Columbia University School of Law
Commercial Transactions (L6221)
Professor Avery Wiener Katz
December 11–20, 2002 (self-scheduled)
1. The exam consists of 8 pages, including this cover sheet. Please check now to ensure your copy is complete.
2. The exam is open book; you are free to consult any written materials, and you should have available to you all the assigned course materials.
3. You may not communicate with any person about the contents of the exam while it is being administered, even if you have turned in or not yet picked up your own copy. If during the exam you have any questions regarding its administration, you should contact the office of Academic Services and they will contact me if necessary.
4. Your exam is due 24 hours after you pick it up, or at the end of the exam period, whichever is earlier. The exam period ends at 4 pm on Friday, December 21. You must return your exam in person, and also must return your copy of the exam questions.
5. There are three questions on the exam, each with a separate word limit. You may not use any leftover space from one question in answering another; and any attempt to use shorthand or nonstandard abbreviations will be counted as if full words were used. Answers exceeding the word limit will be penalized by reducing their score in proportion to the excess.
To ensure compliance with the word limit, you must provide a word count for each question. You may have your word processor program perform the count, or alternatively you may make a good faith estimate by counting the words in a sample paragraph or page and extrapolating to the length of the entire exam.
6. To ensure that you receive full credit for your answer, please: (a) write or print your exam ticket number on all parts of your exam; (b) begin your answer to each question on a new sheet of paper, or if you are writing in a bluebook, in a separate bluebook; (c) use double spacing and 1-inch margins, so that I have enough room to make notations on your exam.
7. Good luck on the exam; and for any of you graduating at the end of the term, best wishes. I will post grades on the class website as soon as they are ready, and will post a feedback memo as soon as possible after that.
QUESTION 1 (a of exam, 1000-word limit)
Mal Factor worked in the information technology department of Fidelity Fiduciary Bank (FFB); among his duties was to help program the FFB computer intranet network and to guard it against intrusion from outside hackers. In the course of his work, Mal realized how many security holes there were in the FFB system, and how easy it would be for an outside hacker to gain access to the system and to use it to direct fraudulent payments. He realized that he could use this knowledge to do this himself, and to blame the result on an outsider if necessary. Over the next several weeks, accordingly, Mal engaged in the following transactions of escalating significance:
(1) He changed the payroll records of a fellow FFB employee, Zoe, on whom he had a secret and unrequited crush, so that her salary was reflected in the bank payroll records as being $2700/month, when in fact it should have been only $2100/month. Zoe, who had arranged for direct deposit of her paycheck, was unaware of Mal's crush and was pleasantly surprised when her bank balance turned out to be $600 more than she had expected at the end of the month. She did not say anything about these overpayments, however, either to her bank or to anyone at FFB. Instead, she invested the extra funds in shares in a "dotcom" enterprise, which promptly lost half its market value.
(2) He hacked into the FFB employment records, creating a record relating to a fictitious loan officer named Lam Rotcaf. He then added Rotcaf to FFB's payroll at a monthly salary of $3000, listing Rotcaf's address as a private mailbox maintained at Mailboxes R Us [MRU], a company offering various mailing and shipping services. Over the next three months, FFB's computer created paychecks issued to the order of Rotcaf and mailed them to the MRU mailbox. Factor claimed these paychecks from MRU, indorsed two of them in the name of "Lam Rotcaf", and deposited them in his own account at Bank Two. He indorsed the third paycheck using his real name only, and transferred it to Sharkey, a acquaintance who had a prior claim against Factor arising from a joint business venture gone sour. Sharkey then indorsed the check again, and deposited it into his personal account at Bank Three.
(3) He modified the software program that the FFB computer used for processing incoming checks so that it would delay processing for 48 hours on any check that was presented in an amount that was an exact multiple of $11,111. Mal then arranged with a confederate, Kevin, to deposit in Kevin's account at Bank Three a counterfeit check in the amount of $99,999, drawn on a non-existent account at FFB. Bank Three provisionally credited Kevin's account and forwarded the check for collection to FFB. The check arrived and was physically processed by a check-reading machine on a Wednesday afternoon, but the FFB system held back information relating to the check until Friday afternoon, at which point it determined that the check was counterfeit. By the time that it was notified of the fraud, Bank Three had allowed Kevin to withdraw the $99,999.
(4) Finally, Mal modified the FFB software so that once every five weeks, it would intercept a random incoming wire transfer, divert half the funds to Mal's separately maintained account at Bank Two and the other half to the personal account of a random FFB depositor, and then destroy all record of the diversions by replacing them with a fictitious record of a diversion to an nonexistent account at an offshore bank. The first time this happened, the rogue program diverted a $1.5 million transfer originally sent by Sander, via his depositary bank, Omicron, to the account of Donald, another depositor at FFB . Of this transfer, $750,000 was forwarded to Mal's account, and the other $750,000 was deposited in the account of Lucky, who did not inspect his bank statement or balance his checkbook for several weeks. During this time Lucky wrote a number of checks that, but for the improper credit, would have resulted in an overdraft to his account. When he finally inspected his statement, however, he realized the improper deposit and notified FFB immediately. As for Donald, the diversion of the $1.5 million transfer caused three large checks that he had written on his FFB account to be dishonored on account of insufficient funds, resulting in his missing out on being able to participate in a lucrative building project.
After this last bit of chicanery, Mal decided that the time had come for him to flee with his gains. He withdrew the $750,000 from his Bank Two account, and disappeared, along with his confederate Kevin. The size of this last withdrawal, together with Lucky's subsequent report of the unauthorized $750,000 transfer to his account, enabled FFB to determine that there were problems in its software system. FFB restored its system software from a secure backup, and comparing the original and modified software programs with the assistance of independent experts, discovered all of Mal's misappropriations.
You are an attorney whom FFB has consulted on the question of whether it can recover any of their losses from the other parties involved in the above transactions (aside from Mal and Kevin, neither of whom can be found ). Please write your client a short memo indicating what claims it may have, which of these claims it is most likely to prevail on, and what evidence it would have to present in order to prevail.
QUESTION 2 (a of exam, 1000-word limit)
ValuMart operates a chain of department stores aimed at the discount end of the retail market. Traditionally, it was the leading discount chain in the industry, but has fallen on hard times in recent years due to demographic changes and geographic shifts in its customer base, a general downturn in the economy, and competition from a rival chain, Thrifty Mart, which has managed to offer a more extensive selection of products at lower prices due to its sophistication in managing inventory, and its ability to resist unionization of its work force. ValuMart finds itself in a position of going into the holiday shopping season with a limited supply of cash on hand and uncertainty about its financial prospects in the upcoming year.
In this context, ValuMart is particularly concerned about its business relations with three of its creditors. The first of these, National Media Sales (NMS), is an advertising broker that buys advertising time and space from a variety of independent media outlets (local newspapers, television and radio stations) at wholesale rates, and then resells its rights to its customers at a markup. ValuMart has found it advantageous to buy media access in bulk from NMS because the independent outlets with which NMS deals match up well with ValuMart's target audience, and because advertising thru these outlets allows ValuMart to cover nearly as wide an audience as would be provided by national network television at a substantially lower cost. For the last few years, NMS allowed ValuMart to buy advertising on 30-day unsecured credit, but more recently, since ValuMart fell behind in its payments, NMS has threatened to stop selling its services to ValuMart unless ValuMart pays all amounts in arrears and pays for future advertising on a 50% cash basis. In addition, NMS has asked ValuMart to provide assurance that any payments it receives will not be subject to subsequent attack in bankruptcy proceedings or otherwise. ValuMart regards itself as particularly vulnerable to NMS's demands since, without a reliable way to reach its advertising market during the upcoming months, its sales are likely to fall to a level that will make it unable to pay its debts as they come due.
The second creditor whose good will ValuMart is especially concerned about is Catherine Channing, Inc., a company that sells various lines of clothing and home furnishings endorsed by its president and founder, Catherine Channing. Channing has proved especially successful at creating and marketing an image of stylish yet practical elegance, in a way that presents items symbolic of upper-class indulgence as available to a more plebeian mass market. Last year, with much media fanfare, Channing and ValuMart signed an exclusive distribution contract. ValuMart hoped to upgrade its image to appeal to a somewhat more upscale segment of the retail market, and Channing hoped to gain access to ValuMart's wider distribution network. Since then, Channing has supplied ValuMart with significant amounts of inventory on credit, with ValuMart's obligations being secured by a security interest in inventory and associated receivables that was granted in the distribution contract and was perfected by a financing statement filed last year. This arrangement has worked out less well than was originally hoped, in part because of the general business climate faced by ValuMart, and in part because of unfavorable publicity resulting from a series of unfavorable news reports accusing Channing of various improper business practices. The association of the Channing name with corporate scandal has somewhat undercut Channing's marketing strategy of offering images of upscale consumption to a mass market; and interest in her products and endorsements has fallen off. Some reports in the business press have even suggested that Channing is itself facing solvency problems.
ValuMart would like to slash prices on its inventory of Channing products, both in order to raise cash and also to move them off the shelves, but has not done so because of Channing's resistance. Channing worries that such a price cut would further undermine her public image and the value of her brand; and she also worries that it would jeopardize the value of the ValuMart inventory and receivables ValuMart worries that if it does not cooperate with Channing, she will attempt to get out of the contract, and will call in all outstanding loan obligations owed by ValuMart, under a clause in the security agreement that gives her the right to declare the contract in default and accelerate all outstanding debt upon her reasonable insecurity.
Third, ValuMart must attend to its relationship with its primary lender, Merchants Commercial Bank (Merchants), with which it has enjoyed a long and successful relationship. Merchants has over the years supplied ValuMart with capital for inventory, equipment and real estate development; it has also frequently served as an intermediary for the factoring of ValuMart's customer accounts and credit-card receivables, purchasing these receivables and then reselling them in the secondary market. In addition to these loans, last year Merchants also facilitated ValuMart's distribution contract with Channing, participating in the parties' negotiations and, in the end, privately guaranteeing up to 40% of ValuMart's obligations under its contract with Channing, although this last fact was kept confidential by all the parties. Merchants was motivated to participate in the Channing deal by its knowledge that ValuMart was losing out in its competition with Thrifty Mart, and its belief that ValuMart needed to upgrade its market image in order to survive. At that time, ValuMart owed Merchants over $ 16 million on the various loan contracts it had taken out over the years , and this amount has grown in the last year to $17.5 million. Under ValuMart's contract with Merchants, this total amount, plus any amounts that should be subsequently payable on the Channing guaranty, is secured by a blanket security interest on all of ValuMart's assets. The liquidation value of these assets as currently estimated by ValuMart's accountant, however, is barely adequate to cover this amount. The current value of the Channing inventory is $4 million if it sells at the price that Channing wants it sold at, and $2 million if it sells at the price that ValuMart would like to sell it at. ValuMart's other inventory is estimated to have value of $5 million, its customer accounts and outstanding credit-card receivables are estimated to be worth $2 million, its equipment and retail fixtures are probably worth about $1 million, and its real estate holdings and rights under various shopping center and store leases are probably worth another few million. Then there is the ValuMart brand name, which would probably be worth several million if it could be shopped around as a going concern, but which might be worth much less in a distress sale following a bankruptcy filing. Finally, ValuMart has about $200,000 of cash on hand, but this will not be enough to meet its needs in the upcoming spring season.
You are a legal and financial consultant who has been hired by ValuMart to advise them on the best way of saving their company. Please write a short memo suggesting possible options for refinancing that would meet the needs of ValuMart and its three main creditors, and describing the legal arrangements that would be necessary to implement those options. If you conclude that there are no options available that would satisfy all parties, you may offer other suggestions for managing the conflict among them in a way that would maximize the continuation value of the firm.
QUESTION 3 (a of exam, 1000-word limit). Please answer both parts A and B, which will carry equal weight in the grading.
You are a member of the subcommittee on legal reform of the debtor-creditor law section of the American Bar Association. Your subcommittee is preparing a general report on the state of debtor-creditor law, which will include recommendations to Congress, to state legislatures, and to the American Law Institute and the National Conference of Commissioners on Uniform State Laws. Before the report is promulgated, of course, it will have to be approved by the full committee.
The way your subcommittee has decided to operate is to divide up the relevant issues among individual committee members and to have each member write a short memo to the committee on his or her issue or issues. With regard to each issue that has been assigned, the memos are supposed to explain the practical problem that has given rise to a call for reform, to identify the main arguments for and against reform, and to put forth a tentative conclusion. The memos should be brief, but since the committee is made up of experienced commercial lawyers, you can assume a fair amount of background knowledge on the part of your audience, so that you do not have to spend much time on elementary or threshold issues.
Because you are a relatively senior member of your committee, you have been assigned two issues to write about. You should divide your time and effort equally between the two issues.
Part A. In the case of United Savings Association v. Timbers of Inwood Forest, 484 U.S. 365 (1988), the U.S. Supreme Court held that a secured creditor who is stayed from enforcing its security interest during bankruptcy proceedings, and whose claim against the bankruptcy estate exceeds the value of the associated collateral, was not entitled to any compensation for foregone interest on its underlying claim, or for the loss of the opportunity to use the collateral, during the period in which the bankruptcy stay is in force. This result, which ran counter to the predictions of most academic commentators and to the holding of the most prominent lower court holding that had preceded it, was widely criticized for its lack of attention to the underlying policy considerations that might justify treating secured and unsecured claims differently in bankruptcy. Despite this criticism, however, the holding in Timbers has remained good law and there has been no serious attempt to overturn it through Congressional legislation.
Should Congress now pass legislation that would reverse or limit the result in Timbers, thus bringing secured creditors in bankruptcy closer to the position that they would enjoy in the absence of a bankruptcy filing?
Part B. Section 1-201(37) of the UCC, which sets out various criteria for distinguishing between lease transactions and secured transactions, has been amended in recent years but still continues to give rise to substantial litigation, in part because the statutory tests that are used to classify questionable transactions are so fact-specific. A major source of this litigation arises from the fact that personal property lessors are not required to file any public notice of their reversionary interest in order to maintain priority in the leased property over other creditors of the lessee, while creditors lending against collateral not in their possession are required by Article 9 to file a financing statement that complies with the requirements of Article 9, part 5 in order to take priority in the collateral over lien creditors and certain other competing claimants. While it is possible under the existing provisions of Article 9 for lessors to make a precautionary Article 9 filing, many lessors do not bother to do so. In the recent revision of Article 9, consignment sellers were brought within the Article 9 filing system, and were required to file a financing statement to maintain priority even if, on the substance of the underlying transaction, the seller's interest was a true consignment and not a security interest.
Should Articles 9 and 2A now be amended to require true lessors to file a public financing statement in order to maintain priority in the leased property over lien creditors and other competing claimants?