Article 1: Always Relevant

                               

As of this post, we have covered most of Article1 and Article 3, and close to half of Article 2.  I am very pleased with the growing views on the blog, and have received some encouraging emails from readers.  As I stated when the blog first opened, the primary goal is to teach the basic meaning of the text of the UCC. Periodically, as in the last post, I find a case which requires discussion, but even in that context, the primary focus is on the meaning of the text and how it fits in the overall flow of the UCC.

 As a law professor, I felt it important to begin each class with a review, and periodically, and I feel the same need as to the blog, not just for the readers, but for myself as well.  With the large number of new readers, and a lot of substantive text behind us, I wanted to do a brief review of Article 1 and its impact on the UCC. This is done in the hope that whenever you may encounter a UCC transaction at the drafting, litigation, or intermediate stage, you will be certain to process the transaction through Article1 in addition to the substantive Articles activated.

I believe that Article 1 is the most important Article under the Uniform Commercial Code for two primary reasons.  First, Article 1 applies to all transactions under the Code per Section 1-102. Therefore, regardless of where you are in the Code, Article 1 has impact, and the impact can be dramatic. The substantive Articles deal with the subject matter with the purview of each Article, however, the content of these Articles only presents part of the story, for in order to truly understand the meaning of any of the substantive provisions of the UCC, it is essential to have a thorough understanding of Article 1.

Second, Article 1 contains some of the most powerful and impactful provisions of the Code, provisions which bring light and special meaning to the language of a contract; create remarkable drafting opportunities; and contain the fundamental policies upon which the UCC is drafted:

(a) The Uniform Commercial Code must be liberally construed and applied to promote its underlying purposes and policies, which are: (1) to simplify, clarify, and modernize the law governing commercial transactions; (2) to permit the continued expansion of commercial practices through custom, usage, and agreement of the parties; and (3) to make uniform the law among the various jurisdictions. [Emphasis Added]

As stated in Section 1-103(a)(1)(2)(3),  the drafters of the Code direct that the UCC be ‘liberally construed and applied’ to promote these policies. An attorney who lines up legal arguments with an appropriate policy, coupled with the directives for liberal construction and application, has a great advantage in guiding the court to the desired result.

In addition to the stated policies, Section 1-103 contains one of the most powerful and important provisions of the Uniform Commercial Code:

Unless displaced by the particular provisions of the Uniform Commercial Code, the principles of law and equity, including the law merchant and the law relative to capacity to contract, principal and agent, estoppel, fraud, misrepresentation, duress, coercion, mistake, bankruptcy, and other validating or invalidating cause supplement its provisions.  Section 1-103(b)

The net effect of Section 1-103(b) is to incorporate all ‘principles of law and equity’ which exist, ‘unless displaced by the particular provisions of the Uniform Commercial Code.'  So, if the Code doesn’t knock it out via a ‘particular provision’ the whole body of law involved will supplement the Uniform Commercial Code provisions.  It doesn’t get more powerful than that.       

A simple review of the supplemental principals of law stated illustrates the massive content available to attorneys who are involved in UCC transactions.  The general law of contracts, agency, estoppel, misrepresentation and fraud often are often intertwined in commercial transactions.  Understanding the applicability of any of these supplemental principles, and how to creatively utilize them gives an enormous advantage to someone so armed. 

The impact of Article 1 is dramatically illustrated in the case of In Re Invenux, Inc., 298 B.R. 442, 51 UCC Rep Serv 2d (Bkrtcy. D. Colo. 2003).  The trustee in bankruptcy was attacking the validity of a security agreement on the grounds that it did not adequately describe collateral as required by Section 9-203 The security agreement in question was very detailed in its composition, but did not include stock that was purportedly to be included.  Defendant’s position was that the contract—i.e.—the security agreement, was reformed between the original debtor and the secured party and therefore, stock was incorporated into the security agreement.

The question before the court was very significant for two reasons.  First, if the court did not find a reformation, the security agreement would have been invalid and the security interest unenforceable.  Second, if the court found a reformation, as it did, the result would in effect be concluding that the supplemental principles contained in Section 1-103(b) can override the substantive provisions of another Article.  Considering the incredibly broad scope of Section 1-103(b), the implications are enormous. In re Inveneux is not an aberration as regards the impact of Section 1-103(b) on the substantive articles of the Code, but illustrative of the powerful impact that section can have under the UCC.

I review Section 1-103(b) in connection with every case I review under the Code.  Regrettably, a very large number of commercial transactions involve fraud and misrepresentation.  It may also be that under the law of a particular substantive Article a result may appear to be inequitable. Section 1-103(b) supplements the totality of the Code with the law of equity.  Even if one does not win on such a theory, it forces the opposition to respond and creates doubt.

            Another reason Article 1 is so important is that it contains critical definitions which are applicable throughout the Code.  There are two definitions which are so important and powerful under the Code that they must be highlighted.  These are the definitions of ‘contract’ and ‘agreement.’ 

            To get a full picture of the concept of contracts under the UCC, one must move beyond the instinctive reactions that most of us have when we hear the word ‘contracts’ in connection with the Code, namely, Sales contracts.  The application of the word contract under the UCC embodies much more. It is not an exaggeration to say that it is the most important definition in the Code, certainly from an operative standpoint.  Breach of contract is the essence of all lawsuits under the UCC.  So in viewing the UCC and the word ‘contract,' one should envision the concept as one which permeates the UCC.  By way of illustration, contracts exist under the Code between: buyers and sellers [Article 2]; lessors and lessees [Article 2A]; makers and payees [Article3]; banks and customers [Article 4]; applicant and issuer [Article 5]; issuer and bailor [Article 7] debtor and secured party [Article 9].

            The foregoing contractual relationships are illustrative, not by any means exclusive.  In an earlier post, I suggested the benefits of a systematic approach to all UCC problems.  This creates a consistency of methodology, and the brain will adjust accordingly.  Once the facts are thoroughly understood and diagrammed, I suggest a very detailed analysis of contract and agreement. As you will see shortly, the elements of agreement dramatically impact the bottom line meaning of the contract. Once the analysis of ‘contract’ and ‘agreement’ are in place, Section 103(b) should be reviewed.

  The formal definition of contract is found under Section 1-201(b)(12):

“Contract means… the total legal obligation that results from the parties' agreement as determined by the Uniform Commercial Code as supplemented by any other applicable laws."

It is clear from the foregoing definition, that in order to determine the elements of a particular contract, one must first ascertain the parties’ agreement, defined as follows:

“Agreement” means the bargain of the parties in fact as found in their language or inferred from other circumstances, including course of performance, course of dealing or usage of trade as provided in Section 1-303.              Section 1-201(b)(3)

The language of the parties may be explicit, but what it is fascinating, is that what might appear to be very clear and precise language, or no language, can be literally transformed by the application of course of performance, course of dealing or usage of trade. Each is discussed in Section 1-303(a)(b)(c) respectively.

Course of performance requires, among other things, a contract with multiple occasions for performance and course of dealing requires previous transactions between the parties.  Neither may be present in any given situation.  Amidst this uncertainty there is one thing that can almost always be counted on to supply valuable information to any agreement under the Uniform Commercial Code: Trade Usage.  Commercial transactions take place within the context of an existing industry, 99 plus per cent of the time.  Within that industry, there is a manner of business so customary and fundamental to the industry, that it becomes part of the agreement between the parties, regardless of whether or not it is even discussed.   

Trade usage is defined under Section 1-303(a) as follows:

A "usage of trade" is any practice or method of dealing having such regularity of observance in a place, vocation, or trade as to justify an expectation that it will be observed with respect to the transaction in question….

The impact that trade usage can have in a case is dramatically illustrated in the case of   In Re: Cotton Yard Antitrust Litigation, 505 F.3d 274 (4^th Cir., 2007).  At issue was whether or not plaintiff purchasers of cotton and poly-cotton yarn were required to submit their antitrust case to arbitration via an arbitration provision which, according to defendants, was part of the contract as a result of the regular and customary use of arbitration in the textile industry as a means of resolving disputes.  

At issue on appeal was whether the district court’s ruling which excluded

arbitration for the antitrust claim was correct. The court of Appeals reversed the District Court on the arbitration ruling.  After discussing case law which recognized arbitration as the standard manner of resolving disputes in the industry, the court held that the arbitration provision was automatically part of the contract between the parties as a result of arbitration being a trade usage in the textile industry.  This was true regardless of the fact that it was never formally agreed to by the purchasers.  The court further found that a party’s knowledge of a trade usage, or lack thereof, is irrelevant, a result which is clearly consistent with the text of the statute.

            There are over 86,000 trade associations in the United States, each with its own rules and general codes of conduct.  I recently consulted on a case which had a trade association of six members, but nevertheless had clear cut rules on what was supposed to happen in the event goods supplied by members of the association turned out to be defective.  While these rules may not always be controlling, they are always relevant.

Another very important provision under Article 1 is Section 1-302, the Code’s freedom of contract provision. Subsection (a) allows parties to change the ‘effect’ of provisions under the UCC, while subsection (b) states that ‘the obligations of good faith, diligence, reasonableness and care may not be disclaimed.'  However, the section goes on to state ‘The parties, by agreement, may determine the standards by which the performance of those obligations is to be measured if those standards are not manifestly unreasonable.'

By setting standards for the performance of the items noted, the parties dramatically change the inquiry should the matter end up in litigation.  In a case where no standards are set, the court and/or jury will determine whether or not a particular standard has been met. If standards are set, the inquiry is substantially different.  In this instance, the inquiry is: Were the standards met?  Are the standards set ‘manifestly unreasonable?' If met, and not manifestly unreasonable, they will hold up.  The latter scenario gives the parties much greater control as to the outcome in court.

One of the stated underlying policies of the UCC is ‘uniformity of law among the various jurisdictions’ Section 1-103(a)(3).  The provision has been interpreted by many courts to include decisions from other states in a local jurisdiction.  Therefore, an attorney has the case decisions of 50 states as part of his or her arsenal.  Many attorneys simply do not know about Section 1-103(a)(3) and are a corresponding disadvantage in working with the Uniform Commercial Code.

Another critically important provision under Article 1 is Section 1-304 which states:

Every contract or duty within the Uniform Commercial Code imposes an obligation of good faith in its performance and enforcement.

Good faith is defined as:

…honesty in fact and the observance of reasonable commercial standards  of fair dealing.

Breach of the duty of good faith can have serious consequences. Although the comments to Section 1-304 state that no independent cause of action can be brought for a breach of the duty of good faith, there is case law to the contrary.  In fact, in the case of   In First Nat. Bank in Libby v. Twombly, 213 Mont. 66, 689 P.2d 1226 (Mont. 1984), the court stated:

"When the duty to exercise good faith is imposed by law rather than the contract itself… the breach of that duty is tortious. Therefore, punitive damages are recoverable if the Bank's conduct is sufficiently culpable." First National Bank in Libby at 1230.

Any litigant who can persuade the court to entertain a claim for punitive damages has enormous leverage.

            It is important to note that while the definition of ‘good faith’ quoted above is adopted in the majority of jurisdictions, it has not been adopted in all of them. For example, New York, Illinois and Missouri have not adopted the amended definition of good faith. The minority definition of good faith is ‘honesty in fact in the conduct or transaction’ concerned.  There is no requirement for commercial reasonableness, itself a matter of interesting interpretation.  As the comments to Section 1-304 state, the conduct being reviewed is not the commercial reasonableness of the actual conduct in the transaction, but the commercial ‘fairness’ of the conduct.

            In this regard, it is important to remember Section 1-301 which allows parties to transaction under the UCC to choose the law of any state as long as that state has a ‘reasonable relation’ to the transaction in question.  Individuals involved in multistate transactions should always check the law of the other jurisdiction prior to any drafting so that the law most favorable to the client can be drafted into the contract.  Although the Uniform Commercial Code is designed to be ‘uniform,' it is processed through each state legislature before adoption.  Often changes are made and sometimes they are significant.  In addition, the Code gives various alternatives to the states to adopt.  Section 2-318 dealing with third party beneficiaries of warranties offers a dramatic example and potential impact of the differences between the provisions which may be enacted in a particular states.

            The forgoing sections are illustrative of the impact that Article 1 can have under the Uniform Commercial Code.  Most of the provisions of Article 1 are covered in earlier posts for any readers who want to review the same.  The critical point however, is that if you are involved in UCC transactions—whether at the drafting stage, or litigation—it is essential to have a solid working knowledge of Article 1.  This will give you an enormous advantage in all dealings which you encounter under the UCC.

Article 1; supplementary principles of law' reformation of contract; description of collateral; good faith; freedom of contract; trade usage; course of dealing; course of performance; punitive damages; customer banking relationship.