Good Faith: Impact of Amended Definition Under Article 3

In the last post TRIFFIN v DILLABOUGH, 448 Pa.Super. 72, 670 A.2d 684(1996) was discussed in connection with the holder in due course doctrine.  That case stood for the proposition that the transferee of a negotiable instrument from a holder in due course will acquire those rights even if the transferee has knowledge of a defense to the instrument at the time of transfer.  This result, as noted, is supported by Section 3-203(a). 

On several occasions, the importance of the different definitions of good faith among the various jurisdictions has been emphasized.  In the majority of jurisdictions, the amended definition of good faith has been enacted in Article 1.  Prior to the amendment, good faith simply required honesty in fact per Section 1-201(b)(19).  Under this definition, the inquiry is whether or not an individual acted with a ‘pure heart’.  There was no requirement to act in accordance with reasonable commercial standards.  The amended definition of good faith under Article 1 requires ‘honesty in fact and the observance of reasonable commercial standards of fair dealing in the trade’.

Prior to the adoption of the amended version of good faith under Article 1, the 1990 amendments to Article 3 incorporated the ‘the observance of reasonable commercial standards of fair dealing’ in its definition of good faith.  In those states that adopted the amended version of Article 1, the Article 3 definition under Section 3-103(a)(4) was deleted as unnecessary since the Article 1 definition applies throughout the UCC.

In the abstract, the distinction may not appear to be important.  However, as noted in cases in which then new standard has been applied, the different standards have an enormous impact in the real world.  New York stands alone as the only state that has not adopted Article 3 and additionally has not adopted the amended definition of good faith in Article 1.  As noted in an earlier post, the New York legislature recently enacted many of the changes in the amended version of Article 1, but specifically declined to enact the amended definition of good faith.  Hence, in the state of New York, there is no requirement for the observance of reasonable commercial standards of fair dealing in establishing good faith under Article 3.  Given the unique importance of New York in the commercial world, this distinction is extremely important and should be considered when doing business in the state of New York.

The amended definition and its impact under Section 3-302 has been discussed in a number of cases.  Illustrative of the opinions in these cases, and the impact of the amended definition of good faith on holder in due course status is the case of Any Kind Checks Inc. v Talcott 830 So. 2d 160 (4^th District Court of Appeals, FL, 2002).  The legal question presented in Any Kind was whether the check cashing business was a holder in due course thereby cutting off personal defenses of Talcott on the checks involved. The question of whether or not Any Kind acted in good faith was the determinative question on this issue.

The facts in brief involved the issue of a $10,000 check by Talcott which was fraudulently induced by the payee, a Mr. Guarino.  Talcott subsequently stopped payment on the check which was cashed by Any Kind.  There were no written procedures in place at Any Kind by which a determination to pay or not pay a check over $2,000.  The trial court found that Any Kind did not act in good faith and was therefore not a holder in due course. Any Kind appealed.

In discussing the issue the court of appeals noted:

The good faith requirement of the holder in due course doctrine "has been the source of an ancient and continuing dispute." WHITE & SUMMERS, UNIFORM COMMERCIAL CODE § 17-6 (4th ed.1995). On the one hand, [s]hould the courts apply a so-called objective test, and ask whether a reasonably prudent person, behaving the way the alleged holder in due course behaved, would have been acting in good faith? Or should the courts instead apply a subjective test and examine the person's actual behavior, however stupid and irrespective of the reaction a reasonably prudent person would have had in the same circumstance? The legal establishment has steered a crooked course through this debate.    Any Kind at 164

The court noted that if the ‘honesty in fact’ standard was applied, Any Kind would have holder in due course status ‘since Any Kind's employees were pure of heart, that they acted without knowledge of Guarino's wrongdoing.’ Any Kind at 165

The court went on to note:

To the old, subjective good faith, "honesty in fact" standard, the legislature added an objective component—the "pure heart of the holder must now be accompanied by reasoning that assures conduct comporting with reasonable commercial standards of fair dealing." Maine Family Fed. Credit Union v. Sun Life Assurance Co. of Canada, 727 A.2d 335, 342 (Me.1999). No longer may a holder of an instrument act with "a pure heart and an empty head and still obtain holder in due course status." Id.  Any Kind at 165

The court found that while the conduct of Any Kind may have complied with the good faith standard under the old definition of good faith, it did not comply with the amended definition which requires the observance of reasonable commercial standards of fair dealing.  This was primarily based on the nature of the check cashing business and the difference between standard transactions in that industry and the $10,000 check which was the subject of the dispute.  In this regard, the court stated:

The size of the check, in the context of the check cashing business, was a proper factor to consider under the objective standard of good faith in deciding whether Any Kind was a holder in due course. Any Kind at 167

The court concluded that:

[B]y adopting changes to the "good faith" standard in the holder in due course doctrine, the legislature "necessarily must have concluded that the addition of the objective requirement to the definition of `good faith' serves an important goal. The paramount necessity of unquestioned negotiability has given way, at least in part to the desire for reasonable commercial fairness in negotiable transactions." Any Kind at 168

Any Kind is illustrative of case law which has emerged since the amendment to the definition of good faith.  It remains to be seen what is required under ‘commercial standards of fair dealing’; however one thing is clear: honesty in fact is no longer enough to satisfy the obligation of good faith.  This scenario offers an excellent drafting opportunity to minimize exposure.  Businesses can, by reason of Section 1-302, set standards for what constitutes ‘reasonable commercial standards of fair dealing’ and as long as those standards are not ‘manifestly unreasonable’ they will be upheld.