Date: January 20, 2003
To: Commercial Transactions students
From: Avery Katz
Re:  Feedback on Fall 2002 exam


Here is a summary of how I thought the exam questions should have been approached. Pending permission from the authors, I will also post on the website the top two student answers to each of the questions. What made these answers the best was their coverage of arguments, detail and sophistication in use of facts, and clarity in organization and explanation. If you drew different inferences from the given facts than I did or than the top answers did, you wouldn't have lost points, unless your inferences were unsupportable. 

For your reference, here is a copy of the actual exam.

Your individual exams will be available for inspection at the office of my assistant, Nadine Baker (600/1 JG, 4-7594). I did not make many written comments on the exams themselves; instead, I used a system of symbols to indicate my reaction to particular arguments and inferences. A key to these symbols is attached. If you want to discuss your individual exam, please feel free to contact me. You will find it useful, however, to read this model answer as well as the top answers before we meet.

It was a pleasure teaching the class, and I wish you all well. Please keep in touch.

Question 1: The frauds of Mal Factor

This question was in my opinion the most demanding one on the exam, in part because it was so intricate. (I tried to work in as many doctrinal issues as I could, because you did not have a midterm quiz covering this material, but even so, there were several important issues, such as holder in due course, which were not included). The most common student errors related to such omitted issues. For example, many of you attempted to apply an altered-check analysis under 3-407 to Mal's alteration of Zoe's payroll records, but since Mal changed the records before any check was issued, there was never an original check to alter.) The following analysis, accordingly, is substantially more extensive than what I either expected or received from you in the limited time and space you had; but I am offering it for the sake of completeness.

Excess payment to Zoe

This issue was probably the most trickiest one on the exam, because automatically deposited checks are not covered by Article 3 at all. Article 3 applies only to negotiable instruments, which under 3-104 [definition of "negotiable instrument"] and 3-103(6) and (9) [definitions of "order" and "promise"] must be in writing. Strictly speaking, as the two student model answers noted, the transaction is covered by the Electronic Funds Transfer Act. Several of you analyzed the problem under Article 4A, which is closer but still not applicable because it deals with wholesale wire transactions only. I did give full credit to those who used Article 4A, and close to full credit to those who treated the check as having being physically issued before deposit (though not to those who treated it as an alteration).

We did not cover the EFTA in enough detail for you to conduct a full analysis under it, but in any event, Zoe, who did not deserve the extra $600 and had no reason to think she had earned it, is liable for its return under a common-law restitution theory. The fact that she lost the money on an unlucky investment does not count as reliance. Under Article 4A, one could use the sections dealing with mistaken transfers to reach the same result (and under Article 3, if it were relevant, FFB as drawer could use 1-103 to recover a mistaken payment from an unjustly enriched payee, even if there had been no breach of presentment or transfer warranties).

Checks payable to Lam Rotcaf

These transactions are covered by Article 3, and are classic fictitious payee cases. Since Mal supplied the information to the FFB payroll computer, Mal's intent controls the identity of the payee under §3-110, implying that the intended payee is a non-existent person. Thus, § 3-404(b) applies; and under (b)(1), any person in person in possession of the instrument is its holder, and hence entitled to enforce under 3-301.

All these checks were paid by mistake (since FFB's signature as drawer was not authorized ) and so under 3-418, FFB as drawee is entitled to recover their amount except against a good faith taker. Assuming it acted in good faith, however (one could argue that it did not take sufficient care when it allowed Mal to deposit a check made out to his alias Lam), Bank Two has a good defense to this claim under 3-418(c). Bank Two is also safe from liability under 3-417 since, as a holder, it has not breached any presentment warranties. (Mal, of course, has breached the presentment warranty of 3-417(a)(3), since he knows the check was unauthorized, but he is unavailable to be sued.) So FFB must bear the loss on these checks.

With regard to the third check that Mal signed in his own name and transferred to Sharkey, the indorsement was ineffective under 3-404(b)(2) as the signature of Lam Rotcaf, since "Lam Rotcaf" and "Mal Factor "are not substantially similar. However, the ineffective indorsement does not prevent Mal or Sharkey from becoming holders under (b)(1), and hence both are entitled to enforce under 3-301. The incorrect indorsement , however, probably prevents Sharkey from asserting good faith status, and hence deprives him of his 3-418(c) defense against a mistaken payment claim (for which he would otherwise qualify, because taking a check for an old debt counts as "value" under 3-303). Alternately, it may count as a failure of ordinary care on Sharkey's part, thus providing a basis for FFB's asserting a negligence claim against him under 3-404(d).

Possibly FFB can bring a negligence claim against Mailboxes R Us at common-law, on the theory that MRU's providing Mal with a mailbox under a false name helped him carry out the fraud, but there is no explicit basis for such a claim under any specific provision of Article 3.

Counterfeit check for $99,999

Here everything turns on whether FFB can be excused for missing its midnight deadline on the check. Under 4-301 and 4-302, if a drawee bank does not dishonor a check by the midnight of the day following its receipt of the check, it is accountable for the check. Of course, missing the midnight deadline does not bar a drawee from asserting a valid claim of mistake or breach of warranty, but FFB has no such claim in this case. FFB cannot assert mistake against Bank Three, since Bank Three has given value against the check and so has a good defense under 3-418(c). Similarly, Bank Three has not breached any presentment warranty, since whoever wrote the check (Kevin? Mal?) is treated as drawer under 3-110, and that person designated Kevin as payee. Thus Kevin is a person in possession of a (worthless) check payable to him, and hence a holder . Thus, just as with any other forged check, a person who has taken the counterfeit check for value and in good faith is entitled to enforce it against the drawee. [There is no explicit indication in 3-110 and 3-403 that this analysis applies to counterfeit as well as forged checks, but the policy analysis is the same – the drawee is ordinarily in a better position than the taker from the thief to detect the fraud.]

If FFB has not missed its midnight deadline, however, it can dishonor the check, because under 3-408 it is not liable as drawee on any unaccepted check. In this case Bank Three will be stuck with the counterfeit check and will probably have to bear the loss from the fraud, since none of the negligence or strict liability provisions for drawer liability seem to apply. [3-404 does not apply since this is not a case of an impostor or fictitious payee; 3-405 does not apply because this is not a fraudulent indorsement case; and 3-406 probably does not apply unless Bank Three can successfully argue that FFB's negligence in supervising Mal contributed to a forged signature on the instrument. In the actual case, however, FFB was negligent in not catching and dishonoring the check, not in allowing it to be written in the first place; so this argument is a bit of a long shot.)

It appears on the face of the matter that FFB missed its deadline, since the check was received Wednesday and was not detected until Friday afternoon. On the other hand, 4-109(b) excuses such delay if it occurs for reasons beyond control of the payor bank, and Regulation CC extends the deadline until the end of the second day following receipt if notice is actually given that time. Whether the delay was beyond FFB's control is a factual issue, but probably since it arose out of the malfeasance of an unsupervised FFB employee, the odds are probably against FFB making out this defense. We are not told when and how FFB notified Bank Three of the fraud; possibly it was in compliance with the Reg CC extension.

The diverted wire transfer

Sander, the original sender of the diverted transfer, is entitled to recover the diverted funds from its receiving bank Omicron mistransmission under the money-back rule of 4A-402. As between Omicron and FFB, this depends on whether or not the banks agreed on a security procedure (they probably did) and whether Omicron can prove that the diversion resulted from Mal's interference. If Omicron cannot prove that Mal intercepted and altered its offer, Mal's altered order would be effective as Omicron's order under 4A-202, and Omicron would be liable for the lost funds. Assuming that Omicron can show that it did not order payment to Lucky and Mal, Omicron is excused from liability under 4A-203, and can recover the funds from FFB, who will be left holding the bag.

FFB will be able to recover the $750,000 diverted to Lucky under 4A-303, to the extent recovery would be allowed by the common law of mistake and restitution. It's doubtful that Lucky could successfully argue reliance. In addition, Lucky will be liable to FFB under 4-401 for the amount of the checks he wrote and that FFB paid. 4-401 is clear that checks can be charged against a drawer's account even if they would cause an overdraft. Lucky could try to argue that had FFB not been negligent, he would not have written the checks in question, but it is unclear what damage he has suffered as a result, and in any event we are told he wrote the checks without knowing of the extra $750,000 in his account.

Donald, as beneficiary of the original wire transfer, is entitled to recover interest on the diverted funds under 4A-305(a). No consequential damages are available under 4A-305 unless they are expressly provided in Donald's deposit agreement with FFB. On the other hand, Donald has a plausible claim against FFB for wrongful dishonor under 4-402, and if so, he is entitled to consequential damages under 4-402(b). FFB will argue that it was entitled to dishonor due to insufficient funds; Donald will respond that the funds were only insufficient due to FFB's failure to perform its duties under Article 4A (or alternately, that FFB should be barred from asserting that the funds in Donald's account were insufficient). There is room to argue whether Article 4 or Article 4A should control on the issue of consequential damages.

Question 2: Saving ValuMart

On this question, I was looking for you to combine legal and transactional analysis; in order to do this you had to 1) describe the parties' legal positions as they stand, 2) then discuss the legal effect of possible planning strategies, and finally 3) discuss the relative merits of the various outcomes from the vantage point of the client, Valumart [VM].

It's worth observing at the outset that, because of the discrepancy between the value of VM's assets as a going operation and their value when sold piecemeal, it is worth saving the firm if possible; and the creditor that has the most at stake in a failure — Merchants Bank [MB]— thus has an incentive to cooperate and perhaps to contribute funds to prevent a liquidation. Additionally, one interesting aspect of the question is that the creditor who is in the weakest position legally — National Media Sales [NMS] — is probably in the strongest position from a practical standpoint, since it can cut off Valumart's customer flow by cutting off its advertising, while the creditor in the strongest legal position (Catherine Channing [CC], who has a priority position as a purchase money secured creditor) is probably in the weakest practical position (since her goods are not selling and VM does not need anything further from her at this time.)

Specifically, MB is a general secured creditor, and assuming its security interest was properly perfected, it will take priority over unsecured creditors and over the bankruptcy trustee if there is one. CC is also a secured creditor, and because she lent in order to finance the purchase of her goods, she has purchase-money status and will take priority over MB to that extent. NMS is an unsecured creditor and in the event of insolvency will take third place along with other secured creditors after the secured claims are satisfied. Given the description of the outstanding secured debt and the value of the collateral, however, it appears that there will be nothing left at that point.

NMS accordingly needs some additional incentive to continue supplying advertising services. The solution it proposes, however — paying all amounts in arrears — will be vulnerable as a preferential transfer under Bankruptcy Code §547 if VM files for bankruptcy within 90 days. (Analogous arrangements, such as upgrading NMS to secured status, would also count as a preference.) Thus, the only way to immunize the such a payment from attack is to prop VM up for 90 days afterwards, or to get the funds necessary to pay off NMS from someone other than VM. For example, maybe the stockholders of VM might be persuaded to offer a personal guaranty, or MB might be persuaded to advance additional funds to NMS, to extend a letter of credit, or even to take over NMS's old debt.

It is possible that NMS might be willing to provide future services, even with its old debt outstanding, if it were paid in cash or given a secured position. This would not pose any preference problems, since such payment would be in exchange for a contemporaneously incurred debt, but there is still the issue of where the cash or the secured position would come from. All of VM's assets are already encumbered, and so NMS would have junior status relative to the existing secured creditors. Again, perhaps MB, which has a long term interest in saving the business, might provide funds or be willing to subordinate its security interest so that NMS can obtain a more senior position. NMS also has some incentive to cooperate in saving the business since this is the only way that VM could earn the funds necessary to pay back what it owes NMS for past advertising.

As for CC, she has first priority in the clothing that she provided and that VM is currently holding as inventory, but it is unclear that this priority position gives her any real leverage. VM is not currently in default with regard to any of its monetary obligations toward her, and she cannot call her loan and repossess the inventory absent a default. Under 1-208, she must exercise good faith when declaring a default under the general insecurity clause in her contract with VM, and it is unclear (even unlikely, given the antitrust policy against resale price maintenance) whether VM's cutting the price on her clothing would satisfy this standard, especially since we are told that the clothing is not selling at current prices. CC also runs the risk that VM might declare bankruptcy, in which case she would be stayed from enforcing her security interest under §362 (since the existence of inventory is almost certainly necessary for a successful reorganization). In addition, in bankruptcy her secured claim would be stripped down under §506 to the current value of the CC inventory, which is probably the lower amount that VM wants to sell it at, not the higher price that CC wants to maintain. And it's even possible that a repossession that drove VM out of business would jeopardize the value of the guaranty she holds from MB, by providing MB with a colorable suretyship defense. Since CC's goods are currently in overstock and since the value of her brand name is in free fall, VM probably does not need to worry much about preserving her cooperation — except that it would be prudent to make sure that all required payments and obligations under her sales contract are observed to the letter, to avoid giving her a pretext to declare default.

MB has the most to lose if VM's business fails, both because it is undersecured and because it is liable to CC on its guaranty. It might advance additional funds, but any arrangement to save the firm must ensure that MB is not any worse off than it is under the current situation, and probably will require that MB is given a significant management role.

Two arrangements seem most fruitful. First, VM could file for bankruptcy protection under Chapter 11. This would prevent CC from exercising its threat to repossess the CC inventory, would allow time to reconfigure the firm without risking a rush to collect, and would allow NMS and MB to make new credit arrangements under the supervision of the bankruptcy court, without having to worry that those arrangements were later vulnerable to attack as preferences or fraudulent conveyances. This alternative would not protect NMS on its past debt, but any future media sales could be given special priority in the post-bankruptcy firm refinanced

The main disadvantage of this alternative is that a bankruptcy filing right before the holiday sales season might scare away customers, especially those purchasing goods that might require subsequent service or warranty protection. Accordingly, VM might alternatively get together with its creditors and arrange a private workout in which the creditors agreed among themselves to defer demands for immediate payment in exchange for a mutually acceptable plan for future payments. The main disadvantage of a private workout is that it requires unanimous agreement, and could thus be upset if, for instance, CC instead decided to call its loan. But the prospect of a stay and stripdown in bankruptcy, which would probably reduce the amount that CC could recover relative to a successful workout, might provide CC with the incentive to negotiate a voluntary solution.

Question 3: Recommendations for commercial law reform

Here there was room for you to argue in various ways, and the top student answers illustrate some of the possibilities.  Here I briefly sketch out the main considerations you should have included in your answer.

The first part of the question, which asked you to discuss whether the Timbers of Inwood Forest holding should be overturned by legislation, called for you to discuss and to compare the competing policies underlying Article 9 and the Bankruptcy Code respectively.  The Timbers case interprets the "adequate protection" language of Bankruptcy Code §361 in such a way to undercut some of the advantages of secured credit under Article 9 [because in a non-bankruptcy case, a secured creditor could repossess and sell the collateral in question and start earning interest on its value immediately]. Thus, after Timbers, a secured creditor is in a somewhat better position outside of bankruptcy than it is in bankruptcy. This may be objectionable on distributional grounds (it deprives secured creditors of an advantage that they fairly bargained for and paid for by accepting a lower interest rate than otherwise) as well as on efficiency grounds (because the prospect of lengthy bankruptcy proceedings in which the creditor is not compensated for lost interest may induce creditors to repossess sooner than they would otherwise, and because by weakening the distinction between secured and unsecured credit, the court makes it harder for creditors to specialize in the kind of credit they are most suited for, and thus raise the cost of credit ex ante, making it harder for debtors to get loans in the first place.) It should be acknowledged, however, that the effect of the Timbers decision on the value of secured credit is a fairly marginal one in light of all the other features of bankruptcy, and there may even be aspects of bankruptcy that benefit secured creditors on balance. In addition, the incentive difficulties raised by Timbers can be mitigated by ensuring that creditor protection is adequate in other dimensions and by preventing debtors in possession from dragging out bankruptcy proceedings excessively.

The counterargument in favor of Timbers is that secured creditors already have too much of an advantage in the event of insolvency, and that it is appropriate for bankruptcy to cut back on their rights. In this context, it is worth noting that unsecured creditors tend to be smaller, less sophisticated, and in less of a position to protect themselves with other precautions, so that in many cases they have not been compensated with a higher ex ante interest rate, as the theoretical defenders of secured credit would have it. Additionally, there is an ex post efficiency argument that provision of interest to undersecured creditors may make it harder for firms to reorganize and to preserve their going concern value. [Although this last argument may be countered by the observation that if a business cannot be saved except by paying its suppliers of capital less than the going market rate, it should not be saved.] How one comes out on Timbers, accordingly, depends on how one assesses these rival arguments in the context of the automatic stay.

As for part B of the question, this called for you to discuss and assess the policy arguments underlying the Article 9 filing system, again with reference to a proposal to extend the scope of that system marginally [specifically, to true lease transactions].  As many of you noted, the filing is justified only if the costs of maintaining it are outweighed by the value of the notice provided to subsequent creditors and lenders who might otherwise have difficulty in discovering whether particular assets that they are lending against or buying are encumbered.  With an authoritative filing system, such subsequent parties can find out the ownership and encumbrance status of particular property easily and cheaply.  But if there are likely to be few such subsequent creditors, or if they have other ways of finding out the status of property, mandatory filing is not justified [this is why, for instance, filing is not required for purchase-money loans against consumer goods.] 

Personal property leasing is an increasingly big business and it may well be the case that third parties do not know whether the person in possession of goods owns them or merely holds a leasehold.  Because of the difficulty of distinguishing leases from security interests, furthermore, many leases are filed anyway [though most are not].  So requiring lessors to file may not be that costly, especially now that electronic filing systems are lowering the real cost of compliance with such a system.

On the other hand, there are ways to prove ownership without a filing system and most sophisticated lenders today know that the risk that goods are leased needs to be investigated before advancing funds. In extreme cases, additionally, courts may be able to protect third party purchasers who really misled by using the doctrine of ownership by equitable estoppel.  So the desirability of requiring lessors to file financing statements turns on one assessments of the relative importance of these various considerations.

Key to symbols used to mark exams:

good point or argument


excellent point or argument


fair point, or incompletely or unclearly expressed

weak point

point needs elaboration


point already made, repetitive, or unnecessarily restating facts




very unclear, confused, mixing together separate points


mistake of law, misstatement of fact, misuse of term


point appears mistaken


irrelevant or tangential point


point's relevance unclear


point is not applicable to this situation


non sequitur: conclusion does not follow


fighting facts: contradicting stated facts or making assumptions inconsistent with them


laundry list: throwing in relevant and irrelevant arguments alike, without distinction


lecturing: abstract discussion of conceptual material, unconnected to the problem at hand


unsupported assertion / unidentified assumption


verbose; too much space devoted to the point or points in question


discussion is overly vague or overly general


conclusory; result of argument stated without reasoning


straw argument: overly weak or caricatured argument set up for sake of rebuttal


otherwise good point is overstated or exaggerated


fails to discuss obvious counterargument