Exam feedback memo, Commercial Transactions, Fall 2003

Date: January 30, 2004
To: Commercial Transactions students
From: Avery Katz
Re: Feedback on Fall 2003 exam

Here is a summary of how I thought the exam questions should have been approached. I have also posted on the website the top 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.

Your individual exams will be available for inspection at the office of my assistant, Joseph McGrath (500/10 JG, 4-3268). 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.

The main part of your discussion should have been devoted to how Cash24 can reduce the cost of its check cashing operations. Receipt of electronic payments, money order sales, and payday loans are also issues you should have discussed, but they are less important or complex than the check issues. From a legal point of view it was important to discuss the rules governing liability under Articles 3 and 4 and other statutes; from a business point of view it was important to discuss how Cash24 can take precautions against loss when cashing checks and making loans, and how it can isolate different categories of risk and charge its customers appropriately. In terms of organization, it was probably better to organize your answer by the type of payment mechanism used, discussing legal and practical issues together. Those who first discussed all legal issues and then all practical issues were less successful, in part because this organizational choice required duplicate discussions of the facts, and in part because it made it hard to relate the legal and practical analyses to one another.

Checks generally. With regard to its check cashing services, Cash24 needs to worry both about checks that are not properly payable, and checks that, although properly payable, are dishonored due to insufficient funds or because of stop orders. Furthermore, among checks that are not properly payable, we should distinguish between forged checks (which do not violate the presentment warranty given to the payor bank under 3-417 and 4-208), and checks with forged indorsements and other problems (which do violate the presentment warranty.) With regard to the former, the payor bank will bear the loss from fraud once the check is paid. With regard to the latter, the party who took from the thief will bear the loss; this is probably Cash24. (If Cash24's customer dealt with the thief, then as a formal legal matter, Cash24 will have a good claim against the customer for breach of warranty, but in most cases it will be difficult and expensive to collect from the customer, so in practice Cash24 will probably bear the loss.)

Forged checks. For forged or stolen checks, there is not that much that Cash24 can do to check the authenticity of the instrument. Cash24 could try to contact the drawer before paying, using the information that appears on the face of the check, but this may not be feasible for after-hour transactions. Cash24 might adopt a policy of cashing checks during business hours only, but this would likely cost it business. It might attempt to enter into arrangements with large local employers for pre-clearance of such checks, or for electronic transfer. It might also try to delay payment on checks for a day or two to ensure that such checks clear, but it would probably have to offer a reduced fee in exchange for the delay, since its customers are likely to value instant liquidity. It could also attempt to collect additional information from its customers, or give discounts to repeat customers, in order to increase the admittedly low chance of recovering from a customer for breach of transfer warranty. Similarly, it would be good practice to require customers to indorse checks when cashing them, in order to establish indorser's liability.   Cash24 could also refuse to cash (or charge a higher price for cashing) checks that are especially risky, such as checks drawn on individual checking accounts, while continuing to accept checks drawn on government institutions and large employers, which are less likely to be forged or stolen (and on which the nominal drawer might be liable on a theory of negligence under 3-406, or vicarious liability under 3-405.)

Checks with forged indorsements. For forged indorsements, altered checks, and the like, Cash24 is better able to control its fraud risks by taking ordinary precautions such as requesting ID's and signatures. Taking such precautions will also ensure that Cash24 qualifies for HDC status, and is not liable for contributory negligence on forged checks. It may also make sense to try to classify checks based on different levels of risk (e.g., government versus private checks, in-town versus out-of-town checks, regular customers versus strangers) and charge fees accordingly. We might also refuse to cash checks that have been transferred by the original payee, since these checks raise the risk that fraud has occurred farther up the chain of custody, which we are not it a good position to police. More accurate risk rating will discourage the riskiest customers and will enable us to lower fees for the customers we want the most.

Dishonored checks due to stop orders should not pose a risk, so long as we take the necessary precautions to become HDC's, and so long as the drawer remains solvent. Becoming a HDC requires that we give value (this is standard) and act in good faith. Solvency of the drawer is not a problem so long as we keep to the policy of cashing only business checks. If these conditions are met, we can still enforce the check against the drawer under 3-414. As before, we may wish to adopt a surcharge or higher fees for non-business or large-dollar-amount checks, or try to hold back some of the proceeds of the check for a reasonable period of time as a safeguard (and as an incentive for the customer.)

Electronic benefits transfers. In contrast to the checks it cashes, the payments that Cash24 receives through electronic benefits transfers are practically riskless. Cash24 does not have to worry about NSF or stop orders on such payments since once the order is received, payment is final. Similarly, fraud risk is low due to the nature of the payor. Thus, the main costs of processing such payments come from network and clearinghouse fees, and from the overhead costs of owning the equipment necessary to receive such payments. In addition, such payments tend to be regular (monthly social security checks and the like) so that repeat business with its greater reliability is a factor here. Thus, this may be an area where Cash24 can cut fees (especially if it wants to encourage more of its customers to move away from relatively risky checks to relatively safer EBT's.)

Money orders. Here some of you were a bit confused by the factual assumptions I provided you with, but if you made other assumptions I tried to give credit accordingly. On my instructions, these are effectively instruments where Cash24 is liable as drawer under 3-414. To the extent that Cash24 receives payment when issuing a money order, it faces no risk of loss. (If it receives cash, it will be a good faith purchaser even if the buyer lacks title to the cash; if it receives a check, it will need to charge its customary check cashing fee and take its usual check risk). But now Cash24 faces the usual drawer's risks. It needs to worry about embezzlement by its employees under 3-405, and other types of negligence that assist theft or forgery under 3-406 or subsequent alteration under 3-407. Thus, Cash24 should adopt reasonable policies to supervise its employees and its stock of money order blanks; it should use security paper if this is not too great an expense, and it should make sure that when it issues money orders it does not leave space for potential alterations. Finally, Cash24 should adopt policies with regard to lost money orders that adequately guard against double presentment: e.g., require customers seeking refunds or duplicates to post a portion of the money order as security, requiring its customers to pay the costs of stop orders at Cash24's depositary bank.   Such policies are consistent with the rules of 3-309 on lost instruments.

Payday loans. Finally, the payday loan market is inherently high-risk because the borrowers have low incomes and few liquid assets, and because it is possible for a borrower to lose his job before the day payment is due, or to cash his paycheck at another outlet and then skip town.    One possibility would be to make the loans on a secured basis. This would not confer much of a legal advantage if a financing statement had to be filed (because the costs of perfecting the security interest would be comparable to the fees already charged) but it might be possible to take security in some assets that do not require filing for perfection. For example, if the loan is made to enable the purchase of a particular item, Cash24 could qualify for purchase money status, thus allowing automatic perfection under 9-309(1), and also protection under Bankruptcy Code §522.   Alternatively, Cash24 could take security in the funds owed to the customer by his employer or by a government payor. In the case of an employer, this would be an account under 9-102(a)(2), and a single assignment of an account would arguably (though not obviously) fall under 9-309(2). In the case of a government payor this would be a payment intangible, exempt from filing under 9-309(3), but we would need to investigate whether other law prevents its use as collateral. (Compliance with relevant consumer law such as TILA or the Uniform Consumer Credit Code may also be a factor.)

Other possibilities would be obtaining a third-party guaranty, or checking with the employer or payor to ensure employment status, and sharing information with other check cashing outlets to prevent a borrower from getting a payday loan from one outlet and then cashing a paycheck at another. It might also be worthwhile exploring whether payday borrowers could arrange for direct payment to Cash24, though many might resist. It might also save costs to assign these loans as a group to a factor, who might be able to offer a lower interest rate thru consolidation, or who might specialize in collection or risk assessment thus reducing costs.

Here I will also divide the problem up by individual creditor, and focus on the trustee’s legal power to avoid or prime their interests. You were also asked to discuss practical strategies for renegotiation and reorganization, but you could have gone in a number of directions on this part of your answer, and in any event the prospects for such arrangements would depend on the parties’ legal entitlements. As on the first question, those who first discussed all legal issues and then all practical issues were less successful in writing a concise and coherent answer.

GI purports to hold a security interest in all of E-Buy’s assets, but this claim can be challenged on various grounds. The broadest such ground is attachment. Section 9-203 requires a description of the collateral to appear in the security agreement, and §9-108(c) states that supergeneric “all assets” descriptions do not suffice. In this case we have somewhat more than a bare supergeneric description — in fact, arguably there is a description by category sufficient under 9-108(b), and so it is necessary to discuss the policies underlying the rules of 9-108 (e.g., evidence, fair notice to the debtor, but not notice to third parties who are protected by the filing) and whether they extend to this case. In my view the 9-108 argument is plausible but not guaranteed, so it is necessary to discuss other issues as well.

There is also a question of perfection. Here the main issue is whether the name change from eBuy to E-Buy renders the filing in adequate on the grounds that the listing of the debtor’s name is seriously misleading under §9-506. After the name change, the original filing does not satisfy 9-503(a), which requires an exact match with the name on the corporate registration, so the only way to save the filing is under 9-506(c), which excuses name mistakes that would be discovered by a standard search under the correct name. Whether this standard is satisfied is unclear on the facts; some offices have adopted search software with extremely rigid algorithms that would not turn up a name with an extra hyphen inserted. Even if the name change renders the filing seriously misleading, however, the filing is still good under 9-507(c) to perfect against collateral acquired within 4 months of the name change (i.e., up till six months ago.) Because a significant fraction of the collateral is inventory and receivables, though, and because we are told that economic depreciation on these items is high, it’s quite possible that limiting the security interest to old collateral will substantially reduce its value.

To the extent the security interest is unperfected, the trustee can avoid it under §544(a) of the Bankruptcy Code. The refiling under the correct name would be okay except that it occurred within the 90-day preference period of §547, so it too can be avoided. (Under 547(e), the transfer of the security interest as to later collateral would be deemed to occur as of the moment of the refiling,)

Finally, there is a potential fraudulent conveyance attack based on the argument that, due to the inadequately capitalized leveraged buyout, E-Buy did not receive fair value when it granted the original security interest two years ago. Because the transaction occurred more than one year ago, the trustee cannot use §548 to avoid this transfer, but if a claim can be made out under state fraudulent conveyance law, the trustee can step into the shoes of any unsecured creditor holding such a claim and avoid the transfer under §544b. [Note: before 2005, §548 only allowed the trustee to avoid fraudulent transfers going back one year before the date of the filing. This reachback period got extended to two years by the so-called Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA).] Proving the lack of fair value on the facts will not be clear-cut, however.

Given these arguments it should be possible to arrive at a favorable bargain with GI, especially since it is in GI’s interest that E-Buy survive long enough to pay off as much of its debt as possible.

Zyzyx (Z)

Z’s retention of title in its sales contracts is treated as a security interest under 9-109, so its ability to reclaim the goods or their proceeds depends on its compliance with Article 9. Attachment seems fine, but we are not told about any financing statement being filed so it is possible that Z is unperfected and thus junior to the bankruptcy trustee under §544(a). Z is surely perfected as to chattel paper in its possession under 9-313, but any chattel paper it took within the last 90 days can be recovered by the trustee as a preference under §547, unless it is the proceeds of perfected inventory. If Z has perfected, it also has purchase-money status, and hence priority over GI in the inventory it supplied; under 9-324 this super-priority carries over to cash received upon sale, but generally not to other proceeds. If Z meets all the elements of 9-330, it also gets the factor’s super-priority in chattel paper.

In principle, creditors holding security interests in inventory need to worry about losing their rights to collateral that has turned over in the last 90 days, but given that we are told that the value of the individual items have fallen due to technological obsolescence, §547(c)(5) will probably save the security interest against a preference attack.

Finally, it is unlikely that Z can get the stay lifted under §362 even if it has a valid security interest, because on the facts the inventory is plainly necessary for E-Buy to maximize the value of any liquidation or reorganization. Given that the value of inventory has fallen, however, Z’s security interest is at risk and so Z is entitled to some sort of adequate protection under §361.

Alpha and Beta

Both these creditors have upgraded from unsecured to secured status within the preference period, so their security interests are prima facie invalid under §547(b). Since Alpha subsequently made additional loans to E-Buy, its security interest may be saved to the extent of such loans under the net value test of 547(c)(4). Beta has no such argument

VISA and MasterCard

Both these creditors are unsecured, but they are also account debtors as to unpaid credit-card receivables and thus have the rights of account debtors under 9-404 et seq. Depending on the contract they have with E-Buy, and depending on whether the consumer claims and defenses against E-Buy are valid under the Truth in Lending Act (see below), they may be entitled to exercise their claims as a setoff against unpaid receivables. The extent to which they can do this, however, turns on which particular accounts the consumer defenses are attributable to, and on whether or when they received notice of GI’s security interest in accounts, since 9-404(a)(2) prevents setoffs of cross-claims (as opposed to counterclaims) after the account debtor received notice of the assignment.

As for the individual consumer claims, their validity will depend on sales law and on the particular warranties and promised that were made at the time of sale, since the mere fact that the customers thought they were buying more recent models does not necessarily mean they were entitled to them. Additionally, even if the consumer claims are valid, the consumers are only entitled under TILA to a chargeback on their credit cards if they live within 200 miles of E-Buy, or in the same state. Since the sales were internet sales, this question will turn on the relevant choice-of-law rules, and on whether E-Buy is deemed for purposes of this test as being located in the same state as the consumer – a currently unsettled question

Minor creditors

Finally, you could have addressed the potential claims of GI’s law firm, which holds a partial assignment of GI’s patent infringement claim against Destiny, and of Destiny itself. Most people did not devote any space to these issues, which was probably the right choice, but for what it’s worth, to the extent Destiny is liable, it has account debtor rights on any counterclaim under 9-404 et seq., and the law firm holds a security interest in its share of the claim under 9-109. Whether the law firm is perfected turns on the classification of the claim, if it is deemed a general intangible, the firm may probably auto-perfected under 9-309(2); if it is deemed a commercial tort claim, perfection depends on whether the law firm has filed its interest, which is has probably not.

√	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
?	unclear
??	very unclear, confused, mixing together separate points
x	mistake of law, misstatement of fact, misuse of term
x?	point appears mistaken
#	irrelevant or tangential point
#?	point's relevance unclear
na	point is not applicable to this situation
ns	non sequitur: conclusion does not follow
ff	fighting facts: contradicting stated facts or making assumptions inconsistent with them
ll	laundry list: throwing in relevant and irrelevant arguments alike, without distinction
lec	lecturing: abstract discussion of conceptual material, unconnected to the problem at hand
ua	unsupported assertion / unidentified assumption
vb	verbose; too much space devoted to the point or points in question
vg	discussion is overly vague or overly general
conc	conclusory; result of argument stated without reasoning
sa	straw argument: overly weak or caricatured argument set up for sake of rebuttal
exag	otherwise good point is overstated or exaggerated
c-a?	fails to discuss obvious counterargument