Columbia University School of Law
Commercial Transactions (L6221)
Professor Avery Wiener Katz
April 30, 2007
10:00 am — 1:00 pm
QUESTION 1 (⅓ of exam). Suggested time: 1 hour.
Daniel Drazic operates a retail establishment that does business under the trade name of Dan’s Music Mart. The Music Mart sells and leases musical instruments to both amateur and professional musicians; it also sells sheet and recorded music as well as a variety of accessories such as instrument cases and music stands. Music Mart’s standard installment sales contract provides if the customer fails to make a scheduled payment, Music Mart will have the right to accelerate the balance due; and if the customer then fails to pay the balance or to work out a modified payment plan, title to the instrument will revert back to Music Mart. Conversely, Music Mart’s standard lease contract provides that the customer has the option to purchase the leased item at any point during the term of the lease, at a price equal to the remaining lease payments plus 25% of its estimated market value at the time the option is exercised.
In exchange for the right to draw on a variable line of credit, Music Mart has granted a security interest in its inventory and equipment to its general lender, Lester. Pursuant to this agreement, Lester has filed a financing statement that listed the debtor’s name as “Dan Drazic” and the collateral as “all business assets, including inventory.” Lester is not Music Mart’s only source of credit, however. When Music Mart leases or sells a musical instrument on an installment basis, it transfers the resulting account to Fender in exchange for a cash payment ranging from between 80 to 90% of the total amount due from the lessee or buyer. Under this factoring arrangement, Fender takes physical possession of the associated lease or sales contract, and has the right to collect directly from the account debtor. In event that the underlying item needs to be returned or repossessed, however, Fender typically sells the contract back to Music Mart and lets Music Mart deal with the return.
A. On these facts, if Music Mart subsequently defaults on its loan agreement with Lester, who will have priority in the factored accounts, in any cash proceeds, and in the leased or sold musical instruments?
B. How would your answer change, if at all, if Fender mistakenly relinquished possession of the tangible lease or sales contracts (for instance, by returning them to Music Mart or giving them to someone else who had not agreed to act as Fender’s bailee or agent). What if the tangible contracts were destroyed in a fire (with scanned copies remaining available for evidentiary purposes)?
QUESTION 2 (⅓ of exam). Suggested time: 1 hour.
Your client, Orange Bank, is engaged in discussions to refinance an outstanding loan to Boscorp, a small corporation controlled and managed by a single owner, Billie Bosco. The loan is technically in default, although your client’s loan officers do not believe that Boscorp is actually insolvent (though it is difficult to be completely sure because the answer turns on the value of long-term accounts receivable and of commercial goodwill, both of which are difficult to assess.) Bosco’s personal assets have positive net value, however; and Boscorp’s net income is currently sufficient to cover upcoming payments on the existing loan, so refinancing could make good business sense, especially if the bank covers its risks with appropriate credit enhancements — for instance, by taking a security interest in some of Boscorp’s corporate assets or by getting a personal guaranty from Bosco, perhaps in the form of a co-signed promissory note. Such additional security would limit the borrowers’ flexibility, of course, but your client’s officers believe that Bosco would be willing to pay this cost in order to take advantage of recent reductions in interest rates and to obtain an extension of the loan’s due date. Indeed, Bosco has even expressed interest in a cross-guaranty arrangement under which the Boscorp company would guarantee an old personal loan made to Bosco at the same time that Bosco personally guaranteed a new loan made to Boscorp.
Orange Bank has asked for advice on how to structure a refinancing transaction that minimizes the bank’s risks in the event of Boscorp’s insolvency (or in the less likely event that Boscorp remains solvent while Bosco does not). In particular, the bank’s officers are concerned that a new security interest or guaranty (or payments received following the grant of a new security interest or guaranty) would be subject to attack in a bankruptcy proceeding, especially given the close relationship between the corporate and individual debtors. In response to this request, please write a short memo outlining the potential legal risks involved in this transaction, and what steps if any can be taken to lessen such risks. If you see any significant risks to the transaction beyond those already identified by the bank, do not neglect to address those risks in your memo as well.
QUESTION 3 (⅓ of exam). Suggested time: 1 hour.
You are staff counsel to the Senate Subcommittee on Financial Services. Your boss, Senator Lightyear, has been receiving an increasing number of constituent complaints about fraud, forgery and mistake in Internet payments transactions, particularly in consumer transactions involving person-to-person intermediaries such as Paypal, and in direct debit transactions in which customers supply bank account information to merchants or creditors, who then draw directly from the payor’s bank account using an automatic clearinghouse system. The complaints range from cases of deliberate fraud arising from theft or misuse of consumer passwords used to access the relevant payment systems, to mistakes arising when processing delay or the lack of a clear confirmation message leads consumers to refresh a webform or to re-click an Internet link, thus unintendedly authorizing a duplicate payment, to general confusion among consumers about just what risks they undertake when making online payments.
The Senator has asked you to draft a brief memo describing possible legal and regulatory responses to this problem, and outlining the main advantages and disadvantages of such responses. Since the Senator’s time and attention span are limited, however, you should limit your discussion to three main alternatives: (1) a legal framework similar to that currently provided for checks under UCC Articles 3 and 4, with a reasonably thick set of loss allocation rules designed to distinguish among various types of fraud and mistake and among different types of negligence, (2) a framework similar to that provided when consumers use credit cards, with broad payor immunity for fraud combined with a general principle that payors are responsible for transactions they actually authorize; and (3) a regime of freedom of contract, under which consumer rights and duties are determined by their agreements with particular payment providers, subject to general contract defenses such as unconscionability and mistake.
In your memo, you may comment on the political feasibility of the approaches you describe, but this should not be the focus of your analysis. Instead, you should concentrate your attention on the policy consequences of these approaches, if adopted in the form of legislation or administrative regulation.
END OF EXAM