent law:

/__. the fixed amount requirement would not allow for an acceleration Clause.

The fixed amount requirement would allow for a provision adding costs of collection and attorney fees.The words of negotiability requirement would not be met by using the term "bearer."

d. Exactly two of the above.

.f'_ . Assuming each of the following statements is a'ue, which is most relevant in determining whether a seller has breached,the implied warranty of merchantability?

/a: The subject matter of the sale is a drill press.The seller sold the drill press after having used it for personal or household use.The drill press is not fit for its usual purpose.

The buyer is in the salvage business. - -_ V'_ _ i S _o 3: / vJ1. A person who has just purchased a non-negotiable imtrument:

/- a. cannot be a holder in due course.

_- b. Has the fights of an assignee._.¢_ Can be a holder, but not a holder in due course.

Exactly two of the above.

-_ 12. If_(er purchases goods "as is"(a.) there are no implied warranties of quality accompanying the sale.--off.. There is no warranty of title accompanying the sale.

/_ There can be no express warranties accompanying the sale.All of the above.

ID # ONLY } "_L.S. 4523

Quiz 4(25 points)

*** On April 5, 2006, Darnell signed and delivered the following instnanent to Pauline in payment for Pauline's car, a 2006 ToyotaAvalon. Damell also gave Pauline a cashier's check of $5000 as down payment.

_,_3 _" April 5, 2006 /, fO_i_i0"A_\

0,_,,OnAp,II,2007.Ipror_etopay,otheorderofPanlthePlumtheamo_toft_enWthou_ddoll_($20,0O0.O0)"_'--_a_ ;e with interest accruing at the rate of seven percent (7%). Such payment is for my purchase of the payee s 2006 Toyota ,,_)_ ,,Avalon. _ I

• :.-, _ v_Yt"

l:5arn_ll. Day _:7:St• I

DYo[eJ On April 7, 2006, Pauline transferred the instrument to Hester Home m payment for an exlstang debt Pauline owned Hester of

p_ $18,750. Hester acted in good faith and had no knowledge of any problems involving Pauline and Damell. On April 8, 2006, Hester/traasferred the instrument to Jeffrey James as a girl. On April 15, 2006, Randall stole the instrument from Jeffrey and sold it to Marge-_ Enovara for $19,000. "_._'_.., The back of the instrument looks like this.

Pay Y-[esterHomePauline Plum

On April 1, 2007, Marge presented the instrument to Damell for payment. Darnell refused to pay, claiming that the Avalon had beennothing but headaches and that Pauline has been totally unresponsive to his complaints. Answer each of the following questions basedon these facts.

1. (5 points) In its original form, what kind of instrument is this, who are the parties and is it negotiable?

,_ i-t iS v',eg_iat,/t, D_vne(I-'i_ _h_ _qa_e.u_ a_ paulitqe.,

4 _e.. ?_,/ee.J

xl

2. (10 points) In short, bullet-like fashion state the rights of Pauline, Hester, Jeffrey and Randall (e.g. holder by negotiation;. holder in due course, etc.)

-_e4_O': _,laeY of ov4ev p_er _ _e_c3oWia+im ) _DC

-3gf-fve,.]. _:pssesseS_,e_vevpa_e.v) so he. iS _ _o_de.v/ h_s +be ri_la{_

-R__all'. ?osse4sesbe;_ev ?_er, % he. iS a holde_>'5_h_s_-heriqkt_O? _ _"_LOC [Additi°nat _pacc onoaek.] _qd n Ir "+_11% Slo_Rrincipl_