Every contract or duty within the Uniform Commercial Code imposes an obligation of good faith
in its performance and enforcement. [Emphasis added] Section 1-304
In the majority of jurisdictions this
requires ‘honesty in fact and the observance of reasonable commercial standards
of fair dealing’ to everyone involved in commercial transactions under the UCC
per section 1-201(b)(20). In addition,
for those jurisdictions that have not enacted the amended version of Section
1-203, the expanded definition is contained in the various Articles, for
example Section 2-103(1)(b) for merchants under Article 2 and Section 3-103 for
transactions under Article 3.
The
question examined in this post is whether or not the obligation of good faith
exists in the calling of a demand note.
For those of you unfamiliar with negotiable instruments, a demand note,
as implied in its name, means that it is payable upon the demand of the holder
of the note:
A promise or
order is “payable on demand” if it (i) states that it is payable on demand or
at sight, or otherwise indicates that it is payable at the will of the holder,
or (ii) does not state any time of payment.
Section 3-108(a)
Does this mean that the holder can demand
payment for any reason or no reason? That is the position taken by most cases
that have examined the issue, as well as the comments to Section 1-309, dealing
with acceleration of payment under a note.
I
certainly understand the need to protect lenders who have extended funds under
a demand note. Their reasonable
expectation as a matter of contract law is that they will be entitled to demand
payment whenever they decide to do so.
On the other hand, honesty in fact and the observance of reasonable
standards of fair dealing are of paramount importance under the UCC. Do we really want a rule under which
arbitrary and sometimes retaliatory behavior is condoned?
Consider the
following: Let us assume that John has signed a promissory note payable to the
order of the Bank in the amount of $140,000.00 calling for payments of $3,500/
month for five years. The loan officer
was Alfred, who had known John for many years. The loan was given to enable
John to open a new restaurant. John has made timely payments for three years,
and recently purchased expensive new equipment for the restaurant which has
been reasonably profitable.
On
the first month of year four, Alfred decides to demand full payment
immediately. The reason Alfred decided
to demand full payment is because he did not like the way that John acted
toward him at a recent fundraiser.
Alfred felt that John should have shown him more respect. He thought ‘I’ll show him’ and demanded full
payment of the note. Obviously, Alfred’s
action is not within the standard of the ‘observance of reasonable commercial
standards of fair dealing in the trade’.
Quite the contrary. Therefore,
Albert has violated the good faith requirement of Section 1-304 or Section
3-103. If it applies.
The
language of Section 1-304 makes it clear that Albert’s demand on the note
should be subject to the obligation of good faith. After all, that section
states that the obligation of ‘good faith’ applies to ‘[e]very contract or duty within the Uniform Commercial Code’. Most
courts have held that there is no good faith requirement imposed on a holder of
a demand note in making a demand for payment. At the very best, this leaves us
with a clear conflict between the overriding obligation to act in good faith
contained in Section 1-304 and the seeming ability of a holder of a demand note
to operate outside of this requirement.
The first indication of the Code’s
position on this can be found in the comments to Section 1-309 which deals with
acceleration clauses. The comments
address the ‘good faith’ requirement that is attendant with an option to
accelerate at will in comparison to a demand instrument stating:
Obviously, this
section has no application to demand instruments or obligations whose very
nature permits call at any time with or without reason.
In following this basic policy, courts have,
with rare exception, found no obligation of good faith in the calling of a
demand note. The rationale generally given
is that the imposition of good faith in the calling of a demand instrument
would add new terms to the contract between the lender and the borrower:
‘The imposition
of a good faith defense to the call for payment of a demand note transcends the
performance or enforcement of a contract and in fact adds a term to the
agreement which the parties had not included….The parties by the demand note
did not agree that payment would be made only when demand was made in good
faith but agreed that payment would be made whenever demand was made.’ Solar
Motors, Inc. v. First National Bank of
Chadron, 249 Neb 758, 545 N.W.2d
714 (1996).
Is this a good result? Should a holder of a demand note be exempt
from the duty to act in good faith in so doing?
Should Alfred by able to demand payment from Fred because he did not
like something Fred did to him personally?
At
least one court has found that there is a duty to act in good faith in the
calling of a demand note. K.M.C. Co.,
Inc., v. Irving Trust Company, 757 Fed.2d 752 (6th Cir.1985). In K.M.C., a financing arrangement existed
between Irving and K.M.C. which, among other things, contained a provision
which allowed for K.M.C. to draw up to $3.5 million, as well as an ongoing note
with a demand clause. On March 1, 1982, Irving refused to advance $800,000
requested by K.M.C. The verdict below
was for K.M.C. and Irving appealed. In
affirming the ruling below, the court addressed the issues pertaining to good
faith.
First,
the court found that a duty of good faith existed with Irving in the
termination of the line of credit. Given
the reality that the refusing further funding was tantamount to a decision to
put it out of business, the court determined that the duty of good faith
required notice prior to the refusal so that K.M.C. would be able to seek
alternative financing. The court also noted that there was adequate inventory
at all times to cover the outstanding balance on the note.
The
court also addressed appellants’ contention on the demand provision contained
in the note:
We agree with
the Magistrate that just as Irving’s discretion whether or not to advance funds
is limited by an obligation of good faith performance, so too would be its
power to demand repayment. The demand
provision is a kind of acceleration clause, upon which the Uniform Commercial
Code and the courts have imposed limitations of reasonableness and
fairness. K.M.C. Co., at 760
Again, this is the minority position, and is
not consistent with the language contained in the comments to Section 1-309.
I
certainly understand the strong policy arguments which support the right of a
holder of a demand note to enforce accordingly.
However, I would not hesitate to argue for a good faith requirement in a
demand note regardless of the comment in Section 1-309 and the cases which hold
otherwise. First, the comments are not
law. Second, Section 1-304 requires good
faith in all contracts and duties under the Code. Third, Section 1-302 states that the parties
to an agreement cannot disclaim the obligation of good faith showing how
important the concept is under the UCC.
Suggestion:
If you represent a client on whom a demand has been made, with no commercial
grounds for making the demand, I would suggest going back to Section 1-103(b)
and finding a supplemental principal of law which will create a favorable
result. For example, a bad faith demand on a note may be acceptable under
Article 3, but the result itself might be inequitable. Equity is a supplemental principle of law
which applies and as we saw in In re
Invenux, the provisions of Article 1 can be used to override certain
substantive provisions of other Articles.
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