Georgetown University Law Center
 Examination in Commercial Law: Sales and Secured Transactions
                           (24 Hours)
 

Professor Avery Katz                                May 2-9, 1995
 

Instructions:

     1.   This exam consists of 7 pages.  Please be sure your exam is complete.

     2.   Your exam is due 24 hours after you pick it up, or at 6 PM on Tuesday, May 9, whichever is
     earlier.  If you use a word processor, you are expected to take precautions against mechanical
     failure, accidental erasure, and similar misfortunes, sufficient to allow you to meet the
     deadline.  Please note that the registrar's office is open only from 9 am to 4 pm on weekends.
     Please type your exam if it is convenient; otherwise, please write legibly.  If you write your
     exam by hand, please submit a typed version of it to the registrar's office by the end of the
     day on Friday, May 12.  Please begin each essay question on a new sheet of paper and staple
     each essay question separately (or use a separate blue book for each question) as I will
     separate them to do the grading .  Please also write your exam ticket number on the first page
     of each essay question.  I will not read any material that appears on scrap paper.

     3.   The exam is open book; you are free to consult any written materials, and you should have
     available to you the assigned course materials.

     4.   Until the examination is completed at 6 PM on the 9th, you may not communicate with any
     person about the contents of the examination, whether or not you or the other person have
     started or completed the exam.  If during the exam you have any questions regarding its
     administration or substance, you should contact the registrar's office and they will contact me
     if necessary; this will preserve the Law Center's policy of anonymous grading.

     5.   There are two questions having equal weight in determining your grade.  Each question has a
     1500-word length limit.  Any attempts to use shorthand or nonstandard abbreviations (other
     than the names of the hypothetical parties) will be counted as if full words were used.  You
     may not use any leftover space from one question in answering the other.  Answers
     exceeding the length limit will be penalized by reducing their score in proportion to the
     extent of the excess.

           I will assume for purposes of administering the limit that a typical double-spaced typed page
     with 1-inch margins contains about 300 standard English words when using 12-pitch fixed-
     width type (12 words per line times 25 lines per page), or about 250 words when using 10-
     pitch type.  Alternatively, if you use proportional spacing or a different size typeface, you
     may make a good faith estimate by counting the words in a sample paragraph and
     extrapolating to the length of your entire exam.

     6.   Good luck on the exam, and for those of you graduating at the end of the term, best wishes.


 
 HONOR STATEMENT

 On my honor and aware of the student disciplinary code, I swear or affirm that I have
neither given nor have I received any unauthorized aid from any other person or persons, nor
have I used any unauthorized materials in writing my answers to this examination.
 

Exam #
  (please sign with exam number only)
 

Date
 

Time received:    Time returned:


QUESTION 1:  50% of exam; limit of 1500 words.

Datamart, a discount retailer of computer equipment and accessories, has fallen on hard times.
While it did quite well up till around a year ago, its market niche was eroded by competition from
office warehouse "megastores."  These megastores sell computers, peripheral equipment, and
software along with many other lines of merchandise ranging from office supplies to office furniture.
 They provide no technical support or repair services whatsoever and sell at deep discount.  Datamart
does provide some minimal technical support and does maintain a service and repair department, but
as a discounter it is not in a position to compete on these terms with full-price retailers that specialize
in providing technical advice and training to their customers.  Datamart's attempts to compete with
the megastores on price, on the other hand, have left it insolvent — a fact it has managed to conceal
from its inventory financer, Irwin Trust.  In fact, for the past six months Datamart has secretly been
in violation of loan covenants in its security agreement with Irwin.  As a result, all its sales during
that period of time were technically in violation of the security agreement.   In this agreement, signed
in October 1990 by its president and sole shareholder, Douglas Dilbert, Datamart granted Irwin a
security interest in "all inventory now owned or hereinafter acquired by the Debtor, including
computers, peripheral equipment, and software."  Datamart also signed a financing statement
covering "inventory," which Irwin filed both under the names of "Data Mart" and "Douglas Dilbert
d/b/a Data Mart" on October 15, 1990.  Later, on January 15, 1994, Irwin amended its filing and
recorded it under the correct legal name of "Datamart, Inc."

Datamart has managed to keep its financial condition secret through a combination of artifices.
It makes a significant fraction of its sales on a 6-month and 12-month credit basis.  Some of these
sales were on open account and some were under a credit contract that reserves title in the goods
sold until all amounts due are paid by the customer.  Since July 1993 it has been borrowing against
these accounts receivable and customer contracts from a factor, R.T. Firefly & Bros., without telling
Irwin.  Initially, Datamart simply provided Firefly with photocopies of its account invoices and credit
contracts, but as the amounts borrowed began to increase, Firefly asked for more definite records.
Eventually, Datamart signed a financing statement covering "accounts receivable," which Firefly
filed on December 15, 1993.

In the past year the funds provided by Firefly proved inadequate to cover cash obligations
toward the end of some months and Datamart resorted to more fraudulent stratagems to make ends
meet. In particular, it began as a temporary expedient to recirculate computer equipment that had
been left in its service department for repairs and upgrades.   Datamart repackaged this equipment
and resold it to retail customers, representing it as new goods; after a delay, it then substituted later-
delivered equipment to its service customers.  In some cases it even substituted the equipment of
later service customers for earlier ones; no customers, however, ever noticed the difference.

What has really driven Datamart over the edge, however, is a well-publicized flaw in the
Neptunium microprocessor, which is used in a majority of computers Datamart sells.  In February,
the manufacturer of the Neptunium chip, Ultron, Inc., announced that about 25% of Neptunium chips
contained a minor design flaw that in rare circumstances could affect the accuracy of certain
calculations using multi-digit floating-point numbers.  In its press release, Ultron assured its
customers that the flaw, which could be determined only by a trained service technician examining
the chip under a microscope, was minor; and that most users would never encounter it unless they
used their computers for applications requiring intensive mathematical calculations, such as
statistical analysis.  Ultron announced that it would provide new chips free of charge to any customer
who could demonstrate that they had one of the defective chips and that their work entailed such use.
This decision received substantial unfavorable publicity in the media, and a large number of
Neptunium users applied for new chips, including many who did not use their computers for
calculation-intensive applications.  Ultron, however, stuck to its guns and refused the claims of many
of these customers.

This development was initially a boon to Datamart as it saw a large increase in the number of
Neptunium machines turned in to its service department from customers who wanted to find out
whether they had a flawed chip; and these machines could be recirculated to new customers.  The
service department soon became overloaded with work, however, and this strategy turned
unprofitable.   Datamart also faced the complaints of many Neptunium customers who wanted new
chips even though they did not meet Ultron's criteria.  In some cases, customers did not even want
replacement chips and tried to return their machines for refunds.  Most of these customers had
bought their computers before Ultron's initial press release, but some had purchased after the initial
announcement but before it had received wide publicity in the popular press.  Some had purchased
after the story had been widely reported, though they had missed the reports.  The customers'
incentives to return their computers have been increased by the fact that the price of Neptunium
computers have fallen by almost 50%.  Part of this is simply the norm in the computer industry, as
prices of new products always fall over time in response to continuous technical innovation by
competitors.  In this case, the price decline was accentuated by Ultron's decision to cut prices on its
machines even further following the bad publicity it received in the media.  Indeed, the
announcement of the Neptunium price cut was followed by a measurable upswing in the number of
previous purchasers who tried unsuccessfully to return their machines.

Irwin has just learned of Datamart's insolvency and is presently inspecting the books.  It has
learned of the factoring arrangement with Firefly, and will soon learn of Datamart's misbehavior with
regard to its service inventory.  As soon as this happens, it will foreclose on its loans and Datamart
will have to close its doors for business.  Right now Datamart's inventory of new equipment is low,
but it has an unusual number of machines left by customers in its service department.  It has a bank
account containing sales proceeds, and a separate bank account containing some funds received from
Firefly.  It also has a significant amount of uncollected accounts receivable, though Firefly will also
lay claim to these.  Collecting these accounts may prove to be difficult, as many of Datamart's
customers are unhappy Neptunium owners.

A few of these Neptunium buyers may even assert claims for additional damages beyond the
cost of their machines.  One such customer, Norbert, stored accounting data from his small business
on his computer, and used an encryption program to keep this data confidential.  He now claims that,
as a result of the Neptunium's design flaw, his encryption program incorrectly encoded his data and it
cannot now be unencrypted.  He is threatening to sue for the cost of reassembling the data and for
lost profits in his business resulting from the loss of the data.  It is unclear whether or not this
problem could have been caused by the Neptunium flaw, even if Norbert had a defective chip.  The
encryption program which Norbert bought at Datamart, came packaged with a prominent warning on
the outside of the package specifically disclaiming any liability for loss of data, but the disclaimer
accompanying his computer was less specific.  It appeared by itself on page 3 of the introductory
section of the owner's manual, immediately following the table of contents.  It read:  "Seller warrants
its products to be in conformance with all technical specifications.  It gives no warranty of
merchantability or of fitness for any particular purpose.  In no event will Seller or its representatives
be liable for any consequential damages resulting from use of its products."  The manual itself was
packaged in shrink-wrap inside the machine's carton.

Irwin wonders which of Datamart's assets it will be permitted to foreclose on, and of these,
which it will be permitted to keep.  It also wonders who will be entitled to collect Datamart's
accounts receivable and customer contracts, and whether these will be worth anything in practice.
Additionally, it wonders who will be entitled to the computer equipment and software sold by
Datamart over the last year.

Write a memo detailing who is entitled to what.
 


QUESTION 2:  50% of exam; limit of 1500 words.

Donner's, a full-service department store of venerable reputation, has, like many other large
retailers, gone through changes in organizational form in recent years.  Three years ago, Donner's
was purchased by Amalgamated Retail Stores (ARS), a conglomerate holding company, in a
leveraged buyout.  In this transaction, which resembled several others it had engaged in recent years,
ARS borrowed substantial sums from its investment bank, Crandall Trust, and used these sums along
with most of Donner's liquid assets at the time to cash out the holdings of the store's longtime
owners.  This transaction substantially increased the debt-equity ratio of the business.  Crandall had
planned to sell much of its ARS debt on the investment market on a subscription basis, but shortly
after the Donner purchase was concluded, two other large retail chains filed for bankruptcy and
received substantial publicity for doing so.  As a result, Crandall found that it could not sell its ARS
subscriptions at a price it regarded as acceptable.  Rather than pay the heavy market penalty then
associated with "junk bonds," Crandall ultimately decided to keep the majority of this debt itself,
though about 20% is now owned by other bondholders in the form of unsecured claims..

Because Crandall had originally planned to sell off the Donner debt, it did not originally
negotiate the kind of protection from Amalgamated as it would have insisted on in a straight loan
transaction.  When it became apparent that Crandall would be holding the bulk of the debt itself, it
renegotiated to obtain additional loan covenants and security in the form of mortgages on Donner's
real estate holdings and Article 9 security interests in trade fixtures (including office equipment).
Because Crandall was negotiating in a weakened position after the fact, however, the standards for
default in its contract with ARS were relatively lenient, and it did not take security in any of
Donner's other assets or in any of ARS's other holdings in other department stores.  As a result,
Crandall's claims against Donner's and ARS are currently substantially undersecured.  On the other
hand, this debt pays an interest rate significantly above Crandall's less risky investments.

For its part, Donner's owes several million dollars to its parent company ARS and almost a
million and a half to vendors of various types of goods.   Some of these vendors have provided
purchase money financing for their goods, representing around 30% of the 1.5 million; the rest are
unsecured. ARS and Donner's owe several million dollars to Crandall.  At this point ARS and
Donner are in compliance with all the loan covenants in their contract with Crandall; the contract
does however contain a general insecurity clause entitling Crandall, if it in good faith deems itself
insecure, to declare ARS in default and to accelerate its loans.  Though Crandall now wishes it had
been able to get protection back in 1992, it does not now wish to declare a default, since this will
likely force Donner's, ARS, or both, into an early bankruptcy filing.   This is to be avoided, since it
would both damage customer goodwill and make it more difficult for Donner's to get credit from
vendors.  It would also distract Donner's management at a critical moment, for the store, while it has
a significant and loyal base of traditional customers, needs to retool its image to meet competition.  It
has come to have a bit of a stodgy reputation compared to some its more trendy competitors, and
wants to make a variety of changes to keep pace with the times and to cultivate a younger and more
free-spending customer base.  This would require remodeling several of its retail locations,
expanding its inventory and bringing in new lines of merchandise, and spending substantial amounts
on marketing and advertising.

Furthermore,  the most ambitious plans for retooling Donner's retail operations would require an
infusion of funds — around $2 million.  Donner's anticipates a cash shortage over the next eighteen
months as it re-invents its public image, and there is some risk of insolvency over the short run.
ARS does not have much cash to spare from its other retail subsidiaries.  In fact, it now appears that
it may have been a mistake to leverage the company so heavily, but there is little prospect for raising
additional equity financing in the short term.  Crandall has some additional funds available but
wonders whether it already has too many eggs in Donner's and ARS's basket.  In the long run it
would like to reduce its exposure to this project by bringing in other investors, though this may not
be immediately feasible.  In the short term, it would like additional security.

ARS is also negotiating with an alternate lender, Second National Merchants and Miners Bank
(2d Bank). Second Bank does not have much experience in lending to full-service department stores
in recent years.  This means that it could afford to diversify the risks of a large retail debtor fairly
well with its other investments, but it also means it knows less about the business of modern large-
scale retailing than Crandall does and would have to make a significant investment in learning about
the trade and investigating Donner's market prospects in order to protect its interests as a creditor.
2d Bank would also consider some sort of cooperative agreement with Crandall, though it has so far
not been in contact with Crandall.

You are counseling 2d Bank in its negotiations with ARS.  Please write a memo outlining the
possible alternatives for providing financing.  In your memo, you should discuss what substantive
arrangements would be economically desirable in the abstract, whether legal considerations,
including the risk of bankruptcy, would argue for any changes in these substantive arrangements, and
what legal measures you would recommend if 2d Bank does decide to become involved.  Since it is
not yet settled whether it is worth spending the additional $2 million on Donner's retooling efforts,
you should give advice based on both hypothetical alternatives.  Additionally, while it should not be
the major part of your memo, you are invited to comment on the larger issue of whether 2d Bank
should get involved at all, or just leave it to Crandall to look after its prior investment.