PAYMENT SYSTEMS ELECTRONIC CASEB OOK

PAYMENT SYSTEMS

ELECTRONIC CASEBOOK

PART ONE

© 2008 by Steven L. Harris

All rights reserved.

1. “Transfer” and “assignment” are synonyms. The latter is commonly used to referto refer to transfers of rights to payment, claims, and liens. The latter commonly is usedto refer to transfers of other interests in property.

C H A P T E R 1

RIGHTS OF CREDITORS, OWNERS

AND PURCHASERS

As consumers, most of us make payments with some frequency. We pay

for housing, food, transportation, and entertainment. We pay for health

care. We pay taxes. We even pay for casebooks. We use a variety of means

to make our payments—cash, check, credit card, debit card, stored–value

(“prepaid”) card. Some of us arrange for recurring bills to be paid

“automatically” from a checking account or billed “automatically” to a credit

card; others make payments using the internet. Businesses, too, make

payments, frequently by check and credit card. Payments of large amounts

often are made by wire transfer.

We may pay attention to the size of a payment and wonder whether we

can afford to make it. But we rarely, if ever, think about the mechanics of

payment transactions or the likely legal consequences if something were to

go wrong. This book addresses those questions. It examines a number of

payment mechanisms in detail—checks, wire transfers, letters of credit,

credit cards—and gives an overview of still others—debit cards and

automated clearing house entries.

Before we turn to a discussion of the payment transactions themselves,

we examine issues surrounding the transfer (or assignment) of rights in

various kinds of personal property, including a right to be paid.1 Our

discussion begins here for several reasons. First, the most popular payment

system, the checking system, involves the transfer of checks. Examining

transfer-related issues outside the checking context enables us to become

acquainted with the legal regime governing transfer and assignment in a

simpler setting. Second, an examination of the law governing transfer and

assignment affords the opportunity to examine important legal doctrines

that appear elsewhere in commercial law and, more broadly, in the law of

property. It is to these doctrines—security of property and good faith

purchase—that we now turn.

2 CHAPTER 1 RIGHTS OF CREDITORS, PURCHASERS & OWNERS

1. Replevin, like sequestration and claim and delivery, is a judicial remedy torecover possession of personal property. Replevin statutes are procedural. They do notcreate the right to possession but rather aid those who are entitled to possession underother law.

2. The Restatement (Second) of Torts defines conversion of personal property as"an intentional exercise of dominion or control over a chattel which so seriouslyinterferes with the right of another to control it that the actor may justly be required topay the other the full value of the chattel." Restatement (Second) of Torts § 222–A(1)(1965). As with A's replevin suit to recover the cotton, C will be liable to A in conversiononly if A's right to control the cotton is paramount to C's right.

3. The principle that the transferee of property acquires all rights that thetransferor had applies not only to goods (see UCC 2–403(1) (1st sentence)) but also torights to payment, whether or not represented by a negotiable instrument (see UCC9–404(a); UCC 3–203(b)), documents of title (see UCC 7–504(a)), and investmentsecurities (see UCC 8–302(a)). The conveyancing rules governing rights to payment arediscussed in Section 2, infra; those governing documents of title, in Section 3. Althoughthis book focuses on personal property, similar principles apply to the transfer ofinterests in real property, such as land and buildings.

SECTION 1. TRANSFER OF INTERESTS IN GOODS

INTRODUCTORY NOTE

In this Chapter we will have occasion to consider the transfer of several

types of personal property, both tangible (e.g., goods) and intangible (e.g.,

a seller’s right to be paid for goods sold). Though our principal concern is

with the transfer of rights to payment, we begin by looking at the rules

applicable to transfers of a type of property that may be more

familiar—goods.

A paradigmatic sequence of events, which can arise in various settings,

is as follows: A is the owner of goods. B acquires the goods under

circumstances that give A the right to recover the goods from B. B,

voluntarily (e.g., by sale or by grant of a security interest) or involuntarily

(e.g., by sheriff’s levy), purports to transfer an interest in the goods to C. A

seeks to recover the goods themselves from C, perhaps by bringing an action

in replevin,1 or to hold C liable for damages in conversion.2

For such cases, the traditional rule is this: B can convey to C, and C can

acquire from B, whatever rights B had in the goods.3 Two different, but

interrelated, ideas are packed into this rule. First, the rule enables B to

dispose of any and all rights that B has. Thus, if B acquires goods free and

clear of all third-party claims, B will be able to convey the goods to C free

and clear. Were the rule otherwise, the value of the goods to B would be

substantially reduced in many cases. When the rule is applied to enable C

to defeat a third party’s claim on the ground that B could have done so, it

sometimes is referred to as a “shelter” or “umbrella” rule.

SECTION 1 PURCHASE OF GOODS 3

The second idea is that B cannot transfer any greater rights than B has;

that is, B may convey whatever rights B has and no more. This aspect of the

rule, which sometimes is referred to by the Latin phrase nemo dat quod non

habet (one cannot give what one does not have), appears to flow from a

broader principle, sometimes referred to as “security of property.” Security

of property means that a person may not be deprived of property rights

without the person’s consent. It means, for example, that a thief cannot

transfer the real owner’s property interest to a third party. A rule of law

contrary to nemo dat, one that would enable a person to convey rights that

the person did not have, would enable the person to deprive another person

of the other’s rights and would violate the security-of-property principle.

The security-of-property principle is far from ironclad; in fact, the law

often enables a person to convey greater rights to personal property than the

person has. Because those to whom the law affords greater rights than their

transferors had often are good faith purchasers for value, the exceptions to

nemo dat often are termed “good-faith-purchase” rules. As you work through

the following materials, try to articulate the reasons underlying the various

good-faith-purchase rules and to assess the validity of those reasons. You

may also wish to consider whether nemo dat no longer is the baseline rule

but rather has become the exception.

Problem 1.1.1. A’s bales of cotton worth $100,000 were stored in A’s

warehouse. B broke into the warehouse and stole the cotton. B resold the

cotton to C, who paid B $100,000, not suspecting the cotton was stolen. C is

in possession of the cotton. A brings a replevin action to recover the cotton

from C. What result? See UCC 2–403; Note (1) on the Basic Conveyancing

Rules, infra.

Problem 1.1.2. Under the facts of the preceding Problem, assume that

C, before learning of A’s interest, resold the cotton to D.

(a) Does A have a cause of action against C? On what theory?

(b) Does A have any rights against D?

(c) If A recovers from D, does D have a right of recourse against C? See

UCC 2–312.

Problem 1.1.3. B, who only recently entered business and has no credit

history, went to A’s place of business with a forged letter of introduction.

Relying upon the letter, which showed B to be Sterling Worth, a merchant

with well-established credit, A delivered cotton valued at $100,000 to B on

credit. B resold the cotton to C, who paid $100,000 for it and took delivery,

not suspecting the fraud. A sues C to replevy the cotton.

(a) What result? See UCC 2–403; Note (1) on the Basic Conveyancing

Rules, infra. What result if A sues C in conversion?

(b) What result if C is a cotton dealer who never dealt with B previously

and took no measures to check on B’s background. (It is customary for cotton

dealers in the area to purchase only from growers or from other dealers


4. In the odd case in which stolen goods are stolen from a thief, the first thief hasthe right to recover the goods from the second. See Hall v. Schoenwetter, 239 Conn. 553,564, 686 A.2d 980, 985 (1996).

whom they know.) See UCC 1–201(b)(20); UCC 2–103(1)(b) [R2–103(1)(j)];

UCC 2–104(1).

(c) What result if C had paid B only $60,000? Cf., e.g., Funding

Consultants, Inc. v. Aetna Casualty and Surety Co., 187 Conn. 637, 447

A.2d 1163 (1982) (trier of fact may reasonably consider whether an

instrument was purchased in good faith if a party pays an amount

considerably less than face value).

(d) What result if C had promised to pay $100,000 but has not yet paid

anything? See UCC 1–204. Under these circumstances, should the law

award the goods to a person who has not paid for them? Does this

transaction pose the same risks to C as does C’s payment of cash to B? Does

this transaction jeopardize A’s interests as much as C’s payment of cash?

(e) What result if C paid B $100,000 but had not yet taken delivery when

A notified C of the fraud? See Note (4) on the Basic Conveyancing Rules,

infra.

NOTES ON THE BASIC CONVEYANCING RULES

(1) Void Title and Voidable Title. The first sentence of UCC 2–403(1),

which embodies the nemo dat principle, takes one only so far. To determine

what the purchaser (C) acquires, one needs to know what rights the

transferor (B) has or has power to convey. What rights does a thief have?

The traditional rule, which still is dominant in Anglo–American law, is that

a thief has “void title,” which is very, very close to having no rights at all4

The “void title” of a thief is to be distinguished from the “voidable title”

referred to in the second sentence of UCC 2–403(1). The drafters of the UCC

may well have assumed that just as “everyone knows” that the owner of

goods may recover them from a thief, who has “void title,” so “everyone

knows” that a seller who is induced by the buyer’s fraud to enter into a

contract of sale may rescind (avoid) the contract and recover the delivered

goods from the defrauding buyer, who has “voidable title.”

The seminal case in the voidable title area is the English case of Parker

v. Patrick, 101 Eng. Rep. 99 (1793), which was followed in Mowrey v. Walsh,

8 Cow. 238 (N.Y.Sup.Ct.1828). The latter posed the question: “where the

goods are obtained by fraud from the true owner [A], and fairly purchased

of, and the price paid to the fraudulent vendee [B], without notice, by a

stranger [C], which is to sustain the loss, the owner or the stranger?” The

court’s answer: “the innocent purchaser for valuable consideration must be

protected.” The only reason mentioned by the New York court for

distinguishing fraud from theft was the one given by the English court in its

one sentence, per curiam opinion—the existence of a statute as to theft. By

mid-century, however, doctrine had developed to the point that the court


could write that, where fraud was involved, “the transaction is not

absolutely void, except at the option of the seller; that he may elect to treat

it as a contract, and he must do the contrary before the buyer has acted as

if it were such, and re-sold the goods to a third party.” White v. Garden, 10

C.B. 926, 138 Eng. Rep. 367 (C.P. 1851).

Professor Gilmore’s summary of the historical development deserves an

extended quotation:

The initial common law position was that equities of ownership are to

be protected at all costs: an owner may never be deprived of his property

rights without his consent. That worked well enough against a

background of local distribution where seller and buyer met face to face

and exchanged goods for cash. But as the marketplace became first

regional and then national, a recurrent situation came to be the

misappropriation of goods by a faithless agent in fraud of his principal.

Classical theory required that the principal be protected and that the

risks of agency distribution be cast on the purchaser. The market

demanded otherwise.

The first significant breach in common law property theory was the

protection of purchasers from such commercial agents. The reform was

carried out through so-called Factor’s Acts, which were widely enacted

in the early part of the 19th century. Under these Acts any person who

entrusted goods to a factor—or agent—for sale took the risk of the

factor’s selling them beyond his authority; anyone buying from a factor

in good faith, relying on his possession of the goods, and without notice

of the limitations on his authority, took good title against the true

owner. In time the Acts were expanded to protect people, i.e., banks, who

took goods from a factor as security for loans made to the factor to be

used in operating the factor’s own business. The Factor’s Acts, as much

in derogation of the common law as it is possible for a statute to be, were

restrictively construed and consequently turned out to be considerably

less than the full grant of mercantile liberty which they had first

appeared to be. Other developments in the law gradually took the

pressure off the Factor’s Acts, which came to be confined to the narrow

area of sales through commission merchants, mostly in agricultural

produce markets.

Even while they were cutting the heart out of the Factor’s Acts, the

courts were finding new ways to shift distribution risks. Their happiest

discovery was the concept of “voidable title”—a vague idea, never

defined and perhaps incapable of definition, whose greatest virtue, as a

principle of growth, may well have been its shapeless imprecision of

outline. The polar extremes of theory were these: if B buys goods from

A, he gets A’s title and can transfer it to any subsequent purchaser; if B

steals goods from A, he gets no title and can transfer none to any

subsequent purchaser, no matter how clear the purchaser’s good faith.


“Voidable title” in B came in as an intermediate term between the two

extremes: if B gets possession of A’s goods by fraud, even though he has

no right to retain them against A, he does have the power to transfer

title to a good faith purchaser.

The ingenious distinction between “no title” in B (therefore true owner

prevails over good faith purchaser) and “voidable title” in B (therefore

true owner loses to good faith purchaser) made it possible to throw the

risk on the true owner in the typical commercial situation while

protecting him in the noncommercial one. Since the law purported to be

a deduction from basic premises, logic prevailed in some details to the

detriment of mercantile need, but on the whole voidable title proved a

useful touchstone.

The contrasting treatment given to sales on credit and sales for cash

shows the inarticulate development of the commercial principle. When

goods are delivered on credit, the seller becomes merely a creditor for

the price: on default he has no right against the goods. But when the

delivery is induced by buyer’s fraud—buyer being unable to pay or

having no intention of paying—the seller, if he acts promptly after

discovering the facts, may replevy from the buyer or reclaim from

buyer’s trustee in bankruptcy. The seller may not, however, move

against purchasers from the buyer, and the term “purchaser” includes

lenders who have made advances on the security of the goods. By his

fraudulent acquisition the buyer has obtained voidable title and

purchasers from him are protected.

Gilmore, The Commercial Doctrine of Good Faith Purchase, 63 Yale L.J.

1057, 1057–60 (1954).

Why do you suppose the UCC neither explains that a thief has void title

nor sets forth a definition of voidable title? Perhaps the drafters thought

that their project—codifying the law of sales—did not require codification

of all the basic common-law rules of personal property conveyancing. Even

if so, it remains puzzling that Article 2 contains some of the “building block”

rules (e.g., the “shelter” principle in the first sentence of UCC 2–403(1)) but

not others. Should Article 2 be revised to set forth basic conveyancing rules?

(2) Conflicting Rules on Good Faith Purchase: Unification.

Consider the observations of the Ontario Law Reform Commission:

It is necessary in every legal system to reconcile the conflict that arises

when a seller purports to transfer title of goods that he does not own, or

that are subject to an undisclosed security interest, to a person who buys

them in good faith and without notice of the defect in title. The

alternative means of resolving this conflict are usually stated in terms

of a policy favouring security of ownership, as opposed to a policy that

favours the safety of commercial transactions. Few, if indeed any, legal

systems have committed themselves fully to the adoption of one or the


other solution. Between these extremes there lies a, range of

compromise solutions that depend on the nature of the goods, the

persons involved, and the type of transaction.

2 Ontario Law Reform Commission, Report on Sale of Goods 283 (1979).

As we have seen, the common law begins with the principle that a buyer

acquires no better title to goods than the seller had. To this principle the

common law admits a number of exceptions, the most significant of which

have been the doctrine of voidable title for cases of fraud and, in Great

Britain, the doctrine of “market overt.” The latter doctrine, which was

codified in the (British) Sale of Goods Act § 22(1), would protect a good faith

purchaser of stolen goods who lacks notice of defects in the seller’s title

where the goods “are sold in market overt according to the usage of the

market.”

In recent times, however, a rule designed to promote honesty among

buyers and the integrity of the market came to be seen as providing a

charter for thieves and fences, a perception heightened by the theft of

paintings by Gainsborough and Reynolds from Lincoln’s Inn and their

sale in Bermondsey market. The market overt exception to the nemo dat

rule has now been abolished.

R. Goode, Commercial Law 425 (3d ed. 2004).

The civil law (including the law of France and Germany) begins with a

very different principle under which a good faith purchaser of goods

generally is protected against the original owner, a principle expressed in

the phrase possession vaut titre (possession is the equivalent of title). Civil

law systems therefore have no need for a doctrine of voidable title for cases

of fraud. But many such systems make an exception for cases of theft,

allowing the original owner of stolen goods to reclaim them from a good faith

purchaser within a statutory period. Some of these systems, however,

require the good faith purchaser who has acquired stolen goods at a fair or

a market or from a merchant who deals in similar goods to return the goods

to the original owner only on reimbursement of the purchase price. This rule

has particular significance when the goods have special value to the true

owner or when the purchaser has “snapped up” the goods at a cheap price

but the true owner has difficulty proving that the purchaser did not act in

good faith.

What accounts for the variety of approaches to the universal problem

raised by good faith purchasers of stolen property? One author links the

variety to “the difficulty of discerning the best solution to a hard question.

Societies may share the goal of minimizing the costs associated with the

theft of property but may disagree over the way to achieve this goal.”

Levmore, Variety and Uniformity in the Treatment of the Good–Faith

Purchaser, 16 J. Legal Stud. 43, 45 (1987). In this regard, consider Problem

1.1.1, supra. As between the two innocent parties, A and C, the more


efficient rule would allocate the loss to the party who could have avoided the

loss at lower cost. Who is that party? Is it less costly for A to protect the

goods from theft (e.g., by hiring more guards or building a stronger fence)

than for C to protect itself from acquiring stolen goods (e.g., by investigating

the circumstances under which B acquired the goods)?

Although the lower-cost loss avoidance analysis projects an aura of

simplicity, its application can be enormously difficult. A complete analysis

would take into account not only the costs of preventing the loss but also a

variety of other costs, including the costs to A (the owner) and C (the good

faith purchaser) of insuring against the loss and the litigation costs

attendant to determining the foregoing costs. And even when efficiency

analysis can be applied with some degree of assurance, other normative

concerns may override it. Judge Posner, for example, assumes that A would

be the lower-cost loss avoider, but he explains that A is the winner under

current law (in the U.S.) because allowing C to win would encourage theft

and “[w]e do not want an efficient market in stolen goods.” R. Posner,

Economic Analysis of Law 91 (5th ed. 1998). See also Weinberg, Sales Law,

Economics, and the Negotiability of Goods, 9 J. Legal Stud. 569, 592 (1980)

(concluding that the “efficiency criterion has proved useful in explaining the

pattern of protection for legally innocent purchasers of goods that exists

under American law,” but recognizing that other issues, such as “costs of a

rule change” and “public and private costs of alternative regimes,” should

be considered before deciding to change the legal rules).

International traffic in ill-gotten goods, like other types of international

trade, seems to be accelerating. More recently, heightened concerns have

been expressed about artwork that may have been looted in Europe

immediately prior to and during World War II and about important cultural

property that has been stolen. The variations in national rules, and the

difficulty of determining which law governs, have led to efforts at

international unification of the law governing the rights of owners of stolen

goods. The most successful of these has been the Convention on Stolen or

Illegally Exported Cultural Objects, promulgated by the International

Institute for the Unification of Private Law (UNIDROIT). Article 2 of the

convention defines “cultural objects” as “those which, on religious or secular

grounds, are of importance for archaeology, prehistory, history, literature,

art or science” and which fall within one of 12 categories, including products

of archaeological excavations, antiquities more than one hundred years old,

property of artistic interest, and rare specimens of fauna, flora, minerals,

and anatomy. As of mid-2008, the convention had entered into force among

29 nations. See http://www.unidroit.org/english/implement/i-95.pdf (visited

July 9, 2008).

(3) Good Faith Purchase and Notice or Knowledge of Conflicting

Claims. To qualify as a “good faith purchaser,” a purchaser must purchase

in “good faith.” The meaning of the term depends on which state’s law


applies. Former Article 1 defined “good faith” as “honesty in fact.”

F1–201(19). However, UCC 2–103(1)(b) provides a more demanding

standard in the case of a merchant: “honesty in fact and the observance of

reasonable commercial standards of fair dealing in the trade.” (A similar,

two-pronged test applies to transactions governed by Articles 3, 4, 4A, and

9. UCC 3–103(a)(4); UCC 4–104(c); UCC 4A–105(a)(6); UCC 9–102(a)(43).)

Revised Article 1 adopts the two-pronged test for all UCC transactions other

than letters of credit: “honesty in fact and the observance of reasonable

commercial standards of fair dealing.” UCC 1–201(b)(20). However, of the

19 states that have adopted Revised Article 1 to date, six have retained the

“honesty in fact” definition in Article 1 and the special definition applicable

to merchants in UCC 2-103(1)(b).

Both formulations of “good faith” are silent concerning the effect of C’s

(a putative good faith purchaser from B) knowledge or notice of A’s claim to

the goods (e.g., that B had only voidable title). Despite this silence, no one

would doubt that C would not have acted in good faith if it purchased goods

with actual knowledge of B’s fraud. Aside from the relatively easy case of

actual knowledge, however, there is a wide range of possible application of

the “good faith” requirement, depending on the facts. Of what relevance is

the fact that purchasers under other UCC articles must act not only in good

faith but also without notice of claims in order to benefit from good-faith

purchase rules? See UCC 3–302(a)(2)(ii) and (v); UCC 7–501(a)(5); UCC

8–303(a)(2); UCC 9–403(b)(3). Of what relevance is the pre-UCC law? “Both

case law and commentators agree that subjective knowledge of the original

seller’s claim was not necessary to disqualify a purchaser from the

protection of the voidable-title or estoppel concepts. Reason to know or

circumstances that would put a reasonable man on inquiry were, sufficient.”

McDonnell, The Floating Lienor as Good Faith Purchaser, 50 S.Ca1.L.Rev.

429, 442 (1977).

The Third Circuit applied the UCC 2–103(1)(b) “merchant” standard of

good faith in this context. In Johnson & Johnson Products, Inc. v. Dal

International Trading Co., 798 F.2d 100 (3d Cir.1986), the court “predict[ed]

that the New Jersey Supreme Court would not impose [on a buyer] a duty

to inquire ... into the chain of title of gray market goods.” (Gray market

goods are goods legitimately manufactured and sold abroad under a

trademark and imported for sale in competition with goods sold by the

American owner of an identical trademark.) The court apparently ignored

the possibility that “reasonable commercial standards of fair dealing in the

trade” may have required an inquiry by the buyer. See UCC 2–103(1)(b).

(4) Delivery and Good Faith Purchase. The role of delivery in good

faith purchase presents an awkward, unsolved problem under Article 2 of

the UCC. In contrast, Articles 3, 7, and 8 face the issue. Articles 3 and 7

confer protection on the “holder” of instruments and documents, which UCC

1–201(b)(21) defines as a person “in possession.” See UCC 3–305 (defenses);


5. As we shall see below in Section 2, filing often operates as a substitute fordelivery where the property purchased is an intangible right to payment and thus notsusceptible of delivery.

UCC 3–306 (claims); UCC 7–502. Article 8 makes clear when possession of

a stock certificate or other investment security (by the transferee itself or by

a third party acting on its behalf) is a necessary condition to becoming a

“protected purchaser” and when it is not. See UCC 8–303(a).

In analyzing the solicitude the law should pay to a buyer (C) who pays

before delivery, consider whether it is usual and necessary for a buyer to

pay before receiving the goods. In most cases of payment before delivery, is

it difficult for the buyer (C) to take precautions against misconduct by the

seller (B)? Would it be easier for the original owner (A) to take precautions?

Should it make any difference whether C has a right to possession as

against its seller, B? If C has no right to recover the goods from B, the

malefactor, it would be surprising if C could recover them from A, who also

is a victim of B’s wrongdoing. Article 2 provides pre-delivery possessory

rights to a buyer only under very limited circumstances. See UCC

2–502(1)(b) (reclamation right with respect to consumer goods if at least

part of the price is paid and the seller repudiates or fails to deliver;

reclamation right with respect to all goods “if the seller becomes insolvent

within ten days after receipt of the first installment on their price”); UCC

2–716(1) (authorizing specific performance of the sale contract “where the

goods are unique or in other proper circumstances”); UCC 2–716(3) (right

to replevin of goods identified to the contract in two limited circumstances).

See also R2–716(1) (authorizing specific performance if the parties to a

contract other than a consumer contract have agreed to that remedy). This

approach would answer Problem 1.1.3(e) in favor of A in all but a few cases.

The problem extends beyond “buyers” to a wider category—called

“purchasers”—that, as we shall see, includes those who extend credit on the

security of goods. When (in our model sequence) B gives C a security

interest in goods to secure a loan, B usually needs to keep the goods for B’s

personal or business use. Accordingly, B usually will not deliver the goods

to C. In this setting, the public filing of a “financing statement,” indicating

that C may have a security interest in the goods, is a substitute for

delivery.5 But this public filing has been conceived with concern for the

creditors of B and other “purchasers” from B—not prior owners of the goods.

Should Article 2 be revised to answer clearly the question whether

delivery, or some equivalent, objective step is necessary for protection as a

good-faith purchaser?

Problem 1.1.4. Assume that instead of buying the cotton in Problem

1.1.3, supra, C acquired a judgment against B and caused the sheriff to levy

on the cotton pursuant to a writ of execution. Before the sheriff sells the


goods, A discovers the fraud.

(a) Who has the better claim to the goods? See UCC 2–403; Oswego

Starch Factory v. Lendrum, infra; UCC 1–201(b)(29), (b)(30); UCC 1–204;

Note(1) on Reliance and Nonreliance Parties, infra.

(b) What result if the sheriff sells the cotton to D before A discovers the

fraud? See Mazer v. Williams Bros., 461 Pa. 587, 337 A.2d 559 (1975) (buyer

at sheriff’s sale not “bona fide purchaser” under F1–201(32), (33), F8–302).

Problem 1.1.5. What result in Problem 1.1.3 if, instead of buying the

cotton, C took it as security for a loan that C had extended to B six months

earlier? See UCC 1–201(b)(29), (b)(30); UCC 1–204; Note (2) on Reliance and

Nonreliance Parties, infra.

Oswego Starch Factory v. LendrumSupreme Court of Iowa 1881.57 Iowa 573, 10 N.W. 900.

Action of replevin by Oswego Starch against sheriff Lendrum. Plaintiff’s

petition alleged that plaintiff had sold and shipped goods to Thompson &

Reeves, and that this firm prior to the purchase was knowingly insolvent

and intended to defraud plaintiff of the purchase price. Defendant Lendrum

levied on the goods for creditors of Thompson & Reeves and thereafter

plaintiff elected to rescind the sale because of fraud.

Lendrum demurred on the ground, inter alia, that he and the attaching

creditors had no knowledge of the alleged fraud and that therefore the

contract could not be rescinded after the levy. From a decision for Lendrum,

plaintiff appealed.

O BECK, J. ... [T]he point of contest involves the rights of an attaching

creditor without notice.

The title of the property was not divested by the attachment, but

remained in the vendees. The seizure conferred upon the creditors no right

to the property as against plaintiff other or different from those held by the

vendee. The sole effect of the seizure was to place the property in the

custody of the law, to be held until the creditors’ execution. They parted

with no consideration in making the attachment, and their condition as to

their claims were in no respect changed. Their acts were induced by no

representation or procurement originating with plaintiff which would in law

or equity give them rights to the property as against plaintiff. Plaintiff’s

right to rescind the sale inhered in the contract and attached to the

property. It could not be defeated except by a purchaser for value without

notice of the fraud....

Our position is simply this, that as an attaching creditor parts with no

consideration, and does not change his position as to his claim, to his

prejudice, he stands in the shoes of the vendee. . . . The innocent purchaser


6. In most states, a judgment creditor may obtain a judicial lien on a debtor's realproperty by recording a memorandum or abstract of the judgment in the real estaterecords or (depending on local law) having the court clerk enter the judgment in thedocket book. Upon the recordation or docketing, a judgment lien (which is a species ofjudicial lien) arises on all of the debtor's interests in real property in the county. In onlya few states does a judgment lien extend to personal property. See, e.g., Cal. Code Civ.Proc. § 697.530 (judgment lien arises on most nonexempt personal property upon filinga notice with the Secretary of State). Because this book is concerned exclusively withpersonal property, we shall have no more to say about judgment liens.

7. In a minority of states, an inchoate execution lien arises on all property of thejudgment debtor that is located and that can be found within the bailiwick when the writis delivered to the sheriff; however, the inchoate lien cannot be enforced against specificproperty until the sheriff levies upon the property and the lien becomes consummate.If the sheriff fails to levy before the writ expires, the inchoate lien is discharged.

for value occupies a different position, and his rights are, therefore,

different. [Reversed.]

NOTES ON RELIANCE AND NONRELIANCE PARTIES

(1) The Position of a Creditor Who Levies. Oswego Starch concerns

an attempt by creditors of Thompson & Reeves to use the judicial process to

collect a debt owed to them by the firm. Courses on Creditors’ Rights provide

a detailed examination of the legal process for collection of debts. For our

purposes, the following, highly simplified overview should suffice. Collecting

a debt through the judicial process typically involves three steps. The first

is to obtain a judgment against the debtor. The second is to acquire a lien

on particular property of the judgment debtor. The third is to turn the lien

into cash.

A lien is a property interest of a particular kind. The holder of the lien

(the lienor) may use the property subject to the lien for only one purpose,

to apply toward satisfaction of the debt it secures. A lien that arises through

the judicial process is called a judicial lien. It must be distinguished from

a lien that arises by agreement of the parties, known as a consensual lien

or security interest. Although state laws and procedures governing

postjudgment liens vary, generally speaking a judgment creditor acquires

a judicial lien on personal property, such as goods and rights to payment, in

one of two ways.6 The creditor may obtain from the clerk of the court a writ

of execution, instructing the sheriff to levy upon or attach (seize) goods or

other personal property of the judgment debtor located within the sheriff’s

bailiwick (usually a county). In the majority of states, the creditor acquires

an execution lien (which is a species of judicial lien) on whatever property

the sheriff levies upon before the writ expires.7

While levy is a suitable means for acquiring a lien upon tangible

personal property, a different method is necessary when the creditor seeks


8. Most states make some provision for attachment, and other prejudgment, liensunder limited circumstances, e.g., upon a showing that the defendant is about to abscondfrom the jurisdiction or hide property otherwise available to creditors. Prejudgment liensare similar in many ways to postjudgment liens. The principal difference is that thecreditor ordinarily cannot cause the former to be turned into cash until judgment isentered against the defendant-debtor. Many of the restrictions on the availability ofprejudgment remedies, including those affording the debtor notice of the exercise of theremedy and an opportunity to be heard, reflect cases decided under the Due ProcessClause of the Fourteenth Amendment. See, e.g., North Georgia Finishing, Inc. v.Di–Chem, Inc., 419 U.S. 601, 95 S.Ct. 719, 42 L.Ed.2d 751 (1975) (discussingconstitutional requirements surrounding prejudgment garnishment of corporate debtor'sbank account).

to acquire a lien on a debtor’s intangible personal property, which, by its

very nature, cannot be seized. A common example of intangible property is

a right to payment from a third party. Suppose, for example, that Creditor

has reason to know that Dana, its judgment debtor, has a $100 claim

against Kerry. Creditor could cause the clerk of the court to issue a writ of

garnishment instructing Kerry (the garnishee) to inform the court whether

Kerry is indebted to Dana and, if so, for how much. In most jurisdictions, a

garnishment lien (which is another species of judicial lien) on Dana’s right

to payment from Kerry arises when the writ is served upon Kerry.

Garnishments often are used to reach bank accounts. This is because a bank

account is actually a debt owed by the bank to its depositor.

Oswego Starch concerns yet another species of judicial lien—an

attachment lien. Before they obtained judgment against Thompson &

Reeves, certain creditors obtained a writ of attachment, which instructed

the sheriff, Lendrum, to levy upon (i.e., seize) property belonging to

Thompson & Reeves.8 After the sheriff’s levy, the plaintiff, Oswego Starch,

sought to replevy the goods from Lendrum on the ground that Thompson &

Reeves had obtained them from Oswego Starch by fraud.

The Oswego Starch decision represents the preponderant view of the

pre-UCC case law. See 3 Williston, Sales § 620 (1948). Is it persuasive?

What is the basis of the distinction the court draws between a judicial lien

creditor, against whom the right to rescind may be exercised, and a

“purchaser for value,” who would defeat this right? Is the court correct that

“an attaching creditor parts with no consideration”? If so, then how could

the creditors in Oswego Starch have obtained judgment against Thompson

& Reeves, the debtor?

Does UCC 2–403(1) change the pre-UCC result? B’s rights to the goods

are subject to A’s right to rescind the transaction and recover the goods. See

Problem 1.1.3, supra. But does B have power to convey greater rights? Even

if B has “voidable title” (see Note (1) on the Basic Conveyancing Rules,

supra), the answer is “no,” unless the lien creditor is a “good faith purchaser

for value.”


A lien creditor is likely to meet the good faith and value requirements.

See UCC 1–201(b)(20); UCC 1–204. Is the lien creditor a “purchaser”? The

UCC defines “purchase” (UCC 1–201(b)(29)) to include “taking by sale,

discount, negotiation, mortgage, pledge, lien, security interest, issue or

re-issue, gift or any other voluntary transaction creating an interest in

property.” One will note that the list of transactions includes “taking by . . .

lien,” and a judgment creditor who levies execution on property often is

called a “lien creditor.” See UCC 9–102(a)(52). But the word “lien” is a

chameleon; prior to the UCC voluntary transactions creating mortgages and

similar security interests were often said to create a “lien.” In the setting of

the types of transactions listed in the definition of “purchase” and the

concluding characterization that the list applies to “any other voluntary

transaction,” it seems fairly clear that the drafters did not mean to say that

the seizure of a debtor’s property by a sheriff acting for a creditor makes the

creditor a “purchaser.” This conclusion becomes inescapable in the light of

UCC sections that distinguish between, on the one hand, lien creditors and,

on the other, transferees or purchasers. See, e.g., UCC 9–317(a), (b).

Does any policy justify distinguishing between a judicial lien creditor

and a buyer? Consider some of the ways in which the two are different.

Unlike a buyer, who contracts to purchase all of the rights to the goods, a

lien creditor acquires only a limited interest in (i.e., a lien on) the goods.

And unlike a buyer, whose rights arise by virtue of its contract, a judicial

lien creditor acquires its rights through the judicial process. Finally,

whereas a buyer typically acquires its rights in exchange for new

consideration (current payment or a promise to pay), a lien creditor’s

extension of credit is divorced from the property on which it subsequently

obtains a lien. Is any of these distinctions relevant?

(2) The Position of an Article 9 Secured Party. All things being

equal, a creditor would be in a better position if it could acquire a lien

without first having to obtain a judgment and invoke the power of the

sheriff. At the time a creditor extends credit, or at any time thereafter, the

creditor and debtor may agree that the creditor would have a limited

interest in particular property. The nature of this interest is such that if the

debtor fails to pay, the creditor may cause the property to be sold and apply

the proceeds to the satisfaction of its claim without the need to incur the

costs and delay attendant to obtaining a judgment and collecting it through

the judicial process. When the property concerned is personal property, this

kind of consensual lien, which arises by the agreement of the parties, is

called a security interest. (A consensual security interest must be

distinguished from a judicial lien, which arises through the exercise of

judicial process, and a statutory lien, which arises by operation of law in

favor of certain suppliers of goods and services.) A security interest affords

yet another benefit to the holder that a judicial lien does not. Whereas the

law governing judicial liens differs from state to state, the law governing


9. The most serious challenge to a secured party's good faith is likely to arise fromits knowledge or notice of competing claims. See Note (3) on the Basic ConveyancingRules, supra.

security interests, including the rights and duties of the immediate parties

(debtor and creditor) and the rights of third parties, is found largely in UCC

Article 9.

Like a judicial lien creditor, an Article 9 secured party can be expected

ordinarily to meet the good faith and value requirements.9 But unlike a

judicial lien creditor, a secured party is a “purchaser” as defined in UCC

1–201. This means that an Article 9 secured party, like a buyer, may cut off

A’s right to rescind a transaction and recover goods, whereas a judicial lien

creditor cannot. Can one justify this distinction?

One can draw several comparisons with buyers and judicial lien

creditors. An Article 9 secured party is like a buyer, in that its rights in the

goods (a security interest, defined in UCC 1–201(b)(35)) arise by contract.

See UCC 9–109(a)(1). It is like a judicial lien creditor in that it acquires only

a limited interest in the goods. This limited interest entitles the secured

party, upon its debtor’s (B’s) default, to repossess the goods, sell them, and

apply the proceeds to its claim against the debtor.

Sometimes, an Article 9 secured party takes a security interest in

specific goods owned by the debtor at the time the loan is made or acquired

by the debtor in conjunction with the extension of credit. In this respect a

secured party is like a buyer, exchanging new consideration for an interest

in goods. Other times, as in Problem 1.1.5, supra, an Article 9 secured party

takes a security interest to secure an antecedent debt, i.e., a debt owed

before the security interest is taken. This secured party seems to be

analogous to a judicial lien creditor—it has extended credit on an unsecured

basis, and its acquisition of rights in particular property is not a quid pro

quo for the loan (although it may have taken the security interest in

exchange for its forbearance in exercising its remedies).

(3) The Role of Reliance in Resolving Competing Claims. Personal

property law often distinguishes among third-party claimants on the basis

of whether they gave value in reliance upon the transferor’s (in our case,

B’s) apparent ownership of particular property. This distinction is reflected

in Oswego Starch, supra, as well as in Mowrey v. Walsh, 8 Cow. 238, 245

(N.Y.Sup.Ct.1828) (“The judgment creditor had not advanced money upon

these goods, and his loss placed him in no worse situation than he was in

before the fraud.”).

What is the appropriate role for reliance to play in resolving competing

claims to goods? Consider the following:

(i) Is a third party’s reliance on its transferor’s apparent ownership

of goods at all relevant to whether that party’s claim to goods should

prevail?


(ii) If reliance is relevant, should the strength of a person’s claim to

goods turn on whether the person actually relied, or should it turn on (i)

whether the person belongs to a class that generally relies and on (ii)

whether, had the person investigated, it would have uncovered facts

that would have formed the basis for reasonable reliance upon the

debtor’s ownership (e.g., the goods in question were located in the

debtor’s warehouse in boxes addressed to the debtor)?

(iii) As an empirical matter, do buyers generally give value in

reliance upon their seller’s apparent ownership of particular property?

Do judicial lien creditors? Do Article 9 secured parties?

Problem 1.1.6. A owned cotton worth $100,000. A placed it in storage

with B, who not only stores cotton but also regularly buys and sells it. B

wrongfully sold and delivered the cotton to C, who did not suspect B’s

wrongdoing, for $100,000. A sues C to replevy the cotton.

(a) What result? See UCC 2–403; UCC 1–201(b)(9); Notes on

Entrustment, infra.

(b) What result in part (a) if C had promised to pay $100,000 but has not

yet paid it when A claims the cotton?

(c) What result in part (a) if C, instead of buying the cotton from B, had

taken it as security for a loan that C had extended to B six months earlier.

Compare Problem 1.1.5, supra.

(d) What result if B had wrongfully delivered the cotton to C who is in

the cotton business, as security for a loan that C had extended to B six

months earlier, and C had sold the cotton to D, who suspected nothing, for

$100,000? Cf. Canterra Petroleum, Inc. v. Western Drilling & Mining

Supply, 418 N.W.2d 267 (N.D.1987) (buyer in ordinary course of business

can cut off rights of true owner who entrusts goods to merchant-dealer when

employees of merchant-dealer transfer goods to “dummy corporation,” which

then sells to the buyer). See also PEB Article 2 Report 130 (“[I]t should be

made clear that if the goods are entrusted to Merchant #1, who sells to

non-BIOCB [non-buyer in ordinary course of business] Merchant #2, who

sells to BIOCB, the BIOCB takes ‘all rights’ or takes ‘free’ of a security

interest.”). Would the result be different if B had wrongfully delivered the

cotton to C for temporary storage purposes and not as security?

NOTES ON ENTRUSTMENT

(1) The Historical Development of the Law of “Entrusting.” UCC

2–403(2) represents a sharp break with the traditional law of good faith

purchase. Under facts similar to those in Problem 1.1.6, the common law

usually favored the original owner. Merely entrusting possession to a dealer

was not sufficient to clothe the dealer with the authority to sell. “If it were

otherwise people would not be secure in sending their watches or articles of


10. According to Professor Gilmore: “For some reason, the security transferees whowere protected in the voidable title subsection by the use of the term ‘purchaser’ do notqualify for protection under the entrusting section. I have no idea why the draftsmenchose thus to narrow the protected class.” Gilmore, The Good Faith Purchase Idea andthe Uniform Commercial Code: Confessions of a Repentant Draftsman, 15 Ga. L. Rev.605, 618 (1981). The Ontario Law Reform Commission was “attracted to the distinction”:

The supporting theory is, presumably, grounded on either of the following premises:namely, that commerce will not be impeded if lenders are required to assume therisk of a merchant-borrower exceeding his actual authority; or, that lenders are inas good a position as are entrusters, or perhaps even better, to protect themselvesagainst a dishonest merchant.

2 Ontario Law Reform Commission, Report on Sale of Goods 314–15 (1979).

It also has been suggested that transfers for security are transfers “in which theprice or consideration received for the goods . . . is likely to be considerably less than theamount normally received in a sale of the same goods in other transactions.” Leary &Sperling, The Outer Limits of Entrusting, 35 Ark.L.Rev. 50, 65 (1981).

jewelry to a jeweller’s [sic] establishment to be repaired, or cloth to a

clothing establishment to be made into garments.” Levi v. Booth, 58 Md. 305

(1882).

During the nineteenth century, however, many states enacted “Factor’s

Acts” under which an owner of goods who entrusted them to an agent (or

“factor”) for sale took the risk that the agent might sell them beyond the

agent’s authority. A good faith purchaser from the agent, relying on the

agent’s possession of the goods and having no notice that the agent’s sale

was unauthorized, took good title against the original owner. (See the

discussion by Professor Gilmore in Note (1) on the Basic Conveyancing

Principles, supra.) But the Factor’s Acts did not protect the good faith

purchaser where, as in Problem 1.1.6, the owner entrusted the goods to

another for some purpose other than that of sale. A mere bailee could not

pass good title, even to a good faith purchaser for value.

In this regard UCC 2–403(2) goes well beyond the Factor’s Acts, since

it applies to “[a]ny entrusting,” i.e., “any delivery” under UCC 2–403(3),

regardless of the purpose. The section gives protection, however, only to a

“buyer,” not to all those who give value and take in good faith from the

person to whom the goods are entrusted. Contrast the narrow scope of

“buyer in ordinary course” under UCC 1–201(b)(9) with the definitions of

“purchase” and “purchaser” in UCC 1–201(b)(29) and UCC 1–201(b)(30). See

Comment 3 to UCC 2–403.10

(2) Testing the Limits of UCC 2–403(2): Porter v. Wertz. Despite its

apparent simplicity, UCC 2–403(2) contains a number of wrinkles, several

of which came to light in Porter v. Wertz, 68 A.D.2d 141, 416 N.Y.S.2d 254

(1979), affirmed mem., 53 N.Y.2d 696, 439 N.Y.S.2d 105, 421 N.E.2d 500

(1981), a case with particularly interesting facts:

Samuel Porter, an art collector, owned Utrillo’s painting “Chateau de

Lion-sur-Mer,” but lost the painting through the machinations of one Harold


“Von” Maker—sometimes operating under the name of Peter Wertz, a junior

collaborator over whom, the trial judge observed, Von Maker “cast his

hypnotic spell . . . and usurped his name, his signature and his sacred

honor.”

Von Maker had engaged in several transactions as an art dealer. (Other

activities had led to arrests for possession of obscene literature and theft of

checks, and to conviction for transmitting a forged cable in connection with

a scheme to defraud the Chase Manhattan Bank.) Von Maker (alias

“Wertz”), in his capacity as art dealer, approached Porter and expressed an

interest in the Utrillo. Porter, unaware of Von Maker’s illegal activities,

permitted Von Maker to hang the Utrillo temporarily in Von Maker’s home

pending a decision as to purchase.

Without Porter’s knowledge, Von Maker’s junior collaborator, the true

Peter Wertz, sold the Utrillo to an art dealer, Feigen Galleries. Feigen sold

the painting to Brenner, who resold it to a third party, who took the

painting to South America.

Porter brought actions for conversion against Wertz and Von Maker and

also against the purchasers, Feigen and Brenner. Defendant Feigen argued

that Porter “entrusted” the painting to Von Maker and as a consequence: (1)

Feigen was protected under UCC 2–403(2) as a “buyer in ordinary course of

business,” and (2) Porter’s claim as owner was barred by equitable estoppel.

The trial court rejected Feigen’s defense based on UCC 2–403(2) but

concluded that Porter was barred by equitable estoppel and dismissed his

action. The Appellate Division reversed the trial court and held that neither

statutory estoppel (UCC 2–403(2)) nor equitable estoppel barred recovery.

It found that Feigen was not a buyer in ordinary course because Wertz, from

whom Feigen bought the Utrillo, was not an art dealer (“[i]f anything, he

was a delicatessen employee”) and because Feigen did not act in good faith

(good faith, as defined in UCC 2–103(1)(b) “should not—and cannot—be

interpreted to permit, countenance, or condone commercial standards of

sharp trade practice or indifference as to the ‘provenance’, i.e., history of

ownership or the right to possess or sell an object d’art, such as is present

in the case before us.”).

Feigen appealed to the Court of Appeals, which affirmed the Appellate

Division. The court wrote (421 N.E.2d at 501):

Because Peter Wertz was not an art dealer and the Appellate

Division has found that Feigen was not duped by Von Maker into

believing that Peter Wertz was such a dealer, subdivision (2) of section

2–403 of the Uniform Commercial Code is inapplicable for three distinct

reasons: (1) even if Peter Wertz were an art merchant rather than a

delicatessen employee, he is not the same merchant to whom Porter

entrusted the Utrillo painting; (2) Wertz was not an art merchant; and

(3) the sale was not in the ordinary course of Wertz’ business because he

SECTION 2 ASSIGNMENT OF INTERESTS IN RIGHTS TO PAYMENT 19

11. Although it received amicus briefs on the “good faith” question from both theNew York State Attorney General (arguing that good faith among art merchants requiresinquiry as to ownership) and the Art Dealers Association of America, Inc. (arguing thata duty of inquiry would cripple the art business), the court found no need to reach thequestion.

1. The term “assignment” commonly refers to voluntary transfers of rights topayment, claims, and security interests and other liens.

did not deal in goods of that kind [F 1–201(9)].11

Would it have made any difference if Feigen had bought the Utrillo from

Von Maker rather than from Wertz? Why?

What is the relevance, if any, of the knowledge of either the entruster or

the buyer? Does it make a difference under UCC 2–403(2) if the original

owner of the goods does not know that the person to whom the owner

entrusts them is a merchant who deals in goods of that kind? See Atlas Auto

Rental Corp. v. Weisberg, 54 Misc.2d 168, 281 N.Y.S.2d 400 (Civ.Ct.1967)

(knowledge of dealer-merchant status is necessary element of entrusting).

Accord, Leary & Sperling, The Outer Limits of Entrusting, 35 Ark. L. Rev.

50, 83–85 (1981) (relying on Atlas Auto). But cf. Antigo Co-op. Credit Union

v. Miller, 86 Wis.2d 90, 271 N.W.2d 642 (1978) (knowledge by secured party

that debtor was a dealer-merchant not necessary for applicability of

analogous provision in F9–307(1)).

Suppose Feigen had been duped by Von Maker into believing that Wertz

was an art dealer. Suppose that Feigen had been duped by Wertz, who held

himself out as an art dealer. Compare UCC 2–104(1) with UCC 2–403(2). In

Sea Harvest, Inc. v. Rig & Crane Equipment Corp., 181 N.J.Super. 41, 436

A.2d 553 (1981), the court said: “A buyer’s misunderstanding that the seller

was in the business of selling does not improve the former’s position.” Do

you agree with this reading of the UCC?

SECTION 2. ASSIGNMENT OF INTERESTS IN RIGHTS TO

PAYMENT

We turn now from transfers of goods to assignments of rights to payment

(or, as they often are called, receivables).1 One can earn a right to payment

in a wide variety of settings. Lenders of money and sellers of goods, services,

and real property come readily to mind. But persons who are entitled to a

tax refund or who win the Powerball jackpot likewise enjoy a right to

payment, as do tort victims and ex-spouses in whose favor a judge has

entered a support order.

Like an interest in goods, an interest in a right to be paid is property.

Just as the owner of goods can sell them or use them to secure a loan, a

person who has a right to be paid at a future time can assign that right in

order to obtain funds now. The rules governing transfers of interests in


goods take account of the fact that goods are tangible. See, e.g., UCC

2–403(2) (“entrustment” rule). Rights to payment are intangible; you can’t

see them; you can’t touch them. The legal rules governing the purchase of

rights to payment often reflect this practical difference.

Many rights to payment are evidenced by a writing; others are evidenced

by an electronic record. These written and electronic records may have legal

significance for purposes of the Statute of Frauds or under the rules of

evidence; however, as we shall see, most have no legal significance insofar

as assignment of the right to payment is concerned. Rights to payment that

are embodied in a negotiable instrument (as defined in UCC 3–104(a)) are

an exception to this general rule. Negotiable instruments constitute a type

of property in which an intangible right takes on some of the attributes of

the tangible piece of paper that evidences the right. As such they fall into

an intermediate category between tangible and intangible property.

(A) COMPETING CLAIMS TO NEGOTIABLE NOTES

Problem 1.2.1. A sold and delivered goods to Q, who promised to pay

$5,000 for them 30 days after delivery. Q’s obligation to pay was evidenced

by a purchase order. (An example of a purchase order form appears on page

22, infra.) B stole the purchase order from A and delivered it, together with

B’s signed assignment of the right to payment, to C, who paid B $4,200 and

took possession of the assignment without suspecting B’s wrongdoing. Who

owns the right to be paid by Q? Does UCC Article 2 apply? See UCC

2–105(1) [R2–103(1)(k)].

Problem 1.2.2. A owned $1,000 in $100 Federal Reserve Notes. B stole

the $1,000 and gave it to C, who did not suspect the theft, in payment for

cotton. A sues C to replevy the money. What result? Does Article 2 or 3 of

the UCC apply? See UCC 2–105(1) [R2–103(1)(k)]; UCC 1–201(b)(24); UCC

3–102(a); UCC 3–104(a), (e); Miller v. Race, infra. See also In re Koreag,

Controle et Revision S.A., 961 F.2d 341 (2d Cir.1992) (in currency exchange

contract “money is not the medium of exchange, but rather the object of

exchange” and “currency thus constitutes ‘goods’” under Article 2); City of

Portland v. Berry, 86 Or. App. 376, 739 P.2d 1041 (1987) (“money rule”

applied to $500 and $1,000 bills though Treasury has not printed them since

1945 and “has been systematically taking them out of circulation and

destroying them since 1969”).

Problem 1.2.3. A was the owner of a negotiable promissory note, made

by M, who promised “to pay on demand to bearer $1,000.” B stole the note

from A and gave it to C, who did not suspect the theft, in return for $950. A

sues C to replevy the note.

(a) What result? See UCC 3–306; UCC 3–302; UCC 1–201(b)(21); UCC

3–201; UCC 3–109; UCC 3–303; Miller v. Race, infra; Note (3) on Negotiable

Instruments and Negotiation, infra.


(b) Would it make a difference if the note were dated May 15, 2003, and

C purchased it on February 18, 2008? See UCC 3–304(a).


by M, who promised “to pay on demand to the order of A $1,000.” B stole it

from A and for $950 sold it to C, who did not suspect the theft. A sues C to

replevy the note.

(a) What result? See UCC 3–306; UCC 3–302; UCC 1–201(b)(21); UCC

3–201; UCC 3–205; UCC 3–403; UCC 1–201(b)(41). (As to B’s liability to C,

see UCC 3–416(a)(2).)

(b) What result if, before selling the note to C, B had indorsed the note

on the back by forging A’s signature?

(c) What result if, before the theft, A had indorsed the note on the back

by signing “A”?

(d) What result if, before the theft, A had indorsed the note on the back

by writing “Pay to the order of P, (signed) A”?


PURCHASE ORDER FORM


*. [Bank of England notes did not become legal tender until 1833. 3 & 4 Wm. IV,c. 98, § 6. Until 1931 the holder of a bank note had a right to payment of the note ingold.]

Miller v. RaceCourt of King’s Bench 1758.1 Burr. 452, 97 Eng. Rep. 398.

It was an action of trover against the defendant, upon a bank note,[*] for

the payment of twenty-one pounds ten shillings to one William Finney or

bearer, on demand.

The cause came on to be tried before Lord Mansfield at the sittings in

Trinity term last at Guildhall, London: and upon the trial it appeared that

William Finney, being possessed of this bank note on the 11th of December

1756, sent it by the general post, under cover, directed to one Bernard

Odenharty, at Chipping Norton in Oxfordshire; that on the same night the

mail was robbed, and the bank note in question (amongst other notes) taken

and carried away by the robber; that this bank note, on the 12th of the same

December, came into the hands and possession of the plaintiff, for a full and

valuable consideration, and in the usual course and way of his business, and

without any notice or knowledge of this bank note being taken out of the

mail.

It was admitted and agreed, that, in the common and known course of

trade, bank notes are paid by and received of the holder or possessor of

them, as cash; and that in the usual way of negotiating bank notes, they

pass from one person to another as cash, by delivery only and without any

further inquiry or evidence of title, than what arises from the possession. It

appeared that Mr. Finney, having notice of this robbery, on the 13th

December, applied to the Bank of England, “to stop the payment of this

note:” which was ordered accordingly, upon Mr. Finney’s entering into

proper security “to indemnify the bank.”

Some little time after this, the plaintiff applied to the bank for the

payment of this note; and for that purpose delivered the note to the

defendant, who is a clerk in the bank: but the defendant refused either to

pay the note, or to re-deliver it to the plaintiff. Upon which this action was

brought against the defendant.

The jury found a verdict for the plaintiff, and the sum of 21l. 10s.

damages, subject nevertheless to the opinion of this Court upon this

question—“Whether under the circumstances of this case, the plaintiff had

a sufficient property in this bank note, to entitle him to recover in the

present action?” . . .

LORD MANSFIELD now delivered the resolution of the Court.

After stating the case at large, he declared that at the trial, he had no

sort of doubt, but this action was well brought, and would lie against the


defendant in the present case; upon the general course of business, and from

the consequences to trade and commerce: which would be much incommoded

by a contrary determination.

It has been very ingeniously argued by Sir Richard Lloyd for the

defendant. But the whole fallacy of the argument turns upon comparing

bank notes to what they do not resemble, and what they ought not to be

compared to, viz. to goods, or to securities, or documents for debts.

Now they are not goods, not securities, nor documents for debts, nor are

so esteemed: but are treated as money, as cash, in the ordinary course and

transaction of business, by the general consent of mankind; which gives

them the credit and currency of money, to all intents and purposes. They are

as much money, as guineas themselves are; or any other current coin, that

is used in common payments, as money or cash.

They pass by a will, which bequeaths all the testator’s money or cash;

and are never considered as securities for money, but as money itself. Upon

Ld. Ailesbury’s will, 900l. in bank-notes was considered as cash. On

payment of them, whenever a receipt is required, the receipts are always

given as for money; not as for securities or notes.

So on bankruptcies, they cannot be followed as identical and

distinguishable from money: but are always considered as money or cash.

It is a pity that reporters sometimes catch at quaint expressions that

may happen to be dropped at the Bar or Bench; and mistake their meaning.

It has been quaintly said, “that the reason why money can not be followed

is, because it has no ear-mark:” but this is not true. The true reason is, upon

account of the currency of it: it can not be recovered after it has passed in

currency. So, in case of money stolen, the true owner can not recover it, after

it has been paid away fairly and honestly upon a valuable and bona fide

consideration: but before money has passed in currency, an action may be

brought for the money itself. There was a case in 1 G. 1, at the sittings,

Thomas v. Whip, before Ld. Macclesfield: which was an action upon

assumpsit, by an administrator against the defendant, for money had and

received to his use. The defendant was nurse to the intestate during his

sickness; and, being alone, conveyed away the money. And Ld. Macclesfield

held that the action lay. Now this must be esteemed a finding at least.

Apply this to the case of a bank-note. An action may lie against the

finder, it is true; (and it is not at all denied:) but not after it has been paid

away in currency. And this point has been determined, even in the infancy

of bank-notes; for 1 Salk. 126, M. 10 W. 3, at Nisi Prius, is in point. And Ld.

Ch. J. Holt there says that it is “by reason of the course of trade; which

creates a property in the assignee or bearer.” (And “the bearer” is a more

proper expression than assignee.)

Here, an inn-keeper took it, bona fide, in his business from a person who

made an appearance of a gentleman. Here is no pretence or suspicion of


collusion with the robber: for this matter was strictly inquired and

examined into at the trial; and is so stated in the case, “that he took it for

a full and valuable consideration, in the usual course of business.” Indeed

if there had been any collusion, or any circumstances of unfair dealing, the

case had been much otherwise. If it had been a note for 1000l. it might have

been suspicious: but this was a small note for 21l. 10s. only: and money

given in exchange for it.

Another case cited was a loose note in 1 Ld.Raym. 738, ruled by Ld. Ch.

J. Holt at Guildhall, in 1698; which proves nothing for the defendant’s side

of the question: but it is exactly agreeable to what is laid down by my Ld.

Ch. J. Holt, in the case I have just mentioned. The action did not lie against

the assignee of the bank-bill; because he had it for valuable consideration.

In that case, he had it from the person who found it: but the action did

not lie against him, because he took it in the course of currency; and

therefore it could not be followed in his hands. It never shall be followed into

the hands of a person who bona fide took it in the course of currency, and in

the way of his business.

The case of Ford v. Hopkins, was also cited: which was in Hil. 12 W. 3,

coram Holt Ch. J. at Nisi Prius, at Guildhall; and was an action of trover for

million-lottery tickets. But this must be a very incorrect report of that case:

it is impossible that it can be a true representation of what Ld. Ch. J. Holt

said. It represents him as speaking of bank-notes, Exchequer-notes, and

million lottery tickets, as like to each other. Now no two things can be more

unlike to each other than a lottery-ticket, and a bank-note. Lottery tickets

are identical and specific: specific actions lie for them. They may prove

extremely unequal in value: one may be a prize; another, a blank. Land is

not more specific than lottery-tickets are. It is there said, “that the delivery

of the plaintiff’s tickets to the defendant, as that case was, was no change

of property.” And most clearly it was no change of the property; so far, the

case is right. But it is here urged as a proof “that the true owner may follow

a stolen bank-note, into what hands soever it shall come.”

Now the whole of that case turns upon the throwing in banknotes, as

being like to lottery-tickets.

But Ld. Ch. J. Holt could never say “that an action would lie against the

person who, for a valuable consideration, had received a bank note which

had been stolen or lost, and bona fide paid to him:” even though the action

was brought by the true owner: because he had determined otherwise, but

two years before; and because banknotes are not like lottery-tickets, but

money.

The person who took down this case, certainly misunderstood Lord Ch.

J. Holt, or mistook his reasons. For this reasoning would prove, (if it was

true, as the reporter represents it,) that if a man paid to a goldsmith 500l.

in bank-notes, the goldsmith could never pay them away.


2. This is not the very note that was the subject of Miller v. Race.

A bank-note is constantly and universally, both at home and abroad,

treated as money, as cash; and paid and received, as cash; and it is

necessary, for the purposes of commerce, that their currency should be

established and secured.

Lord Mansfield declared that the Court were all of the same opinion, for

the plaintiff; and that Mr. Just. Wilmot concurred.

Rule—That the postea be delivered to the plaintiff.

BANK OF ENGLAND NOTE2

FEDERAL RESERVE NOTE

Open your wallet and take a look.


FORM OF COMMERCIAL PROMISSORY NOTE

[Front]




FORM OF COMMERCIAL PROMISSORY NOTE

[Back]


NOTES ON NEGOTIABLE INSTRUMENTS AND NEGOTIATION

(1) Negotiable Instruments and Negotiability. UCC Article 3

applies to “negotiable instruments.” UCC 3–104(a), which defines the term,

preserves the tradition that, in negotiable instruments law, form triumphs

over substance. The term includes only a “promise” (defined in UCC

3–103(a)(9)) or an “order” (defined in UCC 3–103(a)(6)) to pay a fixed

amount of “money” (defined in UCC 1–201(b)(24)). An instrument is a “note”

if it is a promise to pay and a “draft” if it is an order to pay. UCC 3–104(e).

The most common form of draft is a “check.” As used in Article 3, “check”

includes an order to a bank that is payable on demand. UCC 3–104(f).

Other sections in Part 1 of Article 3 explain the requirements that the

promise or order be “unconditional” (UCC 3–106); that it be for a fixed

amount of money, with or without “interest” (UCC 3–112(b)); that it be

“payable to bearer or to order” (UCC 3–109); and that it be “payable on

demand” or “at a definite time” (UCC 3–108). Still other sections in Part 1

are devoted to other aspects of the form of negotiable instruments.

We consider UCC 3–104 and the “formal requisites” of negotiability in

greater detail below. See Problem 1.2.11 and the related materials. For now

it suffices to observe that these formal requirements were based initially on

commercial practice and case law. They were embodied in the pre–1990

version of UCC Article 3 and its predecessors, the Negotiable Instruments

Law of 1896 (which was adopted in each of the United States) and the

(British) Bills of Exchange Act of 1882. The continued emphasis on form

may seem an anachronism, but perhaps it serves a purpose. Rights to

payment that are embodied in negotiable instruments constitute a different

kind of property from rights to payment that are not so embodied. One who

owns, or becomes a party to, a negotiable instrument assumes special risks.

The formal requisites, like the fence and warnings around high voltage

equipment, arguably confine and identify the danger areas. Of course, the

formalities afford no warning to one who is unfamiliar with this specialized

branch of the law.

(2) Uses of the Negotiable Note. Lord Mansfield’s opinion in Miller

v. Race rests on what he perceives to be the commercial utility of enabling

those who are paid in bank notes, like those who are paid in cash, not to

worry about where the paper has been: “[T]rade and commerce . . . would be

much incommoded by a contrary determination.” Nor need a person who

takes payment in bank notes be concerned about the transaction giving rise

to the note. As Lord Mansfield stated in a later opinion, “The law is settled,

that a holder, coming fairly by a bill or note, has nothing to do with the

transaction between the original parties . . . .” Peacock v. Rhodes, 2 Doug.

636, 99 Eng. Rep. 403 (K.B. 1781).

Today, of course, people do not use promissory notes—even notes made

by banks—like cash. Would trade and commerce suffer if takers of stolen

promissory notes ran the risk that the notes were stolen? If the rationale of


3. This has been true for quite some time. Writing more than sixty years ago, KarlLlewellyn observed:

I shall not undertake to explain how or why the commercial system of a century agolost the use of notes to evidence the credit-price of freshly delivered goods. It isenough here that the practice went into decline, and that between merchants goodsare now delivered typically on purely “open” credit (resulting in a “book account,”and “account receivable”), often with the buyer, if he is financially strong, payingwithin ten days against a large “cash discount.” The giving of a commercial notebetween dealers has come to be the gesture with which a stale account, long overdue,is promised really to be met next time. Such a note smells.

Llewellyn, Meet Negotiable Instruments, 44 Colum.L.Rev. 299, 321–22 (1944).

Miller v. Race does not explain the result in Problem 1.2.3, then what does?

In the commercial setting, negotiable notes rarely are used to evidence

an obligation to pay for goods sold on credit.3 When a negotiable note is

used, it typically is in connection with a loan of money. Nevertheless, in

either case, the payee (i.e., the person to whom the note is payable) may sell

the note or use it to secure a loan. Like Article 2, Article 3 contains both

security-of-property and good-faith-purchase rules governing the extent to

which a purchaser (buyer or secured party) takes a negotiable instrument

free from competing claims. Unless a person has the rights of a holder in

due course (“HDC”), the person takes the instrument subject to any existing

claim of a property or possessory right in the instrument or its proceeds.

UCC 3–306. A person having the rights of a holder in due course takes free

of the claim to the instrument. Id. The freedom from “claims” is analogous

to the protection from ownership interests that Article 2 affords to a good

faith purchaser of goods. See UCC 2–403 and Section 1, supra.

(3) Holder in Due Course. “Holder in due course” is the name given

to certain good faith purchasers for value of negotiable instruments under

Article 3. UCC 3–302(a) defines the term. Observe that not every person

who takes an instrument in good faith and for value qualifies as an HDC.

One also must be without notice of any of a variety of claims, defenses, and

irregularities. (You may recall that notice of competing claims may be

relevant to a putative good faith purchaser’s “good faith” under Article 2.)

Two other requirements for becoming a holder in due course are less

obvious. First, one must be the holder of an “instrument,” which UCC

3–104(b) defines as a “negotiable instrument.” Second, the person must be

a “holder.” When the instrument is payable to an identified person and the

identified person is in possession of the instrument, the person is the holder.

Alternatively, when the instrument is payable to bearer, the person in

possession is the holder. See UCC 1–201(b)(21).

M’s note in Problem 1.2.4, like the overwhelming majority of negotiable

promissory notes, is payable to the order of an identified person (A) and not

payable to bearer. To become a holder, C not only must take possession but

also must obtain the indorsement (signature) of A, the payee. Custom


dictates that A will indorse the note on the back. A’s indorsement may

identify C as the person to whom the instrument is payable (e.g., A’s

signature may be accompanied by the words “Pay to C”), or it may identify

no such person (e.g., it may consist only of A’s signature) and thereby make

the note payable to bearer. See UCC 3–205(a), (b). In either case, C will

become a holder upon taking possession of the note. If C also meets the

other requirements of UCC 3–302(a), then C will become a holder in due

course and take free of all claims, including A’s ownership claim.


by M, who promised “to pay on demand to bearer $5,000.” B stole the note

from A and gave it to C, who did not suspect the theft, in return for $2,500.

A sues C to replevy the note.

(a) What result? See UCC 3–103(a)(4); UCC 3–303; Note on Value, infra.

Compare Problem 1.1.3(c), supra, page 3.

(b) What result if C had promised to pay B $5,000 but has not yet paid

it? Compare Problem 1.1.3(d), supra. Would you advise C to pay B now, after

learning of the theft?

(c) What result if B gave the note to C in exchange for C’s promise to

deliver specially manufactured goods?

(d) What result if B gave the note to C in exchange for a $5,000 check

that is still in B’s hands? See UCC 3–303, Comment 5.

(e) What result if C took the note as security for a $2,500 loan that C had

extended to B six months earlier? See UCC 3–302(e). Compare Problem

1.1.5, supra.

NOTE ON VALUE

Good-faith-purchase rules are designed to protect purchasers for value.

See, e.g., UCC 2–403(1), (2); UCC 3–302(a)(2). The general definition of

“value” makes it clear that one gives “value” if one gives “any consideration

sufficient to support a simple contract.” UCC 1–204(4). But as defined in

Article 1, “value” is a broader concept than “consideration”; one can give

value by giving something that one already was obligated to give and that,

because of the pre-existing duty rule, would not qualify as consideration. See

UCC 1–204(2).

In Swift v. Tyson, Mr. Justice Story justified this result in connection

with the good faith purchase of negotiable instruments. Taking as given

that the holder of a negotiable instrument acquires good-faith-purchase

rights only where the holder receives the instrument for a valuable

consideration, the court asked:

. . . And why upon principle should not a pre-existing debt be deemed

such a valuable consideration? It is for the benefit and convenience of

the commercial world to give as wide an extent as practicable to the


4. Ironically, Swift v. Tyson is better known today for the choice-of-law rule thatwas given its quietus in Erie Railroad Co. v. Tompkins, 304 U.S. 64, 58 S.Ct. 817, 82L.Ed. 1188 (1938), than for the rule of negotiable instruments that survived. Devoteesof the “federal common law” will recall Clearfield Trust Co. v. United States, 318 U.S.363, 63 S.Ct. 573, 87 L.Ed. 838 (1943), in which it was concluded that “the rights andduties of the United States on commercial paper which it issues are governed by federalrather than local law.” For later applications of the Clearfield doctrine, see Note, 66 IowaL.Rev. 391 (1981). That the UCC is a source of federal common law, see United Statesv. Conrad Pub. Co., 589 F.2d 949, 953 (8th Cir.1978); Note, 20 B.C.L.Rev. 680, 680–81(1979).

credit and circulation of negotiable paper, that it may pass not only as

security for new purchases and advances, made upon the transfer

thereof, but also in payment of and as security for pre-existing debts.

The creditor is thereby enabled to realize or to secure his debt, and thus

may safely give a prolonged credit or forbear from taking any legal steps

to enforce his rights. The debtor also has the advantage of making his

negotiable securities of equivalent value to cash. But establish the

opposite conclusion, that negotiable paper cannot be applied in payment

of or as security for pre-existing debts, without letting in all the equities

between the original and antecedent parties, and the value and

circulation of such securities must be essentially diminished, and the

debtor driven to the embarrassment of making a sale thereof, often at

a ruinous discount to some third person, and then by circuity to apply

the proceeds to the payment of his debts. . . . The doctrine would strike

a fatal blow at all discounts of negotiable securities for pre-existing

debts.

Swift v. Tyson, 41 U.S. (16 Pet.) 1, 20, 10 L.Ed. 865 (1842).4 Could the same

argument be made with equal force with respect to goods?

For the purposes of Articles 3 and 4, the general definition of “value” in

UCC 1–204 is subject to the modifications imposed by UCC 3–303, UCC

4–210, and UCC 4–211. UCC 3–303(a)(3) preserves the departure from the

pre-existing debt rule justified by Mr. Justice Story. Indeed, UCC 3–303(b)

goes on to say that, for purposes of Articles 3 and 4, an instrument issued

for value is supported by consideration even if this would not be so under

contract law, as in the case of a note issued for an antecedent debt. See UCC

3–303, Comment 1, Case # 1.

Although UCC 3–303(a)(3) broadens the definition of “value,” subsection

(a)(1) narrows it substantially. It provides that a purchaser who gives a

promise takes an instrument for value only “to the extent that the promise

has been performed.” As Comment 2 explains, “The policy basis for

subsection (a)(1) is that the holder who gives an executory promise of

performance will not suffer an out-of-pocket loss to the extent the executory

promise is unperformed at the time the holder learns of dishonor of the

instrument.” In terms familiar to the law of contracts, the expectation to

which an executory promise gives rise is not enough; there must be actual


5. The exception in UCC 4–210(a)(2) will be considered later in the course.

reliance in the form of performance of that promise. Subsections (a)(4) and

(5) provide limited exceptions to this principle, notably in the case where the

executory promise is embodied in a negotiable instrument.5

How persuasive do you find this explanation? Did the holder in part (e)

of Problem 1.2.5, who took the note to secure an antecedent debt, suffer an

out-of-pocket loss in reliance on the negotiation of the note? Did the holder

in part (c), who took the note in exchange for a promise to deliver specially

manufactured goods?


by M, who promised “to pay on demand to bearer $1,000.” B stole it from A

and gave it to C, who did not suspect the theft, in return for $1,000. (These

are the facts of Problem 1.2.3, supra, page 20) C gave the note to his

daughter, D, as a gift for her twenty-first birthday. A sues D to replevy the

note. What result? See UCC 3–306; UCC 3–203. Would your answer change

if D had stolen the note from her father, C? See UCC 1–201(b)(15).


by M, who promised “to pay $5,000 to the order of A on June 30, 2008.” A

sold the note to B, who paid $4,200 for it. A agreed to retain possession of

the note and collect it for B when it came due. Thereafter, in violation of the

agreement, A sold and delivered the note to C without an indorsement. B

learns about the purported sale to C and demands that C “give me back my

note immediately.”

(a) What result? See UCC 3–306; UCC 3–102(b); UCC 9–109(a)(3); UCC

9–102(a)(65); UCC 9–102(a)(47); UCC 9–330(d); UCC 1–201(b)(35) (2d

sentence); Note on Multiple Assignments of Rights to Payment, infra.

(b) Recall Problem 1.1.6, supra, page 16. How does the rule in UCC

9–330(d) compare with the rule in UCC 2–403(2)?

NOTE ON MULTIPLE ASSIGNMENTS OF RIGHTS TO PAYMENT

The typical commercial note is payable to the order of an identified

person (the payee). Although a note may be transferred or negotiated many

times, most negotiable notes are transferred or negotiated once (if at all),

from the payee to a purchaser. The risk that the transferor acquired the

note through theft or fraud and that the true owner will claim it from the

purchaser, as in Problem 1.2.3 on page 20, supra, is negligible. A greater

risk, but one that is still rather small, is that the transferor previously sold

the note or used it to secure a loan or other obligation.

We have seen that a holder in due course takes free of ownership claims

to the instrument. See UCC 3–306; Problems 1.2.3 and 1.2.4, supra.


6. A form of purchase order appears on page 22, supra.

Inasmuch as a security interest is a property claim, a person having the

rights of a holder in due course also takes free of security interests that

secure an obligation. See UCC 3–306; UCC 9–331(a). But, as explained

below, even if the purchaser of a note is not a holder in due course, the

purchaser is likely to prevail over competing secured parties if it takes

possession of the note. See UCC 9–330(d).

To see why the law protects most purchasers of negotiable instruments

who take possession, it will be useful first to understand how the law deals

with multiple assignments of rights to payment that are not embodied in a

negotiable instrument. Consider these facts. An equipment dealer (Dealer)

is having difficulty selling its wares. Dealer finally succeeds in selling a

machine to Buyer, who agrees to pay $100,000 for it in 30 days. Dealer

assigns the right to payment (“account”) to Finance Company, which pays

Dealer $100,000 less a discount. But Dealer is in desperate financial straits.

The following day, Dealer assigns the same right to payment to Bank, which

also pays Dealer $100,000 less a discount. Who has the better claim to the

right to payment, Finance Company or Bank?

We have seen this problem before, with respect to goods. A person who

contracts to buy goods that the seller does not own normally acquires no

rights in the goods. See UCC 2–403(1) (first sentence). Nemo dat quod non

habet. We also have seen circumstances where an owner who parts with

possession of goods risks losing its ownership interest. See UCC 2–403(1)

(2d sentence) (owner who delivers goods to a fraud empowers the fraud to

divest the owner of its ownership rights); UCC 2–403(2) (buyer in ordinary

course of business from a merchant who deals in goods of the kind and to

whom the goods have been entrusted acquires all rights of the entruster).

A buyer can protect itself to a considerable degree by demanding to see the

goods before contracting to buy them and then taking immediate possession

of the goods it bought.

A purchaser of Dealer’s right to payment from Buyer cannot do the

same. Though the sale of a $100,000 item of equipment might be evidenced

by a formal written agreement, goods frequently are bought and sold on the

basis of a purchase order and a confirmation (remember the “Battle of the

Forms”?).6 These writings may provide helpful, if not essential, evidence

that the obligation was incurred. Even so, possession of these writings

typically affords no right to collect from Buyer. (This situation is to be

contrasted with a right to payment evidenced by a negotiable instrument.

As we shall see, the right to enforce a negotiable instrument typically

depends on possession of the instrument.)

In the absence of a negotiable instrument, who enjoys the superior right

to collect the amount owing from Buyer? (This right to payment is called an

“account.” See UCC 9–102(a)(2).) “To the delight of contracts teachers, the


7. Except as otherwise provided by statute, the right of an assignee is superior tothat of a subsequent assignee of the same right from the same assignor, unless

(a) the first assignment is ineffective or revocable or is voidable by the assignor orby the subsequent assignee; or

(b) the subsequent assignee in good faith and without knowledge or reason to knowof the prior assignment gives value and obtains

(i) payment or satisfaction of the obligation,

(ii) judgment against the obligor,

(iii) a new contract with the obligor by novation, or

(iv) possession of a writing of a type customarily accepted as a symbol or asevidence of the right assigned.

Restatement (Second) Contracts § 342.

courts fashioned no fewer than three colorfully captioned rules to resolve

this issue. There was a ‘New York’ rule, an ‘English’ rule, and a

‘Massachusetts’ or ‘four horsemen’ rule.” E. Farnsworth, Contracts 714 (4th

ed. 2004). Fortunately, these multiple rules have all but fallen into

desuetude. The Restatement (Second) of Contracts adopts the

Massachusetts rule, which is most protective of good faith purchasers.7

In most transactions, however, UCC Article 9 (and not the common law)

resolves the competing claims of multiple assignees. The applicable Article

9 rules are somewhat complicated. To simplify, Article 9 provides:

a system by which a secured creditor can perfect a security interest in

most kinds of personal property by filing in a government office a

financing statement briefly describing that interest. [A form financing

statement appears in UCC 9–521(a).] Because Article 9 is not limited to

assignments of accounts for security, its rules on filing extend to

outright sales of accounts as well. Under the Code, in a contest between

two assignees that have given value, the assignee that first files a

financing statement covering its assignment prevails. Thus the second

assignee might achieve priority over the first assignee by filing first.

E. Farnsworth, Contracts 719 (4th ed. 2004).

Just as a buyer of goods can rely on the seller’s possession, an assignee

of accounts can rely on the filing system to reduce the risk that it is

purchasing property to which someone else has a claim. If an assignee

“checks the files before it takes an assignment and finds no other financing

statement, it can, by filing immediately itself, get priority over any other

assignee, even if the other assignee’s assignment was prior in time.” Id.

Unlike accounts, negotiable instruments can be the subject of

possession. Accordingly, Article 9 provides that a purchaser of an

instrument loses priority to a subsequent purchaser if the latter “gives value

and takes possession of the instrument in good faith and without knowledge

that the purchase violates the rights” of the earlier purchaser. UCC

9–330(d). A subsequent purchaser who takes possession may prevail even


8. Restatement (Second) of Contracts § 336(1) provides as follows:

By an assignment the assignee acquires a right against the obligor only to theextent that the obligor is under a duty to the assignor; and if the right of theassignor would be voidable against the obligor or unenforceable against him ifno assignment had been made, the right of the assignee is subject to theinfirmity.

As to A’s liability to B, Restatement (Second) of Contracts § 333(1) provides:

Unless a contrary intention is manifested, one who assigns . . . a right byassignment . . . for value warrants to the assignee . . . that the right, asassigned, actually exists and is subject to no limitations or defenses goodagainst the assignor other than those stated or apparent at the time of the

if the initial purchaser had filed a financing statement and even if the

subsequent purchaser checked the public record and saw the financing

statement. Of course, if the subsequent purchaser is a holder in due course,

then the purchaser will take free of all claims to the instrument. See UCC

9–331(a); UCC 3–306.

(B) DEFENSES TO RIGHTS TO PAYMENT

A purchaser who takes an assignment of a right to payment of some

kind (e.g., the assignor’s right to payment for goods sold or the payee’s right

to payment of a negotiable instrument) is concerned not only with taking the

property free from the claims of third parties but also, and usually more so,

with acquiring the ability to enforce the obligation free of the obligor’s

defenses.

Problem 1.2.8. A manufactures and sells auto parts on credit to

wholesale dealers. One customer, O, contracted to pay $60,000 for a

shipment of goods. When the time for payment came, O paid only $20,000

because the goods were seriously defective.

(a) A brings suit against O for the $40,000 balance. What result? See

UCC 2–709; UCC 2–714; UCC 2–717.

(b) What result in part (a) if O refused to pay the balance because A had

failed to repay a $40,000 loan from O? Does UCC 2–717 apply? See UCC

2–717, Comment 1; Note (6) on Defenses to Payment Obligations, infra. If

not, what law does apply? See UCC 1–103(b).

Problem 1.2.9. Suppose that, under the facts of the Problem 1.2.8(a),

A assigned to B, a finance company, “all A’s existing and after-acquired

rights to payment for goods sold (‘accounts’) and all notes and other

instruments representing such rights to payment.” B properly demanded

payment from each of A’s customers, including O, who paid only $20,000

because the goods were seriously defective. B brings suit against O for the

$40,000 balance.

(a) What result? See UCC 9–404(a); Note (1) on Defenses to Payment

Obligations, infra. Cf. Restatement (Second) of Contracts § 336(1).8


assignment . . . .

9. Restatement (Second) of Contracts § 336(2) provides: “The right of an assigneeis subject to any defense or claim of the obligor which accrues before the obligor receivesnotification of the assignment but not to defenses or claims which accrue thereafterexcept as stated in this Section or as provided by statute.”

(b) What result if O paid only $20,000 because A had failed to repay a

$40,000 loan from O? Does it matter when A’s default occurred? See UCC

9–404(a). Cf. Restatement (Second) of Contracts § 336(2).9

(c) Assume the contract of sale contained the following provision: “Buyer

[O] understands and acknowledges that Seller [A] may assign Seller’s rights

under this Agreement for collateral purposes or otherwise. Buyer agrees

that, in the event of any such assignment, Buyer will not assert against any

assignee any claims or defenses that Buyer may have against Seller arising

under this Agreement or otherwise.” What result in parts (a) and (b)? See

UCC 9–403(a)–(c); UCC 3–305.

(d) Why would anyone sign a contract that contains the provision set

forth in part (c)? Consider the options that would be available to O if it

refused to agree to A’s terms and see Note (2) on Defenses to Payment

Obligations, infra.

Problem 1.2.10. A manufactures and sells auto parts on credit to

wholesale dealers. To obtain funds immediately, A assigned to B, a finance

company, “all A’s existing and after-acquired rights to payment for goods

sold (‘accounts’) and all notes and other instruments representing such

rights to payment.” A promptly delivered each assigned instrument to B.

One customer, M, signed a promissory note, in which M agreed to pay

$60,000 on a specified date “to the order of A” for a shipment of goods. B

properly demanded payment from each of A’s customers, including M, who

paid only $20,000 because the goods were seriously defective. B brings suit

against M for the $40,000 balance.

(a) What result if A had indorsed the note, “pay to B, [signed] A” before

delivering it? See UCC 3–412; UCC 3–104; UCC 3–301; UCC 3–305(a), (b);

UCC 3–302; UCC 1–201(20); UCC 3–205; UCC 3–303; UCC 3–103(a)(4);

UCC 1–201(25); Note (4) on Defenses to Payment Obligations, infra.

(b) What result if A delivered the note to B without having indorsed it?

Can B even bring suit against M? See UCC 3–412; UCC 3–301; UCC 3–203;

UCC 3–305. Would B improve its position by obtaining A’s indorsement

before bringing suit? See UCC 3–203(c).

(c) Assume that A delivered the note without having indorsed it. What

result if M refused to pay for the goods because A had failed to repay a loan

from M? Does it matter when A’s default occurred? See UCC 3–203(c); UCC

3–305(a) and Comment 3 (last paragraph).

(d) To what extent do your answers to this Problem differ from your


answers to Problem 1.2.9? Are the differences justified?

Kaw Valley State Bank & Trust Co. v. RiddleSupreme Court of Kansas, 1976.219 Kan. 550, 549 P.2d 927.

O FROMME, JUSTICE.

This action was brought by The Kaw Valley State Bank and Trust

Company (hereinafter referred to as Kaw Valley) to recover judgment

against John H. Riddle d/b/a Riddle Contracting Company (hereafter

referred to as Riddle) on two notes . . . . The two notes were covered by

separate security agreements and were given to purchase construction

equipment. . . . Kaw Valley had acquired the two notes and the security

agreements by assignment from Co-Mac, Inc. (hereafter referred to as

Co-Mac), a dealer, from whom Riddle purchased the construction

equipment.

In a trial to the court Kaw Valley was found not to be a holder in due

course of one of the notes. Its claim on said note, totaling $21,904.64, was

successfully defended on the grounds of failure of consideration. It was

stipulated at the trial that none of the construction equipment for which the

note was given had ever been delivered by Co-Mac. Kaw Valley has

appealed.

. . .

Prior to the transactions in question Riddle had purchased construction

equipment and machinery from the dealer, Co-Mac. A number of these

purchases had been on credit and discounted to Kaw Valley by Co-Mac.

Including the Riddle transactions, Kaw Valley had purchased over 250

notes and security agreements from Co-Mac during the prior ten year

period. All were guaranteed by Co-Mac and by its president personally.

In May, 1971, Riddle negotiated for the purchase of a model 6-c

Caterpillar tractor, a dozer and a used 944 Caterpillar wheel tractor with

a two yard bucket. Riddle was advised that this machinery could be

delivered but it would first be necessary for Co-Mac to have a signed note

and security agreement to complete the transaction. An installment note,

security agreement and acceptance of delivery of the machinery was mailed

to Riddle. These were signed and returned to Co-Mac. Ten days later, the

machinery not having been delivered, Riddle called Co-Mac and inquired

about purchasing a D-8 Caterpillar and a #80 Caterpillar scraper in place

of the first machinery ordered. Co-Mac agreed to destroy the May 11, 1971

papers and sell this larger machinery to Riddle in place of that previously

ordered.

The sale of this substitute machinery was completed and the machinery

was delivered after the execution of an additional note and security


agreement. However, the May 11, 1971 papers were not destroyed. The note

had been discounted and assigned to Kaw Valley prior to the sale of the

substitute machinery. Thereafter Co-Mac, who was in financial trouble,

made regular payments on the first note to Kaw Valley. The note was thus

kept current by Co-Mac and Riddle had no knowledge of the continued

existence of that note. The 6-c Caterpillar tractor, dozer and the used 944

Caterpillar wheel tractor were never delivered to Riddle. Riddle received no

consideration for the May 11, 1971 note . . . .

On February 24, 1972, representatives of Riddle, Co-Mac and Kaw

Valley met for the purpose of consolidating the indebtedness of Riddle on

machinery notes held by Kaw Valley and guaranteed by Co-Mac. . . .

Thereupon a renewal note and security agreement for $44,557.70 dated

February 24, 1972, was drawn consolidating and renewing the seven

remaining notes. Riddle then asked Kaw Valley if this was all that it owed

the bank and he was assured that it was. The renewal note was then

executed by Riddle.

It was not until March 12, 1972, that Riddle was advised by Kaw Valley

that it held the note and security agreement dated May 11, 1971, which

Riddle believed had been destroyed by Co-Mac. This was within a week after

a receiver had been appointed to take over Co-Mac’s business affairs. Riddle

explained the machinery had never been delivered and Co-Mac promised to

destroy the papers. No demand for payment of the May 11, 1971 note was

made on Riddle until this action was filed.

. . .

The primary point on appeal questions the holding of the trial court that

Kaw Valley was not a holder in due course of the note and security

agreement dated May 11, 1971.

[F3–305] provides that unless a holder of an instrument is a holder in

due course he takes the instrument subject to the defenses of want or failure

of consideration, nonperformance of any condition precedent, nondelivery

or delivery for a special purpose. [Cf. UCC 3–305(a).] It was undisputed in

this case that Riddle received no consideration after executing the note. The

machinery was never delivered and he was assured by Co-Mac that the

papers would be destroyed. The parties so stipulated. If Kaw Valley was not

a holder in due course the proven defense was a bar to recovery by Kaw

Valley.

[F3–302] states a holder in due course is a holder who takes the

instrument (1) for value, (2) in good faith and (3) without notice of any

defense against it. [Cf. UCC 3–302(a).] It was not disputed and the court

found that Kaw Valley took the note for value so the first requirement was

satisfied. The other requirements were subject to dispute. The trial court

concluded:

“Kaw Valley State Bank and Trust Company is not a holder in due


course of the note and security agreement, dated May 11, 1971 for the

reason that it did not establish in all respects that it took said

instruments in good faith and without notice of any defense against or

claimed to it on the part of John H. Riddle, and Kaw Valley State Bank

and Trust Company therefor took said instruments subject to the

defense of failure of consideration. (Citations omitted.)”

So we are confronted with the question of what is required for a holder

to take an instrument “in good faith” and “without notice of defense”. We

will consider the two parts of the question in the order mentioned.

“Good faith” is defined in [F1–201(19)] as “honesty in fact in the conduct

or transaction concerned.” The first draft of the Uniform Commercial Code

(U.C.C.) as proposed required not only that the actions of a holder be honest

in fact but in addition it required the actions to conform to reasonable

commercial standards. This would have permitted the courts to inquire as

to whether a particular commercial standard was in fact reasonable. (See

Uniform Commercial Code, Proposed Final Draft [1950], § 1-201, 18, p. 30.)

However, when the final draft was approved the test of reasonable

commercial standards was excised thus indicating that a more rigid

standard must be applied for determining “good faith”.

From the history of the Uniform Commercial Code it would appear that

“good faith” requires no actual knowledge of or participation in any material

infirmity in the original transaction.

The second part of our question concerns the requirement of the U.C.C.

that a holder in due course take the instrument without notice of any

defense to the instrument. [F1–201(25)] provides:

“A person has ‘notice’ of a fact when

“(a) he has actual knowledge of it; or

“(b) he has received a notice or notification of it; or

“(c) from all the facts and circumstances known to him at the time

in question he has reason to know that it exists. A person ‘know[s]’ or

has ‘knowledge’ of a fact when he has actual knowledge of it. ‘Discover’

or ‘learn’ or a word or phrase of similar import refers to knowledge

rather than to reason to know. The time and circumstances under which

a notice or notification may cease to be effective are not determined by

this act.” [Cf. UCC 1–202.]

As is apparent from reading the above statute the standard enunciated

is not limited to the rigid standard of actual knowledge of the defense.

Reason to know appears to be premised on the use of reasonable commercial

practices. Since “good faith” and “no notice of defense” are both required of

a holder to claim the status of a holder in due course it would appear that

the two standards are not in conflict even though the standards of conduct

may be different.

There is little or no evidence in the present case to indicate that Kaw


Valley acted dishonestly or “not in good faith” when it purchased the note

of May 11, 1971. However, as to “notice of defense” the court found from all

the facts and circumstances known to Kaw Valley at the time in question it

had reason to know a defense existed. The court found:

“During the period 1960 to May, 1971, plaintiff purchased from

Co-Mac over 250 notes and secured transactions and held at any given

time between $100,000.00 and $250,000.00 of such obligations. All of

which were guaranteed by Co-Mac and personally guaranteed by D. J.

Wickern, its president. Conant Wait personally handled most if not all

of such transactions for plaintiff. Mr. Wait was aware that Co-Mac was

making warranties and representation as to fitness to some purchasers

of new and used equipment. Mr. Wait further knew that some

transactions were in fact not as they would appear to be in that the

money from Kaw Valley would be used by Co-Mac to buy the equipment

that was the subject matter of the sale. Further, that delivery to the

customer of said purchased equipment was sometimes delayed 60 to 90

days for repairing and/or overhauling of same. The plaintiff obviously on

many transactions was relying on Co-Mac to insure payment of the

obligations and contacted Co-Mac to collect delinquent payments. Some

transactions involved delivery of coupon books to Co-Mac rather than

the debtor so Co-Mac could bill service and parts charges along with the

secured debt. Co-Mac collected payments directly from debtors in

various transactions and paid plaintiff. Plaintiff did not concern itself

with known irregularities in the transactions as it clearly was relying

on Co-Mac;

“The coupon book on the May 11, 1971 transaction was not sent to

defendant Riddle; no payments on same were made by defendant Riddle;

the payments were made by Co-Mac until January 25, 1972; prior to

early March, 1972, defendant Riddle did not know plaintiff had the May

11, 1971 secured transaction; knowledge of said transaction came to

defendant Riddle on March 12, 1972 when Mr. Wait contacted defendant

Riddle’s manager; that Co-Mac had shortly before been placed in

receivership; that no demand for any payment on said transaction was

made by plaintiff to defendant Riddle until September 1972.”

To further support its holding that Kaw Valley had reason to know that

the defense existed the court found that when Kaw Valley, Co-Mac and

Riddle met on February 24, 1972, to consolidate all of Riddle’s past due

notes Kaw Valley recognized Co-Mac’s authority to act for it. Co-Mac and

accepted return of the machinery on one of the eight transactions and Kaw

Valley recognized its authority as their agent to do so and cancelled the

$5,000.00 balance remaining due on the note held by the bank.

The cases dealing with the question of “reason to know a defense exists”

seem to fall into four categories.

The first includes those cases where it is established the holder had


information from the transferor or the obligor which disclosed the existence

of a defense. In those cases it is clear if the holder takes an instrument

having received prior or contemporaneous notice of a defense he is not a

holder in due course. Our present case does not fall in that category for

there is no evidence that Co-Mac or Riddle informed Kaw Valley that the

machinery had not been delivered when the note was negotiated.

The second group of cases are those in which the defense appears in an

accompanying document delivered to the holder with the note. For example,

when a security agreement is executed concurrently with a note evidencing

an indebtedness incurred for machinery to be delivered in the future. In

such case the instrument may under certain circumstances disclose a

defense to the note, such as nondelivery of the machinery purchased. Our

present case does not fall in this category because Riddle had signed a

written delivery acceptance which was handed to Kaw Valley along with the

note and security agreement.

A third group of cases are those in which information appears in the

written instrument indicating the existence of a defense, such as when the

note on its face shows that the due date has passed or the note bears visible

evidence of alteration and forgery or the note is clearly incomplete. In our

present case the instrument assigned bore nothing unusual on its face and

appeared complete and proper in all respects.

In the fourth category of cases it has been held that the holder of a

negotiable instrument may be prevented from assuming holder in due

course status because of knowledge of the business practices of his

transferor or when he is so closely aligned with the transferor that

transferor may be considered an agent of the holder and the transferee is

charged with the actions and knowledge of the transferor.

Under our former negotiable instruments law containing provisions

similar to the U.C.C. this court refused to accord holder in due course status

to a machinery company receiving notes from one of its dealers because of

its knowledge of the business practices of the dealer and the company’s

participation and alignment with the dealer who transferred the note.

In Unico v. Owen, 50 N.J. 101, 232 A.2d 405, the New Jersey court

refused to accord holder in due course status to a financing partnership

which was closely connected with the transferor and had been organized to

finance the commercial paper obtained by the transferor and others. The

financing partnership had a voice in setting the policies and standards to be

followed by the transferor. Under such circumstances the court found that

the holder must be considered a participant in the transaction and subject

to defenses available against the payee-transferor. In United States Finance

Company v. Jones, 285 Ala. 105, 229 So.2d 495, it was held that a finance

company purchasing a note from a payee for fifty percent of its face value

did not establish holder in due course status and must be held subject to

defenses inherent in the original transaction. Other jurisdictions have


followed the rationale of Unico. See American Plan Corp. v. Woods, 16 Ohio

App.2d 1, 240 N.E.2d 886, where the holder supplied forms to the payee,

established financing charges and investigated the credit of the maker of the

note; Calvert Credit Corporation v. Williams, 244 A.2d 494 (D.C.App.1968),

where the holder exerted total control over payee’s financial affairs; and

Jones v. Approved Bancredit Corp., 256 A.2d 739 (Del.1969), where

ownership and management of the holder and payee were connected.

In the present case Kaw Valley had worked closely with Co-Mac in over

250 financing transactions over a period of ten years. It knew that some of

these transactions were not for valuable consideration at the time the paper

was delivered since the bank’s money was to be used in purchasing the

machinery or equipment represented in the instruments as already in

possession of the maker of the note. Kaw Valley had been advised that

delivery to Co-Mac’s customers was sometimes times delayed from 60 to 90

days. Kaw Valley continued to rely on Co-Mac to assure payment of the

obligations and contacted it to collect delinquent payments. Some of these

transactions, including the one in question, involved the use of coupon books

to be used by the debtor in making payment on the notes. In the present

case Kaw Valley did not notify Riddle that it was the holder of the note. It

delivered Riddle’s coupon book to Co-Mac as if it were the obligor or was

authorized as its collection agent for this transaction. Throughout the period

from May 11, 1971, to February 25, 1972, Kaw Valley received and credited

the monthly payments knowing that payments were being made by Co-Mac

and not by Riddle. Then when Riddle’s loans were consolidated, the May 11,

1971 transaction was not included by Kaw Valley, either by oversight or by

intention, as an obligation of Riddle. Co-Mac occupied a close relationship

with Kaw Valley and with its knowledge and consent acted as its agent in

collecting payments on notes held by Kaw Valley. The working relationship

existing between Kaw Valley and Co-Mac was further demonstrated on

February 24, 1972, when the $5,000.00 balance due on one of Riddle’s notes

was cancelled when it was shown that the machinery for which the note was

given had previously been returned to Co-Mac with the understanding that

no further payments were due.

[F3–307(3)] provides:

“After it is shown that a defense exists a person claiming the rights

of a holder in due course has the burden of establishing that he or some

person under whom he claims is in all respects a holder in due course.”

[Cf. UCC 3–308(b).]

In the present case the court found that the appellant, Kaw Valley, had

not sustained its burden of proving that it was a holder in due course. Under

the evidence in this case the holder failed to advise the maker of the note of

its acquisition of the note and security agreement. It placed the payment

coupon book in the hands of Co-Mac and received all monthly payments

from them. A close working relationship existed between the two companies


and Co-Mac was clothed with authority to collect and forward all payments

due on the transaction. Agency and authority was further shown to exist by

authorizing return of machinery to Co-Mac and terminating balances due

on purchase money paper. We cannot say under the facts and circumstances

known and participated in by Kaw Valley in this transaction it did not at

the time in question have reason to know that the defense existed. This was

a question of fact to be determined by the trier of fact which if supported by

substantial competent evidence must stand.

. . .

The judgment is affirmed.

NOTES ON DEFENSES TO PAYMENT OBLIGATIONS

(1) Defenses to a Contractual Obligation. Problem 1.2.9 represents

a typical commercial transaction. Seller (A) sells goods to Buyer (O) on open

account, i.e., Buyer’s unsecured obligation is represented by a purchase

order or other record that, perhaps taken together with other records,

creates a contract. Finance Company (B) finances Seller’s rights to payment

(accounts) by advancing funds against the accounts as they arise. In this

way, Seller obtains cash immediately, without having to wait for the credit

period to expire. Depending on how the transaction is structured, the funds

advanced by Finance Company may represent a loan to Seller, secured by

the accounts, or the purchase price for an outright sale of the accounts.

(Accounts receivable financing is quite complicated; further details are best

left to later in the course.)

Upon Seller’s default on its obligation to Finance Company, and even

before if Seller agrees, Finance Company may collect from Buyer on Buyer’s

obligation. See UCC 9–607(a)(1) (in Article 9 terminology, Finance Company

is the “secured party” and Buyer is an “account debtor”). Whether Finance

Company will succeed in collecting from Buyer depends in large part on

whether Buyer is able to pay and whether it is legally obligated to do so.

Before it advances funds to Seller, Finance Company may take steps to

reduce credit risk, i.e., the risk that, when the obligation is enforced, Buyer

will be unable or unwilling to pay. Finance Company normally will

investigate the creditworthiness of Buyer. It may insist that one or more

other persons guarantee the payment of Buyer’s obligations, as was the case

in Kaw Valley. If Finance Company is receiving an assignment of a large

number of receivables, then it may elect to investigate the creditworthiness

of Seller’s customers generally before it agrees to take the assignment. In

addition, Finance Company can take steps to minimize the risk that Buyer

can assert valid defenses to its obligation. These steps may include

determining Seller’s reputation for performing its contracts before Finance

Company advances funds.

Seller’s failure to perform its obligations under the contract with Buyer


10. With respect to transactions not covered by Article 9, see Restatement (Second)of Contracts §§ 336(1), (2), which contain rules that are similar to UCC 9–404(a) and areset forth in notes 7 and 8, supra.

11. UCC 9–404(a) subjects the assignee to a buyer’s claims as well as its defenses.A buyer who pays the contract price for defective goods has a claim against the seller fordamages. See UCC 2–714. A buyer may assert this claim against the seller’s assignee(here, Finance Company) only to reduce the amount the buyer owes; the buyer may notrecover from Finance Company any payments already made. UCC 9–404(b).

12. An assignee that is protected by UCC 9-403(b) essentially receives the sameprotection as does an HDC of a negotiable instrument. See 9-403(c). UCC 9-403(b) is asafe harbor. If other law so provides, an agreement to waive defenses may be enforceablealso by assignees who do not qualify as good faith purchasers and may enable assigneesto take free of defenses that cannot be asserted against an HDC. See UCC 9–403(f).

may give Buyer a legal justification for not paying the price of the goods. For

example, if, as in Kaw Valley, the goods never were delivered, Buyer would

have a defense of failure of consideration. If the goods were delivered and

accepted but were nonconforming, as in Problem 1.2.8(a), Buyer would have

the right to deduct from its obligation for the price (UCC 2–709) its damages

for breach of warranty (UCC 2–714). See UCC 2–717. The right to deduct

sometimes is called a claim in recoupment. See Note (6), infra. Under

some circumstances, Buyer may be able to revoke its acceptance of the

goods. See UCC 2–608. The question for us now is: Are Buyer’s defenses and

claims in recoupment available to defeat Finance Company?

UCC 9–404(a) contains a provision that protects parties to contracts,

like Buyer, from unexpected inroads on their contractual relationships.

Under this provision, the assignee of a right to payment, like the purchaser

of goods, ordinarily acquires no better rights than the assignor had.10 Thus,

the assignment of Seller’s right to payment does not ipso facto deprive

Buyer of its right to defend against the claim.11 UCC 9–404(a) is another

example of the “security of property” (nemo dat) principle discussed in

Section 1, supra. On the other hand, UCC 9–403(b) contains a

good-faith-purchase rule: A waiver-of-defense clause, whereby Buyer

agrees not to assert against an assignee any claim or defense that Buyer

may have against Seller, is enforceable by an assignee who takes the

assignment for value, in good faith, and without notice of any claim or

defense.12

The implications of the preceding sentence may not be readily apparent.

Buyer buys goods on credit from Seller pursuant to an agreement containing

a waiver-of-defense clause. Seller borrows from Finance Company and uses

Buyer’s obligation (and the obligations of Seller’s other customers) to secure

the loan. The goods prove to be defective. If Seller were to demand payment

from Buyer, Buyer would have a defense—either by rejecting the goods if

they have not already been accepted (UCC 2–601), or, if they have been

accepted, by revoking acceptance (UCC 2–608) or recouping damages for

breach of warranty against the buyer’s obligation for the price (UCC 2–714,


2–717). But Finance Company may enforce the agreement and take free of

that defense if it acquired its security interest for value, in good faith, and

without notice of any claims or defenses. In short, Buyer is legally obligated

to pay Finance Company for the defective goods.

Of course, even if Buyer must pay the price to Finance Company, Buyer

still has a claim against Seller. The following considerations, which are

particularly striking in consumer transactions (discussed below in Note (7)),

suggest that Buyer is in a stronger position if it can assert a defense against

Finance Company:

(1) The inertia of litigation. Setting up a defense is easier than starting

an action, even though the “burden of proof” with regard to Seller’s

breach may fall on Buyer in either case. In practice, this consideration

has its greatest impact on the settlement value of Buyer’s claim, since

a reduction in price is much easier to negotiate than a cash refund. (As

we shall see, imposing the “burden of bringing litigation” on the other

party is an objective shared by contracting parties in a variety of

settings.)

(2) The strain of current cash outlay. Buyer may not have the resources

to pay the full amount for defective goods and wait (perhaps for years)

until a legal action against Seller can reach trial and finally be

converted into a judgment.

(3) The risk of Seller’s insolvency. Seller may be insolvent or judgment

proof. Seller may have been a fly-by-night operator, or driven into

sharp practice by financial pressure, or forced to the wall by keen

competition, poor management, or a business recession.

Conversely, these advantages to Buyer in preserving defenses against

an action for the price suggest the importance to Finance Company of

freeing itself from these defenses. Finance Company’s interest is magnified

to the extent that buyers interpose spurious defenses in an attempt to scale

down or avoid their obligation to pay for what they buy.

(2) Who Benefits from a Waiver of Defenses? In considering who

benefits from a buyer’s or other account debtor’s waiver of its defenses, it is

best to concentrate on the normal case, in which the buyer asserts no

defense to its obligation, rather than the abnormal case (popular with

editors of casebooks), in which the buyer does assert a defense. Obviously

the financing agency benefits by being freed from most defenses in the

abnormal case. But in the normal case, the seller and the buyer benefit as

well because of the resulting expansion of the “market” for rights to

payment. The seller, as the payee who dealt with the buyer, would not have

been protected if the seller had retained the right to payment. However, the

seller benefits indirectly from the protection that the waiver of defenses

affords the financing agency to which the seller assigns the account, because

financing agencies, freed from most of the buyer’s defenses, are more willing


to finance transactions and to do so on more favorable terms, e.g., by

lowering the discount and advancing a larger amount against the account.

This, in turn, enables the seller to sell to more buyers on credit and to offer

them more favorable terms. And this may make credit available to the buyer

when it otherwise would be denied or make credit available to the buyer at

more favorable terms than otherwise would pertain. On this reasoning, a

buyer’s ability to waive most defenses as against a financing agency may

benefit all three parties—buyer, seller, and financier.

Waivers of defenses in the consumer setting have been particularly

controversial and have been addressed at both the Federal and State level.

See Note (7), infra.

(3) Liability “on the Instrument”; Person Entitled to Enforce the

Instrument. Signing a negotiable instrument is a significant act: A person

who signs a negotiable instrument becomes obligated to pay it. The precise

terms and conditions of the obligation to pay the instrument are set forth in

UCC 3–412 through 3–415 and depend on the capacity in which the person

signs. For example, the obligation of the maker of a note under UCC 3–412

differs from the obligation of the drawer of a check under UCC 3–414 and

the obligation of an indorser under UCC 3-415. The obligation on the

instrument is separate from, but related to, the obligation for which the

instrument is given (e.g., the obligation to pay for goods). The relationship

between these two obligations is discussed in Note (8), infra.

Generally speaking, an obligation on an instrument is owed to a “person

entitled to enforce the instrument” (“PETETI”). This term is defined in UCC

3–301. Except in the rare cases in which an instrument is lost, destroyed,

stolen, or paid by mistake, the person entitled to enforce the instrument

must be in possession of the instrument, specifically, it must be “the holder

of the instrument” or “a nonholder in possession of the instrument who has

the rights of a holder.”

How does a nonholder acquire the rights of a holder? By “transfer” of the

instrument. “Transfer of an instrument . . . vests in the transferee any right

of the transferor to enforce the instrument . . . .” UCC 3–203(b). This rule

reflects the principle of nemo dat quod non habet discussed in Section 1,

supra. As we saw with respect to goods, nemo dat means that a transferor

with good title can transfer good title even to a person who does not qualify

as a good faith purchaser for value. Likewise, a person having the rights of

a holder in due course can transfer those rights, even to a person that does

not itself qualify as an HDC (e.g., because it is not a holder or did not take

the instrument for value). UCC 3–203(b). Under those circumstances, the

transferee acquires whatever enforcement rights the HDC enjoyed. Nemo

dat also means that a transferor with limited rights can transfer only those

limited rights. The transferee may acquire greater rights than the

transferor, however, if the transferee takes the instrument for value and

otherwise qualifies as a holder in due course.


How is an instrument transferred? “An instrument is transferred when

it is delivered by a person other than its issuer for the purpose of giving to

the person receiving delivery the right to enforce the instrument.” UCC

3–203(a). How does a “transfer” differ from a “negotiation”? Compare UCC

3–203(a) with UCC 3–201(a).

(4) Defenses to Obligations on Negotiable Instruments; Holders

in Due Course. UCC 3–412 imposes on the issuer (maker) of a negotiable

note an unconditional obligation to pay. However, the right to enforce the

obligation of a party to an instrument ordinarily is subject to the claims and

defenses set forth in UCC 3–305(a). These include “a defense of the obligor

that would be available if the person entitled to enforce the instrument were

enforcing a right to payment under a simple contract,” UCC 3–305(a)(2), as

well as certain “claim[s] in recoupment.” UCC 3–305(a)(3).

As is the case with claims, Article 3 contains not only a security-of-

property rule but a good-faith-purchase rule with respect to defenses. The

preceding Note discusses the security-of-property rule found in UCC

3–203(b): Transfer of an instrument vests in the transferee any right of the

transferor to enforce the instrument. UCC 3–305(b) contains the good-faith-

purchase rule: A holder in due course takes free of most defenses and claims

in recoupment.

In effect, the act of signing a negotiable instrument constitutes the

signer’s agreement to waive its defenses and claims in recoupment in favor

of a holder in due course. Who benefits from negotiable instruments having

this quality? Who suffers? Do the benefits justify the costs?

We saw in Note (3) on Negotiable Instruments and Negotiation, supra,

that only a holder qualifies as a holder in due course. To qualify as an HDC,

the holder must take the instrument in value, in good faith, and without

notice of any of a variety of claims, defenses, and irregularities. We

considered the value requirement above. See Note on Value, supra. We now

consider the good-faith and notice requirements.

Good Faith. The standard of good faith applicable to negotiable

instruments—and particularly the relationship of negligence to good

faith—has had a checkered career both in Great Britain and here in the

United States. Indeed, the applicable definition in the UCC itself has

changed over time. The drafters of Article 3 originally laid down a standard

of good faith that was not unlike the merchant’s standard of good faith in

Article 2. In the 1952 edition of the UCC, UCC 3–302(1)(b) read: “(b) in good

faith including observance of the reasonable commercial standards of any

business in which the holder may be engaged . . . .”

The comment to this section explained:

The “reasonable commercial standards” language added here and in

comparable provisions elsewhere in the Act, e.g., Section 2–103, merely

makes explicit what has long been implicit in case-law handling of the


“good faith” concept. A business man engaging in a commercial

transaction is not entitled to claim the peculiar advantages which the

law accords to the good faith purchaser—called in this context holder in

due course—on a bare showing of “honesty in fact” when his actions fail

to meet the generally accepted standards current in his business, trade

or profession. The cases so hold; this section so declares the law.

The 1957 edition applied the “honesty in fact” test of F1–201(19) to

Article 3. The reason given for the change was: “. . . to make clear that the

doctrine of an objective standard of good faith, exemplified by the case of

Gill v. Cubitt, 3 B. & C. 446 (1824) [good faith requires “a proper and

reasonable degree of caution necessary to preserve the interest of trade”],

is not intended to be incorporated. . . .” Am. Law Inst. & Nat’l Conf. of

Comm’rs on Unif. State Laws, 1956 Recommendations of the Editorial

Board for the Uniform Commercial Code 103 (1957).

The 1990 revisions of Articles 3 and 4 returned to a definition of good

faith that is similar to the definition applicable to merchants in Article 2:

“honesty in fact and the observance of reasonable commercial standards of

fair dealing.” UCC 3–103(a)(4). Comment 4 cautions the careless reader,

who might misconstrue the provision as reestablishing the negligence

standard of good faith:

Although fair dealing is a broad term that must be defined in context,

it is clear that it is concerned with the fairness of conduct rather than

the care with which an act is performed. Failure to exercise ordinary

care in conducting a transaction is an entirely different concept than

failure to deal fairly in conducting the transaction. Both fair dealing and

ordinary care, which is defined in Section 3–103(a)(7), are to be judged

in the light of reasonable commercial standards, but those standards in

each case are directed to different aspects of commercial conduct.

What exactly does it mean for a purchaser to be honest but unfair?

Section 205 of the Restatement (Second) of Contracts provides that every

contract imposes upon each party a duty of good faith and fair dealing in its

performance and its enforcement. Comment b explains that, in the context

of good faith purchase, “‘good faith’ focuses on the honesty of the purchaser,

as distinguished from his care or negligence. . . . This focus on honesty is

appropriate to cases of good faith purchase; it is less so in cases of good faith

performance.” On the other hand, in speaking of good faith performance,

Comment d explains that “fair dealing may require more than honesty.”

Notice. UCC 3–302(a)(2) conditions HDC status on a purchaser’s taking

the negotiable instrument not only “in good faith” but also “without notice”

that it is overdue or has been dishonored or of any defense or claim.

(Compare the voidable-title rule of UCC 2-403(1), which does not contain a

separate notice requirement. See Note (3) on the Basic Conveyancing Rules,

supra, pp. 8–9.)


The definition of “notice” in UCC 1–202 includes not only a subjective

standard but also objective ones. Nevertheless, the concept in the UCC is

not nearly as broad as it is in certain other areas of the law. For example,

in other contexts, a person has “constructive notice” of facts appearing in

documents recorded in the public record, even if the person did not see the

document and is ignorant of the facts. Likewise, in other contexts, a person

may have “inquiry notice” of facts that a reasonably prudent person would

have discovered through an inquiry, even if the person does not conduct an

inquiry and is ignorant of the facts. Neither “constructive notice” nor

“inquiry notice” constitutes “notice” under UCC 1–202. Be sure you read the

definition to see why.

Often the same facts may be used both to show lack of good faith and to

show notice, but, as the Kaw Valley case indicates, good faith and notice

need not always overlap in this way.

(5) “Real” and “Personal” Defenses. The defenses specified in UCC

3–305(a)(1), which may be asserted even against a holder in due course,

traditionally are called “real defenses.” With the exception of the maker’s

discharge in bankruptcy, they arise only rarely.

The defenses in specified in UCC 3–305(a)(2), which are not available

against a holder in due course, arise more often. Although they are just as

genuine as the “real” defenses, the defenses that an HDC cuts off are called

“personal” defenses. They include defenses that would be available on a

simple contract, such as fraud in the inducement, misrepresentation, and

mistake in the issuance of the instrument. They also include defenses stated

elsewhere in Article 3. For a list, see UCC 3–305, Comment 2.

The fraud described in subsection (a)(1), which is a real defense, is

referred to as “fraud in the factum.” The maker of a note asserted this

defense under the Negotiable Instruments Law in First National Bank of

Odessa v. Fazzari, 10 N.Y.2d 394, 223 N.Y.S.2d 483, 179 N.E.2d 493 (1961).

Fazzari, who was unable to read or write English, was induced to sign a

note upon the payee’s misrepresentation that it was a statement of wages

the payee had earned and was necessary for income-tax purposes. The note

was negotiated to a bank, which brought an action against Fazzari.

Although Fazzari was induced to sign something entirely different from

what he thought he was signing, he failed to establish a defense of fraud in

the factum. At the time he signed the note, his wife was in an adjoining

room. She was able to read English, but Fazzari did not ask her to read the

note before he signed it. Would the result change under the UCC? See UCC

3–305(a)(1)(iii) (defense of “fraud that induced the obligor to sign the

instrument with neither knowledge nor reasonable opportunity to learn of

its character or its essential terms”).

Fraud in the factum, which may be asserted even against a holder in

due course, should be distinguished from the more common “fraud in the

inducement,” which an HDC cuts off. Fraud in the inducement arises when


13. The statement in the text assumes that, where Buyer’s obligation is anaccount, Buyer did not agree to waive defenses and that, where Buyer’s obligation isembodied in a negotiable instrument, Finance Company is not an HDC. In the formercase, Buyer may use its claim for breach of warranty “only to reduce the amount theaccount debtor owes.” UCC 9–404(b). Buyer may not use this claim to recover fromFinance Company amounts previously paid. Article 3 takes the same approach to rightsto payment that have been embodied in a negotiable instrument. See UCC 3–305(a)(3).

14. Setoff is not restricted to merchants and other commercial parties. SupposeJack and Jill go out to dinner and a movie. Jack pays $12 for Jill’s dinner and Jill pays$8 for Jack’s movie ticket. Rather than give Jack $12 for dinner and then collect $8 fromJack for the movie, Jill will set off her $8 claim against her $12 obligation and pay Jackthe difference, $4.

a person is damaged by justifiably relying on a false representation of a

material fact, if the representation is made with intent to deceive, with

knowledge of its falsity, or with reckless disregard as to whether it is true

or false. Even though fraud in the inducement makes a contract voidable at

the instance of the defrauded party, it does not affect the rights of an HDC

to enforce the defrauded party’s obligation on a negotiable instrument.

(6) Recoupment and Setoff. An HDC also takes free of certain claims

in recoupment. UCC 3–305(a)(3). The UCC does not define “recoupment.”

Generally speaking, it means the right of a defendant to reduce its liability

for damages by deducting damages caused by the plaintiff’s failure to

comply with its obligations in the same transaction. Consider the facts of

Problems 1.2.8(a), 1.2.9(a), and 1.2.10. By accepting nonconforming goods,

Buyer becomes liable for their price under UCC 2–709; however, the

nonconformity gives rise to a claim for damages against Seller (A) under

UCC 2–714. UCC 2–717 affords Buyer a right of recoupment: “The buyer on

notifying the seller of his intention to do so may deduct all or any part of the

damages resulting from any breach of the contract from any part of the price

still due under the contract.” Ordinarily, Finance Company (B) will take

subject to this right of recoupment, regardless of whether Buyer’s obligation

to pay is embodied in a negotiable instrument. See UCC 9–404(a)(1); UCC

3–305(a)(3).13

Not uncommonly, as in Problems 1.2.8(b), 1.2.9(b), and 1.2.10(c), Buyers

seek to set off against their obligation to pay for goods, a claim against the

Seller arising from an unrelated transaction.14 In some jurisdictions, Buyer’s

right to set off would be a good defense against Seller’s action for the price.

Regardless of whether Buyer enjoys setoff rights against Seller, the drafters

of Article 3 apparently intended that Buyer not be permitted to set off

against Seller’s transferees, such as Finance Company. They accomplished

this result through the negative implicit in UCC 3–305(a)(3): The right to

enforce is subject to “a claim in recoupment . . . if the claim arose from the

transaction that gave rise to the instrument.” The right to enforce is not

subject to claims in recoupment (i.e., setoff rights) that arise from other


15. In many jurisdictions, setoff differs from recoupment: the former relates toclaims unrelated to the contract upon which the defendant is being sued, whereas thelatter relates to claims based upon the same contract. Often, however, the term setoff isused to encompass both concepts. In contemplating “recoupment” claims that arise fromunrelated transactions, Article 3 is rather idiosyncratic.

transactions. See UCC 3–305, Comment 3 (last paragraph).15

Enabling the transferee of a note to take free of the maker’s rights of

setoff may result in the anomaly that a transferee who gives no value for the

note (e.g., Buyer’s donee) acquires better rights than a person who gives

value for an assignment of an obligation that is not represented by a note

(e.g., B in Problem 1.2.9(b)), supra. See UCC 9–404(a). Can this anomaly be

justified, especially given that UCC 9–403 analogizes good-faith purchasers

of rights to payment with holders in due course of negotiable instruments?

(7) Good Faith Purchase in Consumer Transactions. Permitting

buyers to waive their right to assert defenses against third parties, whether

by a waiver-of-defense clause or a negotiable note, has been controversial.

In the teeth of statutory language designed to protect freedom of contract

and the negotiability of notes, a substantial number of courts found legal

grounds to place the burden of adjustment for sellers’ defaults upon secured

parties.

Judicial Intervention. By the early 1950’s courts began to hold that, for

one reason or another, a financing agency that was closely connected with

a retailer could not be an HDC and was not protected by a waiver-of-defense

clause. These courts twisted traditional notions of good faith and notice to

reach what they regarded as a just result. According to the Supreme Court

of Arkansas, in an early seminal case, the finance company “was so closely

connected . . . with the deal that it can not be heard to say that it, in good

faith, was an innocent purchaser” of a note given by a buyer for a car.

Commercial Credit Co. v. Childs, 199 Ark. 1073, 1077, 137 S.W.2d 260, 262

(1940). According to the Supreme Court of Florida, where a finance company

had been involved in the transaction it “had such notice of . . . infirmity” in

a note given by a grocer for a freezer. The court also stated the policy behind

such decisions. “We believe the finance company is better able to bear the

risk of the dealer’s insolvency than the buyer and in a far better position to

protect his interests against unscrupulous and insolvent dealers.” Mutual

Finance Co. v. Martin, 63 So.2d 649, 653 (Fla.1953). Other courts followed

suit. See the discussion in Kaw Valley, supra.

The nature of the transaction made it difficult for the financing agency

to divorce itself from the seller sufficiently to avoid being characterized as

“closely connected.” Since the relationship ordinarily is a continuing one,

typically there is a master agreement and some arrangement for a fund to

be retained by the financing agency to secure its right of recourse against

the seller. In addition, the financing agency will insist that the standard

forms for contracts with buyers as well as for assignments be its own.


16. These statutes contain varying definitions of “consumer,” but U3C 1.301 istypical. Its definition of “consumer credit sale” requires: that the buyer be a person otherthan an organization; that the credit be granted pursuant to a seller credit card or by aseller who regularly engages in credit transactions of the same kind; that the goods,services, or interest in land sold be purchased primarily for a personal, family, householdor agricultural purpose; that the debt be payable in installments or a finance charge ismade; and that, with respect to a sale of goods or services, the amount financed notexceed $25,000. Furthermore, the sections quoted here do not apply to transactionsprimarily for an agricultural purpose.

17. The rule defines a consumer as: “A natural person who seeks or acquires goodsor services for personal, family, or household use.”

Courts were particularly solicitous of consumer buyers, and Article 9

deferred to their concerns. See F9–206(1) (validating waiver-of-defense

clauses “[s]ubject to any statute or decision which establishes a different

rule for buyers or lessees of consumer goods.”); accord, R9–403(f). But

inasmuch as buyers had to show a sufficiently close connection between the

seller and the financing agency in each case, judicial decisions fell short of

protecting buyers in all cases.

Legislative Intervention. By the early 1970’s, most state legislatures had

enacted statutes applicable to consumer transactions prohibiting negotiable

instruments and waiver-of-defense clauses, limiting their effectiveness, or

depriving them of effect altogether. Under these statutes, some of which

derive from 1974 version of the Uniform Consumer Credit Code (“U3C”)

3.307, 3.404, it is no longer necessary to show that the financing agency and

the seller were closely connected.16

The 1974 U3C also dealt with a developing practice, known as “dragging

the body,” whereby a seller refers the buyer to a financing agency that

makes a direct loan to the buyer. The loan is secured by an interest in the

goods purchased by the buyer, and the financing agency makes sure that the

loan proceeds are applied to purchase the goods by making its check payable

jointly to the buyer and the seller. Should the buyer refuse payment of the

loan on the ground of a defense against the seller, the financing agency

responds that its contract with the buyer is entirely separate from the

seller’s contract with the buyer and was fully performed when it gave the

buyer (borrower) the money. Statutes protecting consumers in the case of

direct loans include a requirement that there be a sufficient connection

between the seller and the lender; for this reason they tend to be complex.

The FTC Initiative. In 1976, Federal Trade Commission Rule 433 took

effect. Its stated purpose is to deny protection to financing agencies in

transactions involving consumer goods and services.17 But because the FTC

has no jurisdiction over banks and it was thought undesirable to regulate

some financing agencies but not others, the rule was not made applicable to

financing agencies. Instead the rule makes it an “unfair and deceptive trade

practice” for a seller to fail to incorporate in a contract of sale to a consumer


a legend that will preserve the buyer’s defenses against the financing

agency.

If the transaction is one in which the seller assigns the contract with the

buyer to a financing agency, the contract must include the following legend

in at least ten-point, bold type:

NOTICE

ANY HOLDER OF THIS CONSUMER CREDIT CONTRACT IS

SUBJECT TO ALL CLAIMS AND DEFENSES WHICH THE

DEBTOR COULD ASSERT AGAINST THE SELLER OF GOODS

OR SERVICES OBTAINED PURSUANT HERETO OR WITH THE

PROCEEDS HEREOF. RECOVERY HEREUNDER BY THE

DEBTOR SHALL NOT EXCEED AMOUNTS PAID BY THE

DEBTOR HEREUNDER.

If a seller receives the proceeds from a direct loan made to the buyer by a

financing agency to which the seller “refers consumers” or with whom the

seller “is affiliated . . . by common control, contract, or business

arrangement,” the loan contract must include a similar legend. 16 C.F.R.

433.1(d); 433.2. In both cases the legend must state also that the buyer’s

recovery against an assignee with respect to claims and defenses against the

seller may not exceed amounts paid by the buyer under the contract. See 16

C.F.R. 433.2. Placing the required legend on a note does not of itself destroy

the note’s negotiability; however, there cannot be an HDC of the note, even

if the note otherwise is negotiable. UCC 3–106(d).

Staggering numbers of sellers and lenders, large and small, fall within

the terms of the FTC Regulation. Suppose that sellers and lenders are not

inclined to obey the Regulation and fail to use the prescribed provision. How

effective are the FTC’s tools to compel compliance? The FTC is authorized

to bring civil actions against persons who violate FTC cease and desist

orders and (more importantly) against persons who violate FTC rules

respecting “unfair or deceptive acts or practices.” See 15 U.S.C. § 57b.

Suppose a seller or lender nevertheless fails to include the prescribed

formula in a contract and that, under state law, negotiable notes and

waiver-of-defense clauses are effective to bar buyers from asserting defenses

against transferees. Will the FTC Regulation override state law and allow

the buyer to assert a defense or claim a refund? A substantial body of case

law holds that FTC regulations do not ipso facto modify private rights or

confer private rights of action. Under this view, when a contract or note fails

to include the required notice, the consumer buyer would be unable to assert

defenses against an assignee if other law, such as the UCC, so provides.

Other courts have disagreed. For example, one court held that “it would

turn the law on its head” to allow a financier to avoid the consequences of

the notice by its own illegal failure to include the notice in the transaction

documents. Gonzalez v. Old Kent Mortgage Co., 2000 WL 1469313 (E.D. Pa.


18. As to the aromatic nature of this note, see note 3, supra, page 18.

2000). Should this result obtain also where the assignor prepares the

transaction documents and the assignee has difficulty ascertaining whether

the transaction is covered by the FTC rule?

Revised Article 9 answers in the affirmative. Under UCC 9–403(d) an

assignee of a consumer contract takes subject to the consumer account

debtor’s claims and defenses to the same extent as it would have if the

writing had contained the required notice. The 2002 amendment to UCC

3–305, which adds subsection (e), would extend this rule to negotiable

instruments.

(8) The Relationship Between the Obligation on the Instrument

and the Obligation for Which the Instrument Is Given. Consider the

case in which Buyer’s obligation to pay for several deliveries of goods from

Seller is long overdue. To induce Seller to continue making deliveries, Buyer

agrees to repay the past due balance, with interest, under specified terms

that are incorporated into a negotiable promissory note payable to Seller.18

When the agreed time to pay arrives and Buyer defaults (again!), can Seller

recover from Buyer twice—once under UCC 2–709 for the price of the goods

and once “on the instrument” under UCC 3–412? Of course not. When a

person takes a negotiable note for an obligation, such as an obligation to pay

for delivered goods, the obligation is suspended until the note is dishonored

or paid. Payment of the note discharges Buyer’s obligation not only on the

note (UCC 3–412) but also on the contract for the sale of the goods (UCC

2–709). If the note is dishonored and Seller remains the person entitled to

enforce the instrument, then Seller may enforce either the note or Buyer’s

obligation to pay the price of the goods. See UCC 3–310(b)(2), (3). Rules of

pleading and practice may permit Seller to bring both causes of action in a

single complaint; however, Seller will be limited to one recovery.

Suppose that Seller has negotiated the note to Bank. UCC 3–310,

Comment 3, explains:

If the right to enforce the instrument is held by somebody other than the

seller, the seller can’t enforce the right to payment of the price under the

sales contract because that right is represented by the instrument which

is enforceable by somebody else. Thus, if the seller sold the note . . . to

a holder and has not reacquired it after dishonor, the only right that

survives is the right to enforce the instrument.

A person who brings an action on the instrument may take advantage

of special rules of pleading and proof. For example, every negotiable

instrument is presumed to have been issued for consideration, so that even

when the instrument remains in the hands of the original payee, the burden

is shifted to the person obligated on the instrument to show that there was

no consideration. See UCC 3–308(b); UCC 3–303(b).


Problem 1.2.11. Would the answer to Problem 1.2.10(a) be different if

the body of the promissory note read as follows:

For value received, I promise to pay to the order of A, $100,000, payable

$50,000 in six months after date and $50,000 in twelve months after date,

with interest payable monthly at three per cent over Chase Bank Prime to

be adjusted monthly, with the privilege of discharging this note by payment

of principal less a discount of five per cent within thirty days from the date

hereof. The entire principal of this note shall become due and payable on

demand should the holder at any time deem itself insecure. This note is

secured by a security agreement of the same date to which reference is made

as to rights in collateral. See UCC 3–104; UCC 3–106; UCC 3–108; UCC

3–109; UCC 3–112.

Taylor v. RoederSupreme Court of Virginia 1987.234 Va. 99, 360 S.E.2d 191.

O RUSSELL, JUSTICE.

[Olde Towne borrowed $18,000 from VMC, evidenced by a 60-day note

secured by a deed of trust on land in Fairfax County. The note provided for

interest at “[t]hree percent (3.00%) over Chase Manhattan Prime to be

adjusted monthly.” The note provided for renewal “at the same rate of

interest at the option of the makers up to a maximum of six (6) months in

sixty (60) day increments with the payment of an additional fee of [t]wo (2)

points.”]

The dispositive question in this case is whether a note providing for a

variable rate of interest, not ascertainable from the face of the note, is a

negotiable instrument. We conclude that it is not.

. . .

[F3–104(1)] provides, in pertinent part:

Any writing to be a negotiable instrument within this title must

. . .

(b) contain an unconditional promise or order to pay a sum certain in

money. . . .

[Cf. UCC 3–104(a) (“promise or order to pay a fixed amount of money”)]

The meaning of “sum certain” is clarified by Code [F3–106(1)]:

(1) The sum payable is a sum certain even though it is to be paid

(a) with stated interest or by stated installments; or

(b) with stated different rates of interest before and after default or a

specified date; or

(c) with a stated discount or addition if paid before or after the date fixed

for payment; or


(d) with exchange or less exchange, whether at a fixed rate or at the

current rate; or

(e) with costs of collection or an attorney's fee or both upon default.

(2) Nothing in this section shall validate any term which is otherwise

illegal.

Official Comment 1, which follows, states in part:

It is sufficient [to establish negotiability] that at any time of payment

the holder is able to determine the amount then payable from the

instrument itself with any necessary computation. . . . The computation

must be one which can be made from the instrument itself without

reference to any outside source, and this section does not make

negotiable a note payable with interest “at the current rate.”

(Emphasis added.) [F3–107] provides an explicit exception to the “four

corners” rule laid down above by providing for the negotiability of

instruments payable in foreign currency.

We conclude that the drafters of the Uniform Commercial Code adopted

criteria of negotiability intended to exclude an instrument which requires

reference to any source outside the instrument itself in order to ascertain

the amount due, subject only to the exceptions specifically provided for by

the U.C.C.

The appellee points to the Official Comment to [F3–104]. Comment 1

states that by providing criteria for negotiability “within this Article,” . . .

[F3–104(1)] “leaves open the possibility that some writings may be made

negotiable by other statutes or by judicial decision.” The Comment

continues: “The same is true as to any new type of paper which commercial

practice may develop in the future.” The appellee urges us to create, by

judicial decision, just such an exception in favor of variable-interest notes.

Appellants concede that variable-interest loans have become a familiar

device in the mortgage lending industry. Their popularity arose when

lending institutions, committed to long-term loans at fixed rates of interest

to their borrowers, were in turn required to borrow short-term funds at high

rates during periods of rapid inflation. Variable rates protected lenders

when rates rose and benefitted borrowers when rates declined. They suffer,

however, from the disadvantage that the amount required to satisfy the debt

cannot be ascertained without reference to an extrinsic source—in this case

the varying prime rate charged by the Chase Manhattan Bank. Although

that rate may readily be ascertained from published sources, it cannot be

found within the “four corners” of the note.

Other courts confronted with similar questions have reached differing

results.

The U.C.C. introduced a degree of clarity into the law of commercial

transactions which permits it to be applied by laymen daily to countless

transactions without resort to judicial interpretation. The relative


predictability of results made possible by that clarity constitutes the

overriding benefit arising from its adoption. In our view, that factor makes

it imperative that when change is thought desirable, the change should be

made by statutory amendment, not through litigation and judicial

interpretation. Accordingly, we decline the appellee's invitation to create an

exception, by judicial interpretation, in favor of instruments providing for

a variable rate of interest not ascertainable from the instrument itself.

In an alternative argument, the appellee contends that even if the notes

are not negotiable, they are nevertheless “symbolic instruments” which

ought to be paid according to their express terms. Those terms include the

maker's promises to pay “to VMC Mortgage Company or order,” and in the

event of default, to make accelerated payment “at the option of the holder.”

The emphasized language, appellee contends, makes clear that the makers

undertook an obligation to pay any party who held the notes as a result of

a transfer from VMC. Assuming the abstract correctness of that argument,

it does not follow that the makers undertook the further obligation of

making a monthly canvass of all inhabitants of the earth in order to

ascertain who the holder might be. In the absence of notice to the makers

that their debt had been assigned, they were entitled to the protection of the

rule in Evans v. Joyner in making good-faith payment to the original payee

of these non-negotiable notes.

Accordingly, we will reverse the decree and remand the cause to the trial

court for entry of a permanent injunction against foreclosure.

Reversed and remanded.

O COMPTON, JUSTICE, DISSENTING.

The majority views the Uniform Commercial Code as inflexible,

requiring legislative action to adapt to changing commercial practices. This

overlooks a basic purpose of the Code, flexibility and adaptability of

construction to meet developing commercial usage.

According to Code [F1–102(1)], the UCC “shall be liberally construed

and applied to promote its underlying purposes and policies.” One of such

underlying purposes and policies is “to permit the continued expansion of

commercial practices through custom, usage and agreement of the parties.”

[F1–102(2)(b).] Comment 1 to this section sets out clearly the intention of

the drafters:

“This Act is drawn to provide flexibility so that, since it is intended to be

a semipermanent piece of legislation, it will provide its own machinery

for expansion of commercial practices. It is intended to make it possible

for the law embodied in this Act to be developed by the courts in light of

unforeseen and new circumstances and practices. However, the proper

construction of the Act requires that its interpretation and application

be limited to its reason.” (Emphasis added).

The majority's rigid interpretation defeats the purpose of the Code.


Nowhere in the UCC is “sum certain” defined. This absence must be

interpreted in light of the expectation that commercial law continue to

evolve. The [F3–106] exceptions could not have been intended as the

exclusive list of “safe harbors,” as the drafters anticipated “unforeseen”

changes in commercial practices. Instead, those exceptions represented, at

the time of drafting, recognized conditions of payment which did not impair

negotiability in the judgment of businessmen. To limit exceptions to those

existing at that time would frustrate the “continued expansion of

commercial practices” by freezing the Code in time and requiring additional

legislation whenever “unforeseen and new circumstances and practices”

evolve, regardless of “custom, usage, and agreement of the parties.”

“The rule requiring certainty in commercial paper was a rule of

commerce before it was a rule of law. It requires commercial, not

mathematical, certainty. An uncertainty which does not impair the

function of negotiable instruments in the judgment of business men

ought not to be regarded by the courts.... The whole question is, do [the

provisions] render the instruments so uncertain as to destroy their

fitness to pass current in the business world?” Cudahy Packing Co. v.

State National Bank of St. Louis, 134 F. 538, 542, 545 (8th Cir.1904).

Instruments providing that loan interest may be adjusted over the life

of the loan routinely pass with increasing frequency in this state and many

others as negotiable instruments. This Court should recognize this custom

and usage, as the commercial market has, and hold these instruments to be

negotiable.

The majority focuses on the requirement found in Comment 1 to

[F3–106] that a negotiable instrument be self-contained, understood without

reference to an outside source. Our cases have interpreted this to mean that

reference to terms in another agreement which materially affect the

instrument renders it nonnegotiable.

The commercial market requires a self-contained instrument for

negotiability so that a stranger to the original transaction will be fully

apprised of its terms and will not be disadvantaged by terms not

ascertainable from the instrument itself. For example, interest payable at

the “current rate” leaves a holder subject to claims that the current rate was

established by one bank rather than another and would disadvantage a

stranger to the original transaction.

The rate which is stated in the notes in this case, however, does not

similarly disadvantage a stranger to the original agreement. Anyone coming

into possession could immediately ascertain the terms of the notes; interest

payable at three percent above the prime rate established by the Chase

Manhattan Bank of New York City. This is a third-party objective standard

which is recognized as such by the commercial market. The rate can be

determined by a telephone call to the bank or from published lists obtained

on request.


Accordingly, I believe these notes are negotiable under the Code and I

would affirm the decision below.

NOTES ON THE FORMAL REQUISITES OF NEGOTIABILITY

(1) The Importance of Form. Promissory notes, which are often

relatively elaborate and may contain hand-tailored provisions to suit the

particular transaction, are more likely to run afoul of the requisites of

negotiability than are checks and other drafts, which usually are relatively

simple in form. The creditor who is the payee of a note will want to bind the

debtor with numerous obligations in addition to the clean-cut promise to pay

money. The creditor wants to be able to declare the entire debt due if the

debtor defaults on any obligation or if the debtor’s financial position

becomes shaky. The creditor who takes a security interest in personal

property wants to bind the debtor not to make off with the collateral and

also to keep it insured, undamaged, and free from liens.

This need to obtain a wide assortment of promises from the debtor came

into collision with the traditional rules on the proper scope of

negotiability—a tradition epitomized by Chief Justice Gibson’s famous

dictum that a negotiable instrument must be “a courier without luggage.”

Overton v. Tyler, 3 Pa. 346, 45 Am. Dec. 645 (1846). The fences that were

erected to confine the doctrine of negotiability took the form of the “formal

requisites” for negotiable instruments set forth in painful detail in the

Negotiable Instruments Law and carried forward, with significant

relaxations, in Article 3 of the UCC. See UCC 3–104 through 3–113.

Why have such complex “formal requisites”? Why not permit the parties

to a contract to make it a negotiable instrument simply by so stating in the

contract itself? Professor Chafee advanced the following explanation:

Although the law usually cares little about the form of a contract and

looks to the actual understanding of the parties who made it, the form

of a negotiable instrument is essential for the security of mercantile

transactions. The courts ought to enforce these requisites of commercial

paper at the risk of hardship in particular cases. A businessman must

be able to tell at a glance whether he is taking commercial paper or not.

There must be no twilight zone between negotiable instruments and

simple contracts. If doubtful instruments are sometimes held to be

negotiable, prospective purchasers of queer paper will be encouraged to

take a chance with the hope that an indulgent judge will call it

negotiable. On the same principle, if trains habitually left late, more

people would miss trains than under a system of rigid punctuality.

Chafee, Acceleration Provisions in Time Paper, 32 Harv.L.Rev. 747, 750

(1919). Is this the only reason for confining the attributes of negotiability to

a limited class of paper? If the “security of mercantile transactions” is the

only object, why have such complex requisites?


Contrast with Chafee’s remarks the following comment by Professor

Gilmore:

Few generalizations have been more fully repeated, or by

generations of lawyers more devoutly believed, than this: negotiability

is a matter rather of form than substance. It is bred in the bone of every

lawyer that an instrument to be negotiable must be “a courier without

luggage.” It must conform to a set of admirably abstract specifications

which, for our generation, have been codified in Section 1 of the

Negotiable Instruments Law and spelled out in the nine following

sections. These rules are fixed, external and immutable. No other

branch of law is so clear, so logical, so inherently satisfying as the law

of formal requisites of negotiability. To determine the negotiability of

any instrument, all that need be done is to lay it against the yardstick

of NIL sections 1–10: if it is an exact fit it is negotiable; a hair’s breadth

over or under and it is not.

Few generalizations, legal or otherwise, have been less true; the

truth is, in this as in every other field of commercial law, substance has

always prevailed over form. “The law” has always been in a constant

state of flux as it struggles to adjust itself to changing methods of

business practice; what purport to be formal rules of abstract logic are

merely ad hoc responses to particular situations.

Nevertheless, the cherished belief in the sacrosanct nature of formal

requisites serves, as do most legal principles, a useful function. The

problem is what types of paper shall be declared negotiable so that

purchasers may put on the nearly invincible armor of the holder in due

course. The policy in favor of protecting the good faith purchaser does

not run beyond the frontiers of commercial usage. Beyond those confines

every reason of policy dictates the opposite approach. The formal

requisites are the professional rules with which professionals are or

ought to be familiar. As to instruments which are amateur productions

outside any concept of the ordinary course of business, or new types

which are just coming into professional use, it is wiser to err by being

unduly restrictive than by being over liberal. The formal requisites serve

as a useful exclusionary device and as a brake on a too rapid acceptance

of emerging trends.

. . .

. . . As long as the law distinguishes between commercial and

non-commercial property on the basis of form, there will have to be

borderline or fringe litigation. On the whole a continuing trickle of such

litigation is not obnoxious; it produces a clearer state of the law than

does the law of sales where the doctrines say one thing and mean

another, a situation not productive of certainty and predictability.

Gilmore, The Commercial Doctrine of Good Faith Purchase, 63 Yale L.J.

1057, 1068–69, 1072 (1954).


19. This Convention, promulgated by the United Nations Commission onInternational Trade Law (“UNCITRAL”) in 1988, has yet to enter into force.

According to Soia Mentschikoff, the Associate Chief Reporter for the

UCC, “the classification of these pieces of paper [bills of exchange, notes,

checks] as negotiable instruments should be dependent on commercial use

and the nature of the current markets to be protected.” Mentschikoff,

Highlights of the Uniform Commercial Code, 27 Mod.L.Rev. 167, 176 (1964).

Do the UCC provisions seem to take “commercial usage” and current

markets into account?

(2) Variable Interest Rates. Professor Mentschikoff’s suggestion that

negotiability “should be dependent on commercial use and the nature of

current markets to be protected” was severely tested when, after the

enactment of former Article 3, variable rate notes came into widespread use

during the double-digit inflation of the 1970s. Under F3–104, the sum

payable was a sum certain even though payable “with stated interest,” but

there was no provision for a variable rate of interest.

Most courts that considered the issue reached the same conclusion as

did Taylor v. Roeder, supra, although there were occasional contrary

decisions upholding the negotiability of variable rate notes. Many states

enacted statutes allowing variable rate notes to be negotiable. These

statutes are replaced by UCC 3–112(b), which provides that a variable rate

of interest does not impair negotiability and adds that the rate “may require

reference to information not contained in the instrument.”

The United Nations Convention on International Bills of Exchange and

International Promissory Notes contains a comparable provision.19 Under

article 8(6), any rate referred to “must be published or otherwise available

to the public and not be subject, directly or indirectly, to unilateral

determination by a person who is named in the instrument at the time the

bill is drawn or the note is made, unless the person is named only in the

reference rate provisions.” Does the absence of such language in UCC

3–112(b) suggest a different rule?

(3) Acceleration Clauses. Under UCC 3–108(b), negotiability is not

impaired by the fact that the instrument is subject to rights of acceleration.

It may seem surprising that such a provision was thought to be necessary

inasmuch as a note payable at a definite time but subject to acceleration is

no less certain as to time of payment than a note payable on demand.

Nevertheless, under the Negotiable Instruments Law courts generally held

that at least some types of acceleration clauses impaired negotiability.

Typical of the clauses condemned by this argument were those giving the

holder the power to accelerate “at will” or “when he deems himself insecure.”

The comments to an early draft of Article 3 of the UCC gave the

following explanation for this line of decisions:

It seems evident that the courts which give uncertainty of time of


payment as a reason for denying negotiability are in reality objecting to

the acceleration clause itself. This objection may be founded on abuses

of the clause. The signer of an acceleration note, unlike the signer of a

demand note, does not expect to be called upon to pay before the

ultimate date. Normally he understands the acceleration clause to be for

the protection of the holder against his own insolvency or similar

contingencies, and he expects that the note will not be accelerated

without good reason. An unscrupulous creditor can accelerate it without

reason, and a note prematurely called may ruin the debtor . . . . Inquiry

among banks has led to the conclusion that the privilege of acceleration

at the option of the holder has real advantage to the creditor, who

frequently must act on the basis of confidential information or evidence

as to the condition of the debtor which does not amount to definite proof.

The effect of denying negotiability to acceleration paper is not to remedy

any abuses arising in connection with the acceleration clause, which

remains in effect even if the instrument be treated as a simple contract.

It is merely to open the paper to defenses which have nothing to do with

acceleration.

Commercial Code, Comments and Notes to Article III 43–44 (Tent. Draft

No. 1, 1946).

The UCC, therefore, makes the power to accelerate irrelevant to the

issue of negotiability. But UCC 1–309 limits the holder’s power to accelerate

“at will” or “when he deems himself insecure” by requiring “good faith.”

What does “good faith” mean in this sense? See UCC 1–201(b)(20). How easy

would it be for the maker to prove lack of good faith? Does UCC 1–309 limit

the power of the holder of a note payable on demand to demand payment?

Why? See UCC 1–309, Comment 1. Does it limit the power of the holder of

a note that permits acceleration at the holder’s option on the maker’s

default? See, e.g., Greenberg v. Service Business Forms Industries, 882 F.2d

1538 (10th Cir.1989) (refusing to apply the good faith requirement of

F1–208 to a note that permits the holder to accelerate upon the maker’s

default).

One reason for including a clause permitting acceleration “should the

holder of this note deem itself insecure” is suggested by State National Bank

of Decatur v. Towns, 36 Ala. App. 677, 62 So. 2d 606 (1952). In that case the

bank that held such a note as payee was served, before the maturity date of

the note, with a writ of garnishment by which a judgment creditor of the

maker sought satisfaction from the maker’s bank account. However the

bank was held to be entitled to accelerate the maturity date under the

clause and set off its debt ahead of the judgment creditor. “By the

garnishment the judgment plaintiff acquired only the rights to the judgment

defendant. As to the judgment defendant the bank, as a result of the

acceleration clause in the note, had a right of set off against any claim of the

judgment defendant in a suit against it.” The note held by the bank also


contained a clause purporting to give the bank a “lien” on the maker’s

account, but the court did not rely on this, pointing out that a bank has a

right to set off a general deposit against a debt of the depositor if the debt

is matured.

(4) Nonnegotiable Instruments and Magic Words. Under the

Negotiable Instruments Law, unless the instrument complied with the

requisites of negotiability, none of the statutory provisions was applicable.

In many instances the rules were the same for instruments that were not

negotiable, but this was not because the statute controlled but because the

statute was, in part, a codification of common law rules, some of which

applied to nonnegotiable instruments as well. In addition, in a few

instances, courts applied the statutory provisions to nonnegotiable

instruments by analogy. Former Article 3 departed from the approach of the

Negotiable Instruments Law in two significant respects. First, while NIL 1

provided that an instrument had to comply with the stated requisites “to be

negotiable,” F3–104 said only that it must comply “to be a negotiable

instrument within this Article.” According to Comment 1 to that section,

this language left “open the possibility that some writings may be made

negotiable by other statutes or by judicial decision.” Second, F3–805, which

had no counterpart in the Negotiable Instruments Law, created a special

class of nonnegotiable instrument to which all of former Article 3 applied

with the very important exception that “there can be no holder in due course

of such an instrument.” Because it covered nonnegotiable as well as

negotiable instruments, former Article 3 was styled “Commercial Paper.”

Current Article 3, like the Negotiable Instruments Law, “applies to

negotiable instruments” (UCC 3–102(a)) and is styled “Negotiable

Instruments” to reflect its more limited scope (UCC 3–101). Its provisions

might, of course, be applied by analogy to what would have been

nonnegotiable instruments under former Article 3, but such instruments

seem rarely to produce litigation.

To come under Article 3 today, an instrument must be payable to “order”

or “bearer.” See UCC 3–104(a)(1); UCC 3–109. (Of course, the inclusion of

one of these “magic words” does not of itself confer negotiability on an

instrument.) UCC 3–104(c) makes a significant exception in this respect for

checks, as to which magic words are not necessary for negotiability. As

Comment 2 to UCC 3–104 explains, the absence of such words on a check

“can easily be overlooked and should not affect the rights of holders who

may pay money or give credit for a check without being aware that it is not

in conventional form.”

(5) Negotiability Revisited. A quarter of a century after expressing

the thoughts in Note (1), supra, Professor Gilmore had these harsh words

for former Article 3:

As a general rule, anything—including negotiability—which was good


20. [Professor Karl N. Llewellyn (1893-1962) was the Chief Reporter for the UCCas well as the Reporter for Article 2.]

21. The term “transferable record” also encompasses an electronic record thatwould be a document under UCC Article 7 if it were in writing. See Section 3, infra.

enough for Lord Mansfield was good enough for Llewellyn.[20] That

attitude, unfortunately, carried through to the drafting of Article 3 of

the Code, which can be described as the N.I.L. doubled in spades or

negotiability in excelsis. Article 3 gravely takes up each of the pressure

points which developed in the N.I.L. case law and resolves the issue in

favor of negotiability. [In a footnote Gilmore gives examples including

the provisions of F3–109 on acceleration clauses, discussed in Note (3),

supra, and of F3–105 on notes with security agreements.] . . . What

Article 3 really is [is] a museum of antiquities—a treasure house

crammed full of ancient artifacts whose use and function have long since

been forgotten. Another function of codification, we may note, is to

preserve the past, like a fly in amber.

Gilmore, Formalism and the Law of Negotiable Instruments, 13 Creighton

L. Rev. 441, 460-61 (1979).

(6) “Transferable Records.” To qualify as a negotiable instrument

under UCC Article 3, a note must be written. See UCC 3–104(a); UCC

3–103(a)(9). In the 1990’s business transactions increasingly became

evidenced by electronic rather than paper records. We have seen that one

of the major benefits of negotiability—the ability to acquire a right to

payment free of the claims and defenses of the person obligated to pay—can

be acquired by obtaining the obligated person’s agreement to that effect. See

UCC 9–403(b). Other benefits, including the ability to acquire the right to

payment free of third-party claims, cannot be achieved readily (if at all) by

contract. To enable businesses to acquire the benefits of negotiability in an

electronic environment, in 1999 NCCUSL promulgated section 16 of the

Uniform Electronic Transactions Act (“UETA”). UETA has since been

enacted in nearly every state.

UETA 16(a) provides for the creation of a “transferable record”—an

electronic record that would be a note under UCC Article 3 if it were in

writing.21 An electronic record can qualify as a transferable record only if the

issuer agrees that it is a transferable record. UETA 16(a)(2). A person can

become the holder of a transferable record and acquire the same rights as

a holder of a negotiable note under Article 3 by having “control” of the

electronic record. UETA 16(d). As Comment 3 to UETA 16 explains, “Under

Section 16 acquisition of ‘control’ over an electronic record serves as a

substitute for ‘possession’ in the paper analog. More precisely, ‘control’

under Section 16 serves as the substitute for delivery, indorsement and

possession of a negotiable promissory note.” A person who has control and

also satisfies the requirements of UCC 3–302(a) acquires the rights of a


holder in due course. UETA 16(d).

UETA 16 establishes a general standard for control: “A person has

control of a transferable record if a system employed for evidencing the

transfer of interests in the transferable record reliably establishes that

person as the person to which the transferable record was issued or

transferred.” UETA 16(b). It also provides, in UETA 16(c), “a safe harbor list

of very strict requirements for such a system.” UETA 16, Comment 3. To

qualify for the safe harbor, a transferable record must be “created, stored,

and assigned in such a manner that . . . a single authoritative copy of the

transferable record exists which is unique, identifiable, and [with certain

exceptions] unalterable.” UETA 16(c)(1). Neither the general standard nor

the safe harbor mandates the use of particular technology; rather, any

system that accomplishes the purpose of “control”—to reliably establish the

identity of the person entitled to payment—is sufficient.

Federal law also contemplates the creation of negotiable, “transferable

records.” See Electronic Signatures in Global and National Commerce Act

(“E–SIGN”), Pub. L. No. 106–229, § 201, 114 Stat. 464 (2000) (codified at 15

U.S.C. § 7021). Section 201 of E–SIGN generally tracks UETA 16, but the

federal rule applies only to an electronic record that “relates to a loan

secured by real property.” Id. § 201(a)(1)(C).

Although systems for control of electronic notes are still being developed

and refined, one system that is up and running describes its services as

follows:

The eOriginal eCore Business Suite . . . fully complies with E-Sign,

UETA, and UCC Revised Article 9 legislation requirements for the

creation and management of electronic negotiable instruments (e.g.,

bills of lading, promissory notes, chattel paper, etc.). It . . . provides the

means for establishing ownership and control of Electronic Original

documents, allowing for the transfer of ownership of those documents

within a secure and trusted environment, among multiple parties

instantaneously.

http://www.eoriginal.com/products/product_overview.html (visited Apr. 4,

2005).

Problem 1.2.12. In exchange for an anticipated delivery of goods, M

makes a negotiable note payable “to A or order” in the amount of $60,000.

A acquired the goods from the manufacturer, who at A’s instruction “drop

shipped” them directly to M. After accepting the goods, M discovered that

they are seriously nonconforming and refused to pay more than $20,000. A

brings suit against M. What result? Is A a holder in due course? If so, do A’s

rights include the right to enforce M’s obligation free of M’s claim in


22. Restatement (Second) of Contracts § 338(1) provides as follows:

[N]otwithstanding an assignment, the assignor retains his power to dischargeor modify the duty of the obligor to the extent that the obligor performs orotherwise gives value until but not after the obligor receives notification thatthe right has been assigned and that performance is to be rendered to theassignee.

recoupment? See UCC 3–305 & Comment 3. Is it in fact “obvious that

holder-in-due-course doctrine cannot be used to allow Seller to cut off a

warranty claim that Buyer has against Seller”?

NOTE ON PAYEE AS HOLDER IN DUE COURSE

We already have seen two ways in which a party to a transaction is

better off by becoming the payee of a negotiable instrument than the obligee

on a simple contract. Unlike an obligee on a contract, a holder of (or other

person entitled to enforce) a negotiable instrument, including a payee of the

instrument, does not take subject to the obligor’s setoff rights. See UCC

3–305(a); Note (6) on Defenses to Payment Obligations, supra. In addition,

a holder or other person entitled to enforce enjoys the benefits of the rules

of pleading and proof in UCC 3–308.

Of course, a holder in due course receives greater protection than a mere

holder. The HDC doctrine rests upon the idea that third-party purchasers

should be able to acquire negotiable instruments without having to concern

themselves with the transaction giving rise to the instrument. One would

assume, therefore, that the special protection afforded to holders in due

course ordinarily would not be available to a party to the very transaction

giving rise to the instrument. UCC 3–302, Comment 4, observes that “in a

small percentage of cases it is appropriate to allow the payee of an

instrument to assert rights as a holder in due course.” Those cases are ones

“in which conduct of some third party is the basis of the defense of the issuer

of the instrument.” Does Problem 1.2.12 present such a case? If so, what, if

anything, prevents A from acquiring the rights of an HDC and cutting off

M’s claim for breach of warranty?

(C) DISCHARGE (THE “MERGER” DOCTRINE)To what extent, in performing an obligation, must the obligor pay

attention to the whereabouts of the writing that evidences it? An obligor on

an ordinary contract right can safely deal with the original obligee in

discharging the obligation, even if the right is evidenced by a writing, unless

the obligor has received notification of an assignment. The Restatement

(Second) of Contracts so provides in § 338(1).22 UCC 9–406(a) puts the

general rule as follows:


23. If your statute book does not contain the unamended version of UCC 3–602,consult the Revised version but ignore subsections (b), (d), and (f).

[A]n account debtor . . . may discharge its obligation by paying the

assignor until, but not after, the account debtor receives a notification,

authenticated by the assignor or the assignee, that the amount due or

to become due has been assigned and that payment is to be made to the

assignee. After receipt of the notification, the account debtor may

discharge its obligation by paying the assignee and may not discharge

the obligation by paying the assignor.

In contrast, the obligor on a negotiable instrument cannot safely deal with

the original obligee without paying attention to the writing that embodies

the obligation.

Problem 1.2.13. A sold O a machine for O’s factory for $100,000,

payable in 30 days. A assigned the right to payment to the B finance

company, which paid A $100,000 less a discount. At the end of the 30 days,

O, who did not know of the assignment, paid A $100,000. B sues A for

$100,000.

(a) Must O pay again? What could the losing party have done to prevent

the loss? What should the losing party do now? See UCC 9–406(a);

Restatement (Second) of Contracts § 338(1), supra; Note (1) on the Merger

Doctrine, infra.

(b) Suppose that, shortly after the sale of the machine, O received a

letter from B stating,“Pleased be advised that all amounts owing from

yourself to A have been sold to the undersigned. Kindly remit your payment

to the undersigned at the address above.” O is reluctant to pay B; O doesn’t

believe A has stooped so low as to “hock its receivables.” What should O do?

See UCC 9–406(a), (c).

Problem 1.2.14. A sold M a machine for M’s factory for $100,000,

payable in 30 days. In connection with the sale, M executed a negotiable

promissory note, promising to “pay $100,000 to the order of A” in 30 days.

A assigned the right to payment and delivered the note to the B finance

company, which paid A $100,000 less a discount. At the end of the 30 days,

M, who did not know of the assignment, paid A $100,000. B sues A for

$100,000.

(a) Must M pay again if the 1990 (unamended) UCC 3–602 is in effect?23

See UCC 3–301; UCC 1–201(b)(21); UCC 3–203(a), (b). What could the

losing party have done to protect itself? What should the losing party do

now? See UCC 3–601; 1990 UCC 3–602; UCC 3–412.

(b) Must M pay again if R3–602(b) is in effect? What could the losing

party have done to protect itself? What should the losing party do now?

NOTES ON THE “MERGER” DOCTRINE AND PAYMENT BY MISTAKE


(1) Whom Must an Obligor Pay? Knowing the proper party to pay is

(or should be) a major concern for a person who owes a debt. If an obligor

pays the wrong party, the obligor does not discharge its obligation and will

have to pay again—this time to the proper party. Of course, the mistaken

obligor will be entitled to recover a payment from a party who is not entitled

to receive it. See Restatement (Third) of Restitution and Unjust Enrichment

§ 6 (Tent. Draft No. 2) (2002). This restitutionary remedy may provide little

comfort to an obligor who must litigate against a person who wrongfully

kept funds to which it was not entitled.

Like Restatement (Second) of Contracts § 338(1), supra, UCC 9–406(a)

contains what sometimes is referred to as the “notification” rule: Even if a

right to payment has been assigned, the obligor (whom Article 9 refers to as

an “account debtor”) may discharge its obligation by paying the assignor

until, but not after, the account debtor receives a notification “that the

amount due or to become due has been assigned and that payment is to be

made to the assignee.” UCC 9–406(a). Subsections (b) and (c) of UCC 9–406

help protect the account debtor from having to pay twice.

(2) The “Merger” Doctrine and its Decline. UCC 9–406(a) applies

only to an “account debtor”; it does not apply to persons obligated on a

promissory note or other instrument. See 9–102(a)(3) (“account debtor” does

not include persons obligated to pay a negotiable instrument). What law

does apply? If the promissory note is negotiable, then UCC Article 3

determines whom the maker (or other person obligated on the instrument)

must pay to discharge its obligation. One traditional characteristic of

negotiable instruments is that the instrument is treated as if it actually

were the right to payment that it evidences. Alternatively stated, under

traditional negotiable instruments law, the right to payment “merges” into

the writing that evidences the right. Accordingly, when a person takes a

negotiable instrument for an obligation, payment of the instrument

discharges the obligation. See UCC 3–310(b).

The pre-1990 version of Article 3 reflects traditional merger doctrine.

The holder (who, by definition, had possession) of a negotiable note was

entitled to enforce it, see F3–301, and the liability of the maker was

discharged “to the extent of his payment or satisfaction to the holder.”

F3–603(1). The 1990 revision of Article 3 made a significant inroad in the

doctrine by creating the concept of a “person entitled to enforce the

instrument.” The maker’s obligation to pay a note “is owed to a person

entitled to enforce the instrument.” UCC 3–412. And, under UCC 3–602(a),

“an instrument is paid to the extent payment is made . . . to a person

entitled to enforce the instrument. To the extent of the payment, the

obligation of the party obligated to pay is discharged . . . .” We saw in Note

(3) on Defenses to Payment Obligations, supra, that “person entitled to

enforce” an instrument includes not only a holder but also “a nonholder in

possession of the instrument who has the rights of a holder,” UCC 3–301,


24. Note, in this regard, that the 1990 version of Article 3 deleted the requirementof presentment (i.e., demand for payment) as a condition of dishonor for time notes. SeeUCC 3–502(a)(3). A person to whom presentment is made may demand that the personmaking presentment exhibit the instrument. UCC 3–501(b)(2). Does a person whobecomes obligated to pay without presentment enjoy the same right?

and that “transfer” of the instrument, which requires delivery, vests in the

transferee any right of the holder to enforce the instrument. See UCC

3–203. Thus, a transferee of an instrument from a holder would acquire the

holder’s right to enforce the instrument and become a person entitled to

enforce.

As it plays out under Article 3 (1990), the merger concept—in which the

right to payment travels with the paper evidencing it—makes commercial

sense only if (i) makers understand that they cannot discharge their

obligation unless they pay a person in possession of the note, (ii) makers are

in a position to demand that the note be exhibited before making a payment,

and (iii) those in possession of a negotiable instrument reliably have

obtained it by transfer, i.e., by a voluntary delivery for the purpose of giving

the person receiving delivery the right to enforce the instrument. How often

do you think these conditions are met?

Of course, stating the rule may be easier than paying the person entitled

to enforce. Consider, for example, a note that requires payment in monthly

installments. Is it reasonable to expect the maker to demand that the note

be exhibited before each installment is paid?24 Even if so, does the fact that

a person is in possession of the note necessarily mean that the person is

entitled to enforce it? See Problem 1.2.4(a), supra, page 21. Can those who

sign notes reasonably be expected to know the special discharge rules for

negotiable instruments? Can they reasonably be expected to be able to

determine whether any given note is negotiable?

As a practical matter, makers often pay whoever demands payment.

Rarely, however, has a maker been required to pay twice. In many, if not

most, cases, payments have been made to the person entitled to enforce. In

other cases, courts have used a variety of legal doctrines to protect the

maker. As the Restatement (Third) of Property explains with respect to

mortgage notes:

[T]he U.C.C.’s requirement that payment be made to the person in

possession of the instrument is only rarely a problem for payors who pay

the original mortgagee. One reason is that many notes secured by real

estate mortgages are not negotiable in form because their promise to pay

is conditional, because they are not payable to “bearer” or “order,” or

because they contain additional undertakings beyond the payment of

money. See U.C.C. § 3–104 (1995). The U.C.C. does not govern discharge

of nonnegotiable obligations.

Another reason is that very frequently when a mortgage loan is sold

on the secondary mortgage market, the original mortgagee is formally


designated as “servicer” of the mortgage loan by the holder, with full

authority to receive payments on behalf of the holder. Hence such

payments count as if they had been made to the holder directly.

Moreover, if the servicing duties are later shifted to a different entity,

federal law requires that notification of the change be given to the

mortgagor if the mortgage is “federally related”; see 12 U.S.C.A. § 2605.

Some state statutes impose similar duties.

Even when there is no specific grant of collection authority to the

original mortgagee by the holder, courts often find implied authority

from the prior course of dealing between the holder and the mortgagee

. . . . If there is no such course of dealing, the holder’s conduct may estop

it from denying the mortgagee’s authority . . . . Finally, the holder’s

conduct after the mortgagee has received payment may constitute a

ratification of that payment, thus compelling the holder to give credit for

it. . . .

Restatement (3d) of Property (Mortgages) § 5.5, Comment b (1999).

Notwithstanding that traditional merger doctrine “only rarely”

presented a problem, the real-estate bar’s strenuous objections to the

doctrine led to the 2002 amendments to 3–602. These go a long way towards

abandoning the merger doctrine in favor of the “notification” rule. See

R3–602(b), (d). As of October 2007, five states had enacted these

amendments: Arkansas, Kentucky, Minnesota, Nevada, and Texas.

(3) Discharge of Nonnegotiable Instruments. If a promissory note

is not negotiable, then law other than the UCC determines whom a person

obligated on the instrument must pay to discharge its obligation. Certain

types of writings are treated in the ordinary course of business as symbols

of contractual rights and in ordinary course of business are transferred by

delivery with any necessary indorsement or assignment. According to the

Restatement (Second) of Contracts, an obligor on such a symbolic writing

who pays without requiring production of the writing takes the risk that the

person receiving payment does not have possession of the writing because

the person has assigned it. Restatement (2d) of Contracts § 338(4),

Comment g. In other words, “Non-production has the same effect as receipt

of notification of assignment . . . .” Id.

(4) Recovery of Payments Made by Mistake. Although Article 9

specifies the person whom an account debtor must pay to discharge its

obligation, it does not address the rights of the parties with respect to a

payment that is made to the “wrong” person. Rather, it leaves this issue to

non-UCC law. See UCC 1–103(b). An obligor who pays the wrong person

ordinarily may recover the amount of the mistaken payment from the

recipient under the law of restitution. See Restatement (Third) of

Restitution and Unjust Enrichment § 6 (Tent. Draft No. 1) (2001). Indeed,

as Comment a observes, “[m]istaken payment of money not due presents one

of the core cases of restitution, whether liability is explained by reference to


the transferee’s unjustified enrichment or to the transferor’s unintended

dispossession.”

The UCC expressly addresses recovery of a mistaken payment on a

negotiable instrument. The general rule appears in UCC 3–418(b): A person

who pays an instrument by mistake may recover the payment from the

person to whom it was made, “to the extent permitted by the law governing

mistake and restitution.” But UCC 3–418(c) provides that, notwithstanding

UCC 3–418(b), the right to recover a mistaken payment may not be asserted

against (i) a person who took the instrument in good faith and for value or

(ii) a person who in good faith changed position in reliance on the payment.

Consider Problem 1.2.14(a), in which M paid A even though B was the

PETETI. Would M have a right to recover the payment from A under UCC

3–418(b), which incorporates the law of mistake and restitution? If so, does

UCC 3–418(c) immunize A, as “a person who took the instrument in good

faith and for value”? There seems to be no reason why A’s having taken the

instrument in good faith should entitle A to keep a payment that A knew it

was not entitled to receive. Can you think of a way to interpret UCC

3–418(c) so as to preserve M’s right to recover from A?

(D) “SPENT” INSTRUMENTS

To what extent, after making a payment, does the obligor run a risk by

leaving outstanding (without cancellation or some appropriate notation of

performance) the writing that evidences the obligation to pay? In other

words, to what extent can the good faith purchaser of a right to payment

safely rely on the writing as an indication that the obligation has not

already been discharged? The answer may depend on whether the right to

payment is embodied in a negotiable instrument.

Problem 1.2.15. A sold O a machine for O’s factory for $100,000,

payable in 30 days. Before the 30 days were up, O paid A $100,000, but left

the written contract of sale in A’s hands without any notation on it. A then

assigned the right to payment and delivered the written contract to the B

finance company, which paid A $100,000 less a discount without knowing

of O’s payment to A. At the end of the 30 days, O refused to pay B. B sues A

for $100,000. Must O pay again? What could the losing party have done to

protect itself? What should the losing party do now? See UCC 9–404(a);

Restatement (Second) of Contracts § 336(1), supra note 7; Restatement

(Second) of Contracts § 333(1), supra note 7.

Problem 1.2.16. A sold M a machine for M’s factory for $100,000,

payable in 30 days. In connection with the sale, M executed a negotiable

promissory note, promising “to pay to the order of A $100,000” in 30 days.

Before the 30 days were up, M paid A $100,000 but left the written contract

of sale and the promissory note in A’s hands without any notation on them.

A then assigned the right to payment, indorsed the note, and delivered both


the written contract and the note to the B finance company, which paid A

$100,000 less a discount without knowing of M’s payment to A. At the end

of the 30 days, M refused to pay B. B sues M for $100,000.

(a) What is the effect, if any, of M’s payment to A under the 1990

(unamended) UCC 3–602? Is M obligated to pay B? See UCC 3–601(b). What

could the losing party have done to protect itself? What should the losing

party do now? See UCC 3–601; UCC 3–602;

(b) What is the effect, if any, of M’s payment to A under R3–602(b)? Is

M obligated to pay B?

(c) Return to the facts of Problem 1.2.14(b), where M paid A $100,000

after the note was delivered to B. Did M discharge its obligation under

R3–602(b)? Even if so, must M pay B? See UCC 3–601(b); R3–602(d) &

Comment 4.

NOTE ON “SPENT” INSTRUMENTS

Although waiver-of-defense clauses and negotiable notes may

accomplish the same primary objective—to insulate third parties from the

obligor’s defenses—the negotiable note can have legal consequences that

reach beyond a contractual “cut-off” clause. For example, an obligor on an

ordinary right to payment, such as an account, runs no risk by leaving the

writing that evidences the account outstanding. To put it differently, a good

faith purchaser who takes such a right by assignment cannot safely rely on

the writing as an indication that the obligation has not already been

discharged. See UCC 9–404(a); Restatement (Second) of Contracts § 336(1).

In contrast, a person who has executed a negotiable note cannot safely make

payment without obtaining the instrument and seeing that the payment is

noted on it. The reason is that the instrument might be negotiated

thereafter to a holder in due course, who, under the basic rules of UCC

3–305, takes free of the maker’s defenses, including payment. See also UCC

3–601(b) (discharge is not effective against a person acquiring rights of an

HDC without notice of the discharge). Do you think most makers of

negotiable notes are aware of this risk? If so, do you think they take steps

to prevent it from arising? (A railroad or warehouse that has issued a

negotiable document of title—bill of lading or warehouse receipt—runs a

similar risk if it delivers the goods without surrender of, or notation on, the

document. See Problem 1.3.6, infra.)

NEGOTIABILITY—WHO NEEDS IT?

Professor Albert Rosenthal raised quite a stir when he published an

article on negotiable instruments with a provocative title: “Negotiability—

Who Needs It?,” 71 Colum.L.Rev. 375 (1971). In assessing whether the

negotiability of notes serves a useful purpose, it is important to distinguish

between (i) the aspects of negotiability that relate to the mechanics of


1. Not all of Article 7 applies to bills of lading; Part 2 contains special provisionsapplicable only to warehouse receipts. Article 7 was revised in 2003, primarily in orderto accommodate electronic documents of title and to modernize the article to take accountof federal and international developments. Revised Article 7, Prefatory Note. Citationsin these materials to pre-revision Article 7 are to F7–xxx.

transfer, such as the merger doctrine, and (ii) the aspects of negotiability

that afford special protection to holders in due course. With respect to the

latter, one might consider whether allowing good faith purchasers of rights

to payment to take free of claims and defenses is commercially useful. Even

if good-faith-purchase protection is desirable, to what extent should the

protection depend on the use of a negotiable instrument? Would it be

practical for commercial parties who seek the good-faith-purchase benefits

of negotiability to provide for them by contract?

SECTION 3. PURCHASE OF DOCUMENTS OF TITLE

INTRODUCTORY NOTE

Another type of personal property that may serve as collateral for a

secured loan is a “document of title.” As the definition of the term suggests

(UCC 1–201(b)(16)), documents of title purport to cover goods in the

possession of a bailee. The two major types of documents of title are the

“bill of lading” (UCC 1–201(b)(6)), as to which the bailee is in the business

of transporting or forwarding goods (e.g., a railroad), and the “warehouse

receipt” (UCC 1–201(b)(42)), as to which the bailee is engaged in the

business of storing goods for hire (e.g., a warehouse).

A description of the common uses for the bill of lading and the

warehouse receipt will aid in understanding the rights of secured parties

whose collateral consists of documents of title and the rights of transferees

of documents generally.

Bills of Lading. A bill of lading (originally, “bill of loading”) is a

document of title that a railroad or other carrier issues when goods are

delivered to it for shipment. See UCC 1–201(b)(6), (16). The UCC’s rules

governing bills of lading are collected in Article 7.1 However, bills of lading

in interstate shipments and exports are governed by the federal law, 49

U.S.C. §§ 80101–16, and not by the UCC. For present purposes, however,

the differences are not crucial.

The bill of lading, in part, embodies a contract between the carrier and

the shipper (often termed the “consignor,” see UCC 7–102(a)(4)). This

contract sets forth, inter alia, the consignor’s obligations to pay freight and

other charges and the carrier’s obligations with respect to the transportation

and delivery of the goods. It also addresses the carrier’s liability in the event

of casualty to the goods or failure to deliver.

SECTION 3 PURCHASE OF DOCUMENTS OF TITLE 77

Control of the bill of lading can be used to control delivery of the goods.

In this regard, one must distinguish between the nonnegotiable (or

straight) bill of lading and the negotiable one. As is true with instruments,

see supra Section 2, the form of the paper is determinative. See UCC 7–104.

Under the nonnegotiable bill of lading, the carrier undertakes to deliver the

goods to a stated person (the “consignee”). See UCC 7–102(a)(3); UCC

7–104(b). For example, if the bill of lading runs “to Buyer & Co.,” then the

carrier discharges its delivery obligation by delivering the goods to Buyer

& Co. Because the carrier can perform its contract by delivering to the

named person (Buyer & Co.), Buyer need not present the bill of lading or

even have taken possession of it. See UCC 7–403; UCC 7–102(a)(9); UCC

7–404.

Buyer may have bought the goods for resale (to, say, C). If C contracts

to buy the goods before Buyer takes delivery, Buyer will give written

instructions to the carrier to deliver the goods to C, thereby entitling C to

enforce the carrier’s delivery obligation. See UCC 7–403; UCC 7–102(a)(9).

In this way, Buyer can transfer control over the goods without taking

possession of them. Note, however, that although notification of the carrier

entitles C to obtain delivery, the carrier nevertheless may honor Seller’s

instruction to stop delivery if it wishes to do so. See UCC 7–403(a)(4); UCC

2–705.

Under the negotiable bill of lading, the carrier agrees to deliver the

goods to the order of a stated person, e.g., “to the order of Seller & Co.,” or

occasionally to “bearer.” The carrier’s delivery obligation runs to the holder

of the document. See UCC 7–403; UCC 7–102(a)(9); UCC 1–201(b)(21). If the

document runs to the order of Seller but the person to receive the goods is

someone other than Seller (say, Buyer or C), then Seller must indorse and

deliver the bill of lading to that person so that the person becomes a holder.

One of the important practical consequences of shipping under a

negotiable bill of lading is that the carrier will deliver the goods only to one

who surrenders the bill of lading. See UCC 7–403(c)(1). If Seller wants to be

sure of being paid before Buyer gets the goods, Seller may use a negotiable

bill of lading, consign the shipment to the order of Seller, and thereby

maintain control over the goods until Buyer pays. When Seller (or, more

often, its local agent) receives payment, the agent will deliver the indorsed

bill of lading to Buyer. At that point Buyer can take the bill of lading to the

carrier and receive the goods.

Warehouse Receipts. Warehouse receipts (receipts issued by a person in

the business of storing goods for hire, see UCC 1–201(b)(42), function much

like bills of lading: They serve as a receipt for goods delivered to a bailee, set

forth the terms of the contract between the bailor and bailee (warehouse),

and enable parties to transfer control over goods without the need to take

possession of them. Like bills of lading, warehouse receipts may be

negotiable or nonnegotiable, depending upon their form. See UCC 7–104.


Nature delivers great crops at annual harvests, while consumption is

gradual throughout the year. Consequently, commodities of enormous value

must be kept in storage pending processing, distribution, and use. Other

commodities—like fuel oil—are stored in large quantities because their use

is seasonal. In other instances, storage is a significant part of preparation

for use. Seasoning for years in charred oak barrels is of the essence in

making good whiskey. Warehouse receipts may be employed as a means for

traders to deal in these goods without the inconvenience of physical

delivery. A slightly different use arises when a concern, such as a brewer or

a mill, needs to hold commodities that tie up more capital than it can spare.

Using warehouse receipts as collateral may facilitate a low-interest loan

that otherwise would not be available.

A negotiable warehouse receipt and a nonnegotiable warehouse receipt

are reproduced below on pages 80 through 83.

Purchasers of Documents of Title. A person who buys a warehouse

receipt or bill of lading, or a creditor who takes such a document of title to

secure a loan, wishes to be sure that it takes both the document and the

goods free from the claims of third parties, including secured parties. The

first three Problems below address some of the risks that a purchaser runs

in this regard. A purchaser also wishes to take free of any defenses the

issuer (warehouse or carrier) may raise to its delivery obligation. Problem

1.3.4 and the Notes following address three of these potential defenses as

they apply to warehouse receipts: nonreceipt (the warehouse never received

the goods); misdescription (the goods actually received were not as described

in the receipt); and disappearance (the goods disappeared).

Electronic Documents of Title. Although UCC Article 7 originally

contemplated only written documents of title, the storage and

transportation industries have begun to use electronic documents. The first

statutory basis for electronic documents appeared in the United States

Warehouse Act, which authorizes the use of electronic warehouse receipts

covering cotton and contains provisions specifically addressing security

interests in cotton covered by an electronic receipt. See 7 U.S.C. § 259(c)

(repealed 2000). In 2000 the Act was amended to authorize the use of

electronic documents covering other agricultural products as well. See 7

U.S.C. § 241 et seq.

We saw in Section 2, supra, that the Uniform Electronic Transactions

Act provides a statutory framework for the transfer of an electronic record

that would be a note under UCC Article 3 if it were in writing. The same

framework applies to an electronic record that would be a document under

Article 7 if it were in writing. As with electronic notes, an electronic

document (warehouse receipt or bill of lading) is a “transferable record”

under UETA only if the issuer of the electronic record expressly agrees that

the record is to be considered a “transferable record.” See UETA 16(a). A

person can become the holder of a transferable record and acquire the same


rights as a holder of an equivalent document under Article 7 by having

“control” of the electronic record. Id. A person who has control and also

satisfies the requirements of UCC 7–501 acquires the rights of a holder to

whom a negotiable document of title has been duly negotiated

(“HTWANDOTHBDN”). UETA 16(d).

Revised Article 7 borrowed from the UETA structure and concepts. It

explicitly contemplates the use of electronic documents of title as well as

tangible documents of title. See Revised Article 7, Prefatory Note; UCC

1–201(b)(16) (defining “document of title” and explaining the meaning of

“electronic document of title” and “tangible document of title”). It provides

explicitly that due negotiation of an electronic document of title can be

effected through the voluntary transfer of “control.” See UCC 1–201(b)(15)

(defining “delivery); UCC 7–501(b) (due negotiation of electronic document

of title); UCC 7–106 (control of electronic document of title).


NEGOTIABLE WAREHOUSE RECEIPT

[Front—Printed on Green Paper—Reduced in Size]


NONNEGOTIABLE WAREHOUSE RECEIPT

[Front—Printed on White Paper—Reduced in Size]


NEGOTIABLE OR NONNEGOTIABLE WAREHOUSE RECEIPT

[Back—Printed on Same Color Paper as Front]


NEGOTIABLE OR NONNEGOTIABLE WAREHOUSE RECEIPT

[Back—Printed on Same Color Paper as Front]


A warehouse receipt embodying the obligation of the bailee to deliver

goods has some similarity to a promissory note embodying the obligation of

the maker to pay money. After you have worked through the following three

Problems, consider the following: To what extent are the rules applicable to

the transfer of warehouse receipts similar to those applicable to the transfer

of negotiable instruments calling for the payment of money? To what extent

are they similar to those applicable to the transfer of the goods themselves?

To what extent must a person acquire the status of HTWANDOTHBDN in

order to take free of claims to the goods and defenses of the warehouse? To

what extent does such a holder enjoy the same freedom from claims and

defenses as a holder in due course?

Problem 1.3.1. A warehouse receipt covering 600 barrels of whiskey

was issued to “Old Soak Beverage Company or order.” In preparation for a

proposed sale of the whiskey to another company, the president of Old Soak

(A) indorsed the Company’s name on the receipt. That night, Sal Sly (B), an

ambitious bookkeeper, arranged to work late and took the receipt from the

vault. Sly delivered the receipt to a friend in the liquor business (C), who

sold and delivered the receipt to DT Beverage Company (D) for $120,000

cash (the fair market value). Both Sly and the friend disappeared.

(a) Who has the better claim to the whiskey? See UCC 7–104; UCC

7–502; UCC 7–501(a).

(b) Suppose D is Downtown Bank, which took the receipt to secure a new

$25,000 loan. Is A’s claim of ownership of the whiskey superior to D’s

security interest in it? Would the answer change if D took the warehouse

receipt to secure a preexisting, unsecured loan?

(c) What result if B, rather than C, sold and delivered the warehouse

receipt to DT Beverage Company? See UCC 7–501(a)(5) and Comment 1;

UCC 7–504(a). Does the statutory text adequately support the Comment?

(d) Suppose that A’s president had not endorsed the document, but that

B supplied a clever imitation of the president’s signature. Is A or D entitled

to the whiskey? See UCC 7–502(a); UCC 7–501(a)(5) (“negotiated”) (“the

named person’s indorsement”); UCC 7–504(a).

(e) Suppose that the warehouse receipt ran “for the account of Old Soak

Beverage Company.” Is A or D entitled to the whiskey? See UCC 7–104;

UCC 7–504.

Problem 1.3.2. Old Soak Beverage Company (A) instructed Dale Driver

(B), one of its truck drivers, to haul 100 barrels of whiskey from Old Soak’s

warehouse to the bottling works. Instead, Driver hauled the whiskey to

Waiting Warehouse Company, stored the whiskey, and took a warehouse

receipt deliverable to “Dale Driver or order.” Driver then indorsed and

delivered the warehouse receipt to Creative Finance Company (C) to secure

a previously unsecured note. Driver is unable to pay the note, and both

Creative Finance and Old Soak claim the whiskey.


(a) Who prevails? See UCC 7–502; UCC 7–503; UCC 7–504; Note on

Authority and Power of Disposition, infra.

(b) What result if Driver had negotiated the receipt to a friend in the

liquor business, who had negotiated it to Creative Finance?

Problem 1.3.3. While its own warehouse was being refurbished, Old

Soak Beverage Company (A) temporarily stored several hundred barrels of

whiskey with B, a competitor. Without Old Soak’s consent, B delivered the

goods to Waiting Warehouse Company, which issued a negotiable

warehouse receipt to “B or order.”

(a) B indorsed and delivered the receipt to DT Beverage Company (C),

which promised to pay fair value for the whiskey in 30 days and did not

suspect B’s wrongdoing. Who has the better claim to the whiskey, A or C?

Would the answer change if the warehouse receipt were nonnegotiable?

(b) What result if B indorsed and delivered the negotiable warehouse

receipt to Downtown Bank, which took the receipt to secure a new loan and

did not suspect B’s wrongdoing? Would the answer change if the warehouse

receipt were nonnegotiable?

(c) Compare your answers to this Problem with your answers to Problem

1.1.6 on page 16, supra. Can you account for the differences in result?

NOTE ON AUTHORITY AND POWER OF DISPOSITION

Problem 1.3.2 invites you to consider, inter alia, whether Driver had

“actual or apparent authority to ship, store, or sell” the whiskey. UCC

7–503(a)(1)(A). Section 2.02(1) of the Restatement (2006) explains that an

agent has actual authority to take action designated or implied in the

principal's manifestations to the agent. An agent also has actual authority

to take acts necessary or incidental to achieving the principal's objectives.

In determining whether action was designated or implied in the principal’s

manifestations and whether acts are necessary or incidental to achieving

the principal's objectives, one is to look to how the agent reasonably

understands the manifestations and objectives when the agent determines

how to act.

What is the least actual authority that would empower Driver to pass

good title under UCC 7–502 and 7–503? Consider: (i) actual authority to

transport the whiskey to Old Soak’s warehouse; (ii) actual authority to

transport the whiskey to Waiting Warehouse; (iii) actual authority to deliver

the whiskey to a named purchaser; (iv) actual authority to complete a sale

to a named purchaser at a named price.

The near demise of law school courses in Agency makes it desirable to

underline the limited applicability of the term “apparent authority” in UCC

7–503(a)(1). Section 2.03 of the Restatement (Third) of Agency (2006)

provides that:


Apparent authority is the power held by an agent or other actor to affect

a principal's legal relations with third parties when a third party

reasonably believes the actor has authority to act on behalf of the

principal and that belief is traceable to the principal's manifestations.

Note that, unlike actual authority, which depends upon the agent’s

reasonably understanding of the principal’s manifestations, apparent

authority focuses on a third party’s reasonable belief that one person is

authorized to act on behalf of the principal. The third party’s belief must be

traceable to the principal. As comment c to section 2.03 explains, “An agent’s

success in misleading the third party as to the existence of actual authority

does not in itself make the principal accountable.”

Does the notion of “apparent authority” extend to the situations covered

by the “entrusting” provision of UCC 2–403(2), discussed in Section 1,

supra? Even if it does not, “power of disposition” under UCC 2–403 affords

an alternative ground for depriving a person of its ownership interest or

security interest in the goods when that interest comes in conflict with a

claim of a HTWANDOTHBDN. UCC 2–403(2) affords a merchant to whom

goods have been entrusted and who deals in goods of that kind the “power

to transfer all rights of the entruster to a buyer in ordinary course of

business.” As the Notes on Entrustment, supra, pages 16 ff., suggest, the

merchant does not enjoy the power to transfer the entruster’s rights to other

(non-buyer) purchasers. Does UCC 7–503(a)(1) expand this “power of

disposition”? Should it?

Note that even if B (in Problems 1.3.2 and 1.3.3) has “actual or apparent

authority” or “power of disposition,” Old Soak is not necessarily out of luck.

See the last clause of UCC 7–501(a)(5).

(B) DEFENSES

Problem 1.3.4. A fraudulently induced the W warehouse to issue a

negotiable warehouse receipt for $100,000 worth of cotton that was not

delivered to it. A duly negotiated the receipt to B, who did not suspect the

fraud and paid A $100,000.

(a) What are B’s rights against W? See UCC 7–203. See Note (1) on the

Scope of the Warehouse’s Responsibility, infra. (As to B’s recourse against

A, see UCC 7–507.) Would it make a difference if the warehouse receipt had

not been indorsed? If it had not been negotiable?

(b) What result if the receipt had covered barrels of whiskey instead of

bales of cotton and the barrels had contained water? (Is the answer affected

by any of the language of the form warehouse receipts?)

(c) What result if W had received the cotton from A but had lost it in

some way? See UCC 7–204; Note (2) on the Scope of the Warehouse’s

Responsibility, infra. (Is the answer affected by any of the language of the

form warehouse receipts?)


NOTES ON THE SCOPE OF THE WAREHOUSE’S RESPONSIBILITY

(1) Non–Receipt and Misdescription of Goods. What risks does a

secured party take when its collateral consists of goods covered by a

document of title? The problems in this section address the risk of

competing claims to documents of title and priority conflicts. But there are

other risks. For example, what if the warehouse never received the goods

that the document purports to cover (called “nonreceipt”)? What if the goods

are not as described in the warehouse receipt (called “misdescription”)?

Under UCC 7–203, a warehouse is liable in damages to a party to a

warehouse receipt or to a good faith purchaser for value of the warehouse

receipt in the case nonreceipt or misdescription. Note that UCC 7–203

works in favor of all good faith purchasers for value, whether or not the

purchaser takes by due negotiation and even if the warehouse receipt is

nonnegotiable.

What UCC 7–203 gives may easily be taken away. UCC 7–203(1)

provides that the warehouse is not liable to the extent that the warehouse

receipt “conspicuously indicates that the issuer does not know whether all

or part of the goods in fact were received or conform to the description,” but

only if “the indication is true.” The section also provides examples of such

conspicuous indications, including “‘contents, condition, and quality

unknown’.” These disclaimers are standard. For example, examine again the

front pages of the warehouse receipts on pages 80 and 81 and note the

exculpatory language. Damages also will not be available if the party or

purchaser “otherwise has notice” of the nonreceipt or misdescription. UCC

7–203(2).

To the extent a warehouse makes a conspicuous disclaimer on the

warehouse’s receipt that is effective under UCC 7–203, and the disclaimer

is true, a party or purchaser cannot recover from the warehouse. As an

alternative to seeking recovery from the warehouse, a purchaser can seek

damages from its transferor for breach of warranty under UCC 7–507. Of

course, if the transferor is insolvent or judgment-proof, that claim may have

little value.

In many situations, the liability of a warehouse may be much less of an

issue than the effectiveness of a limitation in the warehouse receipt on the

amount for which A may be liable. See, e.g., Section 11(C) of the form of

warehouse receipt (p. 82). Typically, damages are limited to amounts that

are nominal in comparison with the value of stored goods. However, such

limitations are “not effective with respect to the warehouse’s liability for

conversion to its own use.” UCC 7–204(b) (2d sentence).

(2) Liability When Goods “Disappear”: I.C.C. Metals v. Municipal

Warehouse. Under UCC 7–204(a), a warehouse is liable for loss of (or

injury to) the goods caused by its failure to exercise reasonable care but is

not liable for damages that could not have been avoided by the exercise of


2. The substance of the provisions of F7–204 discussed in the text are the same asthose of UCC 7–204.

such care. Observe that this section does not limit the universe of potential

plaintiffs to holders to whom negotiable warehouse receipts have been duly

negotiated or even to holders of negotiable warehouse receipts. Note as well

that the standard of care imposed by UCC 7–204(a) cannot be disclaimed.

UCC 1–302.

Although the burden of going forward with evidence normally rests on

the plaintiff (here, the bailor), a number of cases applying former 7–204

have imposed this burden on the defendant warehouse.2 Of particular

interest is I.C.C. Metals, Inc. v. Municipal Warehouse Co., 50 N.Y.2d 657,

431 N.Y.S.2d 372, 409 N.E.2d 849 (1980), in which a commercial warehouse

informed the bailor, an international metals trader, that it was unable to

locate three lots (845 pounds) of an industrial metal called indium that it

had taken for storage. The bailor commenced an action in conversion,

seeking to recover the value of the indium, $100,000. The warehouse

contended that the metal had been stolen through no fault of its own and

that, in any event, the terms of the warehouse receipt limited the bailor’s

potential recovery to a maximum of $50 per lot, or $150. (The limitation

complied with F7–204(2).)

The trial court granted summary judgment for the bailor for the full

value of the metal. It found that the bailor had made out a prima facie case

of conversion by proffering undisputed proof that the indium had been

delivered to the warehouse and that the warehouse had failed to return it

upon a proper demand. The court concluded that the warehouse’s contention

that the metal had been stolen was completely speculative and that the

warehouse had failed to raise any question of fact sufficient to warrant a

trial on the issue. Finally, the trial court held that the contractual limitation

upon liability was inapplicable to a conversion action. The Appellate

Division affirmed, as did the Court of Appeals.

The Court of Appeals observed that F7–204 contemplated that “a

warehouse which fails to redeliver goods to the person entitled to their

return upon a proper demand, may be liable for either negligence or

conversion, depending upon the circumstances.” Moreover, “although the

merely careless bailee remains a bailee and is entitled to whatever

limitations of liability the bailor has agreed to, the converter forsakes his

status as bailee completely and accordingly forfeits the protections of such

limitations.” See F7–204(2).

In negligence cases, the established rule in New York is that once the

plaintiff proffers proof of delivery to the defendant warehouse, of a proper

demand for its return, and of the warehouse’s failure to honor the demand,

then “the warehouse must come forward and explain the circumstances of

the loss of or damage to the bailed goods upon pain of being held liable for


negligence.” For the first time, the court unambiguously applied the same

burden-shifting rule to conversion cases. Thus, unless the warehouse comes

forward with “an explanation supported by evidentiary proof in admissible

form,” the plaintiff will not be required to prove that the warehouse

converted the goods.

Applying this rule to the explanation presented by the warehouse, the

court stated the following in a footnote:

Viewed most favorably to defendant, this evidence would indicate at

most that theft by a third party was one possible explanation for the

defendant’s failure to redeliver the indium to plaintiff. This is simply

insufficient, since the warehouse is required to show not merely what

might conceivably have happened to the goods, but rather what actually

happened to the goods. Defendant proved only that theft was possible,

and presented no proof of an actual theft. Hence, the proffered

explanation was inadequate as a matter of law.

409 N.E.2d at 853 n.3. The bailor having made a prima facie case of

conversion and the warehouse having failed to present an adequate

explanation, the bailor was entitled to summary judgment. Inasmuch as

judgment was entered for conversion, rather than for negligence, the

contractual limitation of damages became ineffective, see F7–204(2) (2d

sentence), and the bailor became entitled to recover the actual value of the

missing indium.

A dissenting opinion accused the majority of “eras[ing] the critical

distinction between negligence and conversion” and “doing violence to the

law, without rhyme or reason.” What policy considerations support imposing

on the warehouse the burden of going forward with an explanation of what

happened to the goods when negligence is alleged? Do these considerations

support the two principal rulings in I.C.C. Metals : (i) permitting a plaintiff

to sustain a conversion action without proving any intentional wrongdoing

by the defendant and (ii) rendering ineffective a contractual limitation on

liability entered into between two commercial parties? In practical effect,

how far removed is the approach in I.C.C. Metals from the imposition of

absolute liability on the warehouse? Is the result consistent with the

standard of “care” in UCC 7–204(a)? Judicial response to I.C.C. Metals has

been mixed, and Comment 4 to UCC 7–204 expressly disapproves the

holding in the case.

(3) The Great “Salad Oil Swindle.” Questions of warehouse

responsibility in excelsis arose in connection with the 1963 disappearance

from field warehouse tanks in Bayonne, New Jersey, of over a billion

pounds of vegetable oils—one of the great commercial frauds of modern

times. Leading banks in the United States and Britain had made loans

totaling $150 million “secured” by warehouse receipts for oil for which the

bailee was unable to account. See Procter & Gamble Distrib. Co. v.

Lawrence American Field Warehousing Corp., 16 N.Y.2d 344, 266 N.Y.S.2d


3. Federal law codifies the common-law liability of certain carriers for loss orinjury to goods in interstate shipments, imports, and exports. See 49 U.S.C. §§ 11706,14706 (imposing liability for “actual loss or injury to the property caused by” certaincarriers). For certain carriers, the remedies provided “are in addition to remediesexisting under another law or common law.” 49 U.S.C. § 13103.

785, 213 N.E.2d 873 (1965); N. Miller, The Great Salad Oil Swindle (1965);

Brooks, Annals of Finance: Making the Customer Whole, The New Yorker,

Nov. 14, 1964, at 160.

(4) Warehouses, Carriers, and Statutory Interpretation. An

interesting (and puzzling) contrast is presented by the UCC’s language on

the responsibility of warehouses (UCC 7–204) and the provision on the

responsibility of carriers (UCC 7–309). Subsection d of UCC 7–204 states,

“This section does not modify or repeal . . .” and invites each state’s

legislature to insert a reference to any statutes that may impose a higher

responsibility on the warehouse or invalidate a contractual limitation on

liability. On the other hand, UCC 7–309(a) on the responsibility of carriers,

after articulating the “reasonably careful person” test, adds: “This

subsection does not affect any statute, regulation, or rule of law that imposes

liability upon a common carrier for damages not caused by its negligence”

(emphasis added). The phrase “rule of law” (as contrasted with the reference

to specific statutes in UCC 7–204) provides access to (and possibly

development of) the broad common-law liability of carriers as insurers of

goods.3 Note, however, that UCC 7–309(b) affords carriers the opportunity

to limit damages. Do the reasons that led to the absolute liability of carriers

apply to warehouses? Does the difference between the approaches of these

two sections of the UCC bar the extension by analogy of absolute liability to

warehouses? Would the failure of a warehouse to carry insurance protecting

both itself and the owner constitute a default in the “reasonable care”

standard? If so, should the net result be simplified by a change in the

language of the UCC?

In the drafting of statutory provisions like those of Article 7, who are

likely to be more vocal—warehouses or those who may store goods with

warehouses? In construing statutes that are reasonably susceptible to two

interpretations, should courts give voice to those who are less vocal during

the legislative process? Cf. Restatement (Second) of Contracts § 206 (1981)

(“In choosing among the reasonable meanings of a promise or agreement or

a term thereof, that meaning is generally preferred which operates against

the party who supplies the words or from whom a writing otherwise

proceeds.”). Or should courts assume that the squeaky wheel got the grease

and construe the statute to favor the “prevailing” interests?

(C) DISCHARGE

Problem 1.3.5. A, a dealer in cotton, deposited $100,000 worth of cotton

PURCHASE OF DOCUMENTS OF TITLE 91

with the W warehouse, which issued a nonnegotiable warehouse receipt to

A. A transferred the receipt to B, who paid B $100,000. Later, on demand by

A, W redelivered the cotton to A.

(a) Is W liable to B? See UCC 7–403; UCC 7–102(a)(9); UCC 7–404.

Would it make a difference if B had notified W of the transfer before W’s

redelivery to A? See UCC 7–504.

(b) What result if the warehouse receipt had been a negotiable one,

which was issued to A’s order and negotiated to B? See UCC 7–502.

(c) What is the relationship, if any, between the results of the preceding

parts and the results of Problems 1.2.13(a) and 1.2.14(a), supra, page 70?

(D) “SPENT” DOCUMENTS

Problem 1.3.6. A, a dealer in cotton, deposited $100,000 worth of cotton

with the W warehouse, which issued a nonnegotiable warehouse receipt to

A. On demand by A, W redelivered the cotton to A but left the “spent”

warehouse receipt in A’s hands. A transferred the receipt to B, who paid A

$100,000 without knowing that W previously had redelivered the cotton to

A.

(a) Is W liable to B? See UCC 7–403; R7–102(a)(9); UCC 7–504.

(b) What result if the receipt had been a negotiable one, which was

issued to A’s order? Assume that after redelivering the cotton to A, W left

the “spent” warehouse receipt in A’s hands without any notation on it. (See

the notations on the form on page 80.) See UCC 7–502.

(c) What is the relationship, if any, between the results of the preceding

parts and the results of Problems 1.2.15 and 1.2.16(a), supra, page 74?

NOTE ON “SPENT” BILLS OF LADING

A railroad delivered goods without requiring surrender of the negotiable

bill of lading. Months later the holder of the bill of lading changed the dates

to reflect a current transaction and negotiated it to a bank as security for a

loan. The bank was denied recovery against the railroad on the ground that,

in view of the intervening “forgery,” the railroad’s default was not the

“proximate cause” of the bank’s loss. Saugerties Bank v. Delaware &

Hudson Co., 236 N.Y. 425, 141 N.E. 904 (1923) (4–3 decision). The result has

been sharply criticized. See Fulda, Surrender of Documents of Title on

Delivery of the Property, 25 Cornell L.Q. 203 (1940). The UCC seems not to

have dealt with this problem. See UCC 7–306; UCC 7–403(c); UCC

7–501(a)(5); UCC 7–502(1)(d) and Comment 3. Could a warehouse make an

equally strong argument for freedom of liability on a “spent” warehouse

receipt? Cf. American Cotton Cooperative Association v. Union Compress &

Warehouse Co., 193 Miss. 43, 7 So.2d 537, 139 A.L.R. 1483 (1942).