Section 2-607(5)(a): Attorneys’ Fees as Consequential Damages

As noted in previous posts, the designation of a party as a merchant activates a number of special provisions under Article 2.  Among the most important is the warranty of merchantability under Section 2-314.  Subsection (1) to Section 2-314 states as follows:

Unless excluded or modified (Section 2-316), a warranty that the goods shall be merchantable is implied in the contract for their sale if the seller is a merchant with respect to goods of that kind.  Section 2-341(1)

What is or is not merchantable is set forth in Section 2-314(2):

            Goods to be merchantable must be at least such as

(a) pass without objection in the trade under the contract description; and

(b) in the case of fungible goods, are of fair average quality within the description;     and

(c) are fit for the ordinary purposes for which such goods are used; and

(d) run, within the variations permitted by the agreement, of even kind, quality and quantity within each unit and among all units involved; and

(e) are adequately contained, packaged, and labeled as the agreement may require; and

(f) conform to the promise or affirmations of fact made on the container or label if any.

Sales of goods often involve several levels of distribution.  Initially, the sale of raw materials to be used in the manufacture of finished goods; sales from the wholesale to the retail level, and the sale to the retail customer. The warranty of  merchantability will be given at each stage provided the seller is a merchant.  Most of the time, the goods will meet the requisite standard of merchantability; sometimes they will not.  Very often this will occur in a situation involving a middleman who purchases goods for resale.  When the goods sold are not merchantable, and the middleman is sued for breach of warranty, specific rules kick in which the middleman should be aware of if he or she is to minimize exposure. 

Section 2-607(5)(a) contains rules of particular significance when goods are resold by a middleman to a third party.  That section states as follows:

Section 2-607(5)(a) states as follows:

Where the buyer is sued for breach of a warranty or other obligation for which his seller is answerable over

(a)  he may give his seller written notice of the litigation. If the notice states that the seller may come in and defend and that if the seller does not do so he will be bound in any action against him by his buyer by any determination of fact common to the two litigations, then unless the seller after seasonable receipt of the notice does come in and defend he is so bound.

This section enables the middleman who is being sued for the allegedly defective product to put his seller on notice of the litigation and provide him with the opportunity to defend against the litigation.  The failure of the original seller to do so will result in his being ‘bound in any action against him by his buyer by any determination of fact common to the two litigations.’

            As has been stated throughout these posts, it is highly recommended that the actual language of the statute be tracked in this type of situation.  ‘Coming close’ can result in litigation costs that could have been avoided.  In this regard however, and in connection with Section 2-607(5)(a), it must be noted that this section is permissive in nature, and that if a party does not strictly comply with Section 2-607(5)(a), she or he may still maintain a cause of action against her/his buyer for the breach of warranty.

This follows from the language of Section 2-607(5)(a) which states that the buyer ‘may give his seller written notice of the litigation.’  It is clearly permissive.  This question was thoroughly discussed by the Michigan Court of Appeals in Old Kent Bank v Kal Kustom Enterprises, which has impact in all states by reason of the uniformity provision of Section 1-103(1)(b).  See e.g. of In re Hispanic American Television Co., Inc., 113 B.R. 453 (Bankr.N.D.Ill.1990). 

The court in Old Kent discussed the permissive nature of Section 2-607(5)(a) as follows:

The language of M.C.L. § 440.2607(5)(a) is clear and unambiguous.   The statute's plain language reflects its discretionary nature.   Again, the statute states that where a buyer is sued for breach of warranty or other obligation for which his seller is liable, he “may give his seller written notice of the litigation.”

The court went on to state:

Further emphasizing the permissive nature of subsection 2607(5)(a) is the fact that a review of other subsections set forth in M.C.L. § 440.2607(5) indicates that the Legislature intentionally made some portions of the statute mandatory, and others permissive.   Subsections 2607(3)(a) and 2607(3)(b) contain the mandatory “must” in terms of notice.⁵  If the Legislature intended subsection 2607(5)(a) to be mandatory, it would have used similar mandatory language.

            I have been involved in cases where the original seller refuses to come into defend and in some situations completely ignores the notice sent.  This leaves the middleman in a very bad situation, for the original seller is the party best equipped to defend the product he sold.  As a result of this reality, at least one court has awarded attorney’s fees to the middleman who gave proper notice.  The starting point for this analysis is Section 2-714, which deals with buyer’s damages for accepted goods where seller has breached.  That section states as follows:

(1) Where the buyer has accepted goods and given notification (subsection (3) of Section 2-607) he may recover as damages for any non-conformity of tender the loss resulting in the ordinary course of events from the seller's breach as determined in any manner which is reasonable.

(2) The measure of damages for breach of warranty is the difference at the time and place of acceptance between the value of the goods accepted and the value they would have had if they had been as warranted, unless special circumstances show proximate damages of a different amount.

(3)In a proper case any incidental and consequential damages under the next section may also be recovered.

As noted in Section 2-714(3), in a ‘proper case’ incidental and consequential damages may be recovered under Section 2-715:

(2) Consequential damages resulting from the seller's breach include

(a) any loss resulting from general or particular requirements and needs of which the seller at the time of contracting had reason to know and which could not reasonably be prevented by cover or otherwise; and

(b) injury to person or property proximately resulting from any breach of warranty.  

            In addressing the question of attorney’s fees, it must be noted that the attorney’s fees recoverable under Section 2-715(2)(a) are of a different nature than those claimed in a traditional contract litigation.  Attorney’s fees incurred in connection with a litigation in which a non breaching party is, in effect, forced to defend a claim from his buyer for defective goods sold by the original seller, are of a whole different nature.

            The precise issue was discussed by the United States District Court Acushnet Co. v. G.I. Joe’s, Inc., 2006 WL 2729555 (D. Or. Sept. 22, 2006). The case involved a breach of infringement warranty governed by Section 2-312(3) of the UCC.  Acushnet is the sole manufacturer of Titleist golf balls.  G.I. Joe’s purchased what it thought were Titleist balls from Cam Golf. They were in fact fakes.  Acushnet investigated further and learned that other fake Titleist balls were being sold by G.I. Joe’s elsewhere.

            Acushnet sued G.I. Joe’s, who in turn joined Cam Golf, Inc., the latter for breach of the warranty of infringement.  Acushnet and G.I. Joe’s settled with G.I. Joe’s paying $25,000 and incurring $19,300 in attorney’s fees. G.I. Joe sought recovery of both amounts in its action against Cam Golf.   The latter argued that attorneys’ fees were not recoverable, citing supposed authority for that proposition.  G.I. Joe responded:

G.I. Joe’s contends that Cam Golf has confused the issue of recovering attorney’s fees in prosecuting a lawsuit against the seller of goods with attorney’s fees incurred in defending a claim brought against the buyer by a third party. [at page 5]

 In addressing the matter, the court noted the permissive nature of Section 2-607(5)(a) and concluded that attorney’s fees were recoverable under Section 2-715(2)(a),  the Court quoted from Raymond v. Feldman 124 Ore. App 543, 546 (1993) as follows:

The general rule is that attorney’s fees are not recoverable in a breach of contract action unless authorized by statute or the agreement.  However  an exception to the general rule is when a party’s breach of contract involves the non breaching party in litigation with a third party  In such a case the non breaching party may be entitled to recover its litigation costs resulting from the separate action. [at page 6; Emphasis the Court’s]

These consequential damages are recoverable under the language of Section 2-715(2)(a), and the general policy of Section 1-305 which seeks to make non breaching parties whole, and has a special exception for awarding attorney’s fees when permitted under ‘other applicable rules of law’. The rule allowing attorney’s fees in defense of third party products is one of those exceptions. 

I suggest that parties who may be involved in situations in which Section 2-607(5)(a) create a document tracking the language of that section so that effective notice can be given in any situation in which it is required.

Imposters, Fictitious Payees & Effective Indorsements

The basic rule regarding liability on an instrument is expressed in Section 3-401: if a person does not sign the instrument, he or she is not liable on the instrument.  In addition to this basic rule, Section 3-401(a) also provides the first exception to the general rule by providing that a party can be liable on an instrument by an agent’s signature.  It was noted in our discussion of Section 3-402 that the principal in such a situation can be held liable on an instrument even if not specifically named by the agent, assuming that the authority did in fact exist.  Another exception to the general rule was discussed in connection with Section 3-406.  In that situation, a person whose negligence ‘substantially contributed’ to the forgery will be precluded from asserting the forgery against a ‘person who, in good faith, pays the instrument or takes it for value or for collection’.  Hence, liability can be established without the signature having been made.

            This post will discuss a different scenario pertaining to signatures which is activated by the imposter and fictitious payee rules of Section 3-404.  Section 3-404(a) states as follows:

If an impostor, by use of the mails or otherwise, induces the issuer of an instrument to issue the instrument to the impostor, or to a person acting in concert with the impostor, by impersonating the payee of the instrument or a person authorized to act for the payee, an indorsement of the instrument by any person in the name of the payee is effective as the indorsement of the payee in favor of a person who, in good faith, pays the instrument or takes it for value or for collection.

Section 3-406(a) envisions two situations: 

                     Situation # 1:

1.    An imposter;

2.    An issuer who has been ‘induced by the imposter’—by the mails or otherwise-- to issue the instrument to the imposter;

      Situation # 2:

1.    An imposter induces the issuer to issue the instrument to:

·      A person acting in concert with the imposter who impersonates the payee of the instrument; or

·      A person acting in concert with the imposter who impersonates a person authorized to act for the payee.

Examples of the application are relatively simple and straightforward.  In situation # 1, the imposter is simply pretending to be someone he or she is not. The issuer has bought into the scheme and issues an instrument to the imposter.  In situation #2, the accomplice of the imposter is pretending to be the intended payee or someone authorized to act for the payee.

Section 3-406(a) goes on to state that if an instrument so issued is subsequently indorsed ‘by any person’ in the name of the payee to a person ‘who, in good faith, pays the instrument or takes it for value or collection’, such indorsement is ‘effective as that of the payee’.  Assume for example that Imposter induced Issuer to deliver a check for $25,000.00 to the Imposter who claimed to be Fred Jones.  The Imposter’s signature as ‘Fred Jones’ is effective as that of Fred Jones as regards a person who in good faith paid the instrument or took it for value or for collection.  As such, the drawer is liable on his or her drawer’s contract, at least initially. [Exception to be discussed below.]

  The signature in the foregoing example is ‘effective’ even though Fred Jones does not exist. Similarly, if Imposter induced Issuer to deliver a $25,000.00 check payable to Fred Jones to someone pretending to be Fred Jones, or someone authorized to act for Fred Jones, a subsequent indorsement in the name of Fred Jones is effective as that of Fred Jones  to a person who in good faith paid the instrument or took it for value or collection.

Note that the language states that the indorsement ‘by any person in the name of the payee is effective as the indorsement of the payee in favor of someone who pays in good faith or has taken the instrument for value or collection’.  Therefore, if the Imposter or his colleague loses the check and someone else picks it up and indorses ‘Fred Jones’ that too will be considered an effective indorsement to someone who in good faith paid the instrument or took it for value or collection.

The policy of section 3-404(a) is simple: it was the drawer of the check that got duped into issuing the check.  Therefore, the drawer will not be relieved of liability on the check to a person who in good faith paid the instrument or took it for value or consideration.  This is analogous to the rule discussed in the last post, and consistent with the general policy of the Uniform Commercial Code in placing responsibility on parties whose culpable conduct set the series of transactions in motion.

Section 3-404(b) applies to cases dealing with not just fictitious payees, but also instruments issued to existing payees that the issuer does not intend to have any interest in the instrument.  That section also states certain rules with regard to such an instrument prior to any special indorsement on the instrument:

(b) If (i) a person whose intent determines to whom an instrument is payable (Section 3-110(a) or (b)) does not intend the person identified as payee to have any interest in the instrument, or (ii) the person identified as payee of an instrument is a fictitious person, the following rules apply until the instrument is negotiated by special indorsement:

(1) Any person in possession of the instrument is its holder.

(2) An indorsement by any person in the name of the payee stated in the instrument is effective as the indorsement of the payee in favor of a person who, in good faith, pays the instrument or takes it for value or for collection.

It is interesting to note that in such a situation, an indorsement in the name of the payee ‘substantially similar’ to that of the payee will be effective and further, if such an instrument is taken to a depository bank and deposited in an account in a name ‘substantially similar’ to the payee, it will be treated as an effective indorsement.  The latter is true even if the instrument has not been indorsed:

(c) Under subsection (a) or (b), an indorsement is made in the name of a payee if (i) it is made in a name substantially similar to that of the payee or (ii) the instrument, whether or not indorsed, is deposited in a depositary bank to an account in a name substantially similar to that of the payee.

            As stated in Section 3-404(a), the effectiveness of the Impostor’s indorsement is in favor of a ‘person who, in good faith, pays the instrument or takes it for value or collection.’  As discussed in a previous post, good faith under Article 3 means ‘honesty in fact and the observance of  reasonable commercial standards of fair dealing’ either via Section 3-103(a)(6) for those states that have not enacted the amended definition of good faith or via 1-201(b)(20) for those that have. The exception is New York who has neither enacted the amended definition of good faith or the amendments to Article 3.

            As was also discussed, the use of the words ‘reasonable commercial standards of fair dealing’ are intended to focus on the fairness of conduct, not the commercial reasonableness of conduct.  The absence of commercial reasonableness in conduct in the Imposter/Fictitious Payee situation has been addressed in Section 3-404(d):

(d) With respect to an instrument to which subsection (a) or (b) applies, if a person paying the instrument or taking it for value or for collection fails to exercise ordinary care in paying or taking the instrument and that failure substantially contributes to loss resulting from payment of the instrument, the person bearing the loss may recover from the person failing to exercise ordinary care to the extent the failure to exercise ordinary care contributed to the loss.

Therefore, the broad statement dealing with the effectiveness of the indorsement under Section 3-404(a) is limited not only by the good faith requirement, but also by a requirement to exercise ordinary care in paying the instrument or taking it for value or collection.  Ordinary care was discussed in detail in the previous post, but it clearly requires the ‘observance of reasonable commercial standards’ in addition to the commercial fairness requirement of good faith.