Business Law

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F� � E CBA EXAMINATION REVIEW Volume 7 Business Law Certified Bank Auditor Program

Transcript of Business Law

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F���� E������

CBA EXAMINATION

REVIEWVolume 7

Business Law

Certified Bank Auditor Program

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About BAIFor more than 75 years, BAI has focused on partnering with financial services companies to improve their performance through strategic research and information, education and training delivery—all designed to help our clients leverage their most important asset—human capital.

Today BAI provides a comprehensive range of end-to-end employee development solutions designed specifically to meet the needs of financial services companies. BAI offers a wide range of options for companies, including employee surveys, sales assessments, open enrollment conferences and seminars, graduate schools and certification programs; as well as targeted learning and performance solutions. These learning solutions include a variety of e-learning courses, instructor-led workshops, independent study programs and customized seminars and for all employee levels and functional areas within a financial services company. In addition to providing time-tested training content and implementation assistance, BAI offers Aspen, a best-of-class learning management system to help companies track and manage the their employee development initiatives.

We believe one of the keys to our success is our unique ability to fully understand an organization’s business challenges, specific employee development needs and goals so that we will be able to recommend the appropriate solution(s) to ensure achievement of client business objectives. It is our goal to focus on working in partnership with our clients to ensure successful design and implementation of employee development initiatives. We continually strive to improve our solutions and processes in an effort to help our clients realize their business objectives and to get a return on their investment.

AcknowledgementsBAI would like to thank the following contributing authors, whose commitment and expertise made the fi�h edition of the CBA Examination Review possible.

Leo Clarke is Counsel to Watkins & Eager in Jackson, MS. He has over 25 years experience practicing and teaching commercial, corporate, banking and insurance law. He is a member of the California, District of Columbia and Washington Bars and has taught law at Ave Maria School of Law, the University of Dayton, the University of Washington and the University of Mississippi. He has published scholarly and practical articles on those topics. He is an honors graduate of UCLA School of Law and Stanford University.

Rob McDonough, CRP, CIDA is the President and CEO of Strategic Financial Solutions, Inc. a financial services consultancy. Mr. McDouough also serves as an Executive Director of the Global Financial Markets Institute, Inc., which specializes in capital markets, derivatives and risk management consulting and training. Rob has an MBA in Finance and Economics from Georgia State University and a BBA from Emory University in general business administration with a concentration in marketing.

Paul J. Sanchez, CPA, CBA, CFSA conducts a CPA practice in Port Washington, New York. He is also the owner of Professional Service Associates, a consulting and professional training and development business servicing corporate clients (auditors, controllers etc.), CPA firms and others. He is an owner and auditing and financial accounting seminar leader for the Person/Wolinsky CPA Review Courses, a company that prepares candidates to pass the Uniform CPA Examination.

Mollie Newsome Sudhoff, CRCM, CRP is the President of Jefferson Cook Associates, Ltd. and Senior Advisor, Manager Engagements Paragon Compliance Group Winnetka, Illinois. Ms. Sudhoff holds a BBA from Emory University, Atlanta, GA and an MBA from Lake Forest Graduate School of Management, Lake Forest, IL. Mollie directed the Compliance Program for BAI for several years before forming Jefferson Cook Associates, Ltd. (JCA). JCA is a bank regulatory compliance-consulting firm providing compliance review and executive search services. JCA is also a partner

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in Paragon Compliance Group (Paragon). Paragon is a premier provider of compliance training nationwide.

ForewordBAI has maintained a strong commitment to serving the audit community. Since BAI’s founding in 1924, quality service to auditors and a dedication to enhance internal auditing practices, through highly relevant audit research, professional development programs and technical publications, has been one of our primary missions. The corner-stone of this commitment to excellence in bank auditing is the Certified Bank Auditor (CBA Program).

The Certified Bank Auditor Program was established by BAI in 1967 in order to recognize those audit professionals who excel in their field. The CBA Program serves as a commitment to the banking industry, and to the public, that the profession of bank internal auditing is characterized as possessing the utmost in professional qualities. The philosophy of the CBA program is to provide a plateau beyond the basics of internal auditing knowledge, prepare the candidate to meet future challenges, and to raise the professional status of bank internal auditing. Today, more than 5,000 individuals have earned the right to use the CBA designation a�er their name by demonstrating, their knowledge of bank accounting, auditing principles and practices, bank regulations, economics, management and commercial law. The CBA designation is earned by passing a rigorous examination in each of the aforementioned areas. The program gives special recognition to people who by demonstrating proficiency in prescribed standards of performance and knowledge, have demonstrated a high level of competence and ethics.

This reference document has been prepared to assist and prepare the candidate to take the CBA examination. This is the fi�h edition of the CBA examination study manual, and it has been significantly revised to reflect current and progressive audit skill sets.

PrefaceThe purpose of the CBA Examination Review is to assist candidates in preparing for the Certified Bank Auditor (CBA) professional examination by providing complete coverage of the subject ma�er. The fi�h edition is a major enhancement from the previous editions. All material was expanded significantly so that a single-source of comprehensive review materials is provided to the candidate. This makes the candidate’s preparation time more effective and efficient. These references are comprehensive. However, the candidate is advised to supplement these references with other reading materials as needed.

The organization of this reference material parallels the common body of knowledge, which was developed for the Certified Bank Auditor Program by BAI. The examination references are divided into nine volumes:

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Volume 1: Financial Accounting (Part I, A) Subject: Accounting

Volume 2: Managerial Accounting (Part I, B) Subject: Accounting

Volume 3: Auditing Principles (Part II, A) Subject: Auditing Principles and Bank Regulations

Volume 4: Bank Laws and Regulations (Part II, B) Subject: Auditing Principles and Bank Regulations

Volume 5: General Audit Practices (Part III, A) Subject: Auditing Practices

Volume 6: Auditing Specific Bank Applications (Part III, B) Subject: Auditing Practices

Volume 7: Business Law (Part IV, A) Subject: General Business

Volume 8: Economics (Part IV, B) Subject: General Business

Volume 9: Management Issues (Part IV, C) Subject: General Business

General Comments on the Examination

I. THE EXAMCBA is the acronym for the Certified Bank Auditor Program. The CBA designation is internationally recognized, and it is currently administered at nearly one hundred domestic and international testing sites. The present examination consists of four parts, given on two consecutive days, in June and November of each year. Candidates are allowed three-hours to complete each part, and the current format of the CBA exam is entirely multiple-choice questions.

The CBA exam is designed to measure and evaluate basic technical competence of banking and internal audit practices and procedures, including:

a. Application of technical knowledge.b. Understanding of professional responsibilities.c. Ability to make sound decisions.

The common body of knowledge is referenced in all BAI examination materials. The common body of knowledge is an outline of primary skills and knowledge needed by industry professionals to be judged technically proficient as a bank auditor. The examination and review guides are organized in the same manner as the common body of knowledge to provide an organized study program. Each section contains subheadings, and the subject ma�er is given an overall level of difficulty. BAI has the responsibility to ensure the common body of knowledge is reflective of the current state of internal auditing within financial institutions. Questions which appear on the CBA examination test the material contained in the common body of knowledge on page vii.

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II. A STUDY PLANDevelop an overall study plan. First decide which parts of the exam that you wish to take. Statistics indicate that candidates sit for an average of two parts. However, the trend recently has been for candidates to take all four parts in their first si�ing. In general, candidates who believe they have the necessary knowledge and experience are encouraged to take all four parts at their first si�ing.

The second step is to gather the necessary study materials. Allow sufficient time for processing and shipping your examination review orders. When you receive the materials, review the complexity and brevity of the subject ma�er so that you can determine your study needs and plan accordingly.

The third step is to prepare a time schedule for your self-study program. The objective of this plan will be to master the common body of knowledge. It is recommended that you develop a schedule of self-study sessions that systematically covers the topics.

It is recommended that candidates discuss questions, and study with associates and other CBA candidates in organized study groups whenever possible. Statistics indicate candidates have more success when preparing with study partners or groups.

III. EXAMINATION REVIEW MATERIALSThe examination review manuals were constructed using an exhaustive and detailed analysis of the new CBA common body of knowledge, as well as all pertinent reference information. The material is presented in nine comprehensive well cross-referenced volumes. The overriding consideration was to provide comprehensive, effective and easy-to-use examination review guides.

The review material was designed and developed using the CBA common body of knowledge as the frame work. At the beginning of each chapter of the review texts is a self contained table of contents. This contents page directly corresponds to the respective portion of the common body of knowledge for which it represents. Additionally, each volume contains an extensive cross-referenced glossary. These features allow the candidate to easily move throughout the text, and concentrate on the sections that pertain to their weak exam points.

The text makes extensive use of shaded boxes and bullet points. This style is used to make the material easier to read, and to highlight key items throughout the reference. In the back of each of the volumes, candidates will find an acronyms and abbreviations section.

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COMMON BODY OF KNOWLEDGE

Part I: Accounting

A. Financial Accounting (80–90%)1. Accounting Principles

a. Conceptual Frameworkb. Generally Accepted Accounting Principles

2. Bank Accountinga. Financial Statement Presentationb. Specific Accounting Treatmentc. Reporting Standards

3. Financial Statementsa. Ratio Analysisb. Comparative Statementsc. Uses of Financial Statements

B. Managerial Accounting (10–20%)1. Capital Investment Decisions

a. Cash inflows/outflowsb. Capital budgeting & income taxesc. Net present value & internal rate of return

2. Budgets and Responsibility Reportinga. Types of budgetsb. Profit/expense centersc. Controllable and uncontrollable costsd. Cost Accounting

3. Cost-Volume Relationshipsa. Contribution analysisb. Break-even analysisc. Cost-benefit analysis4. Financial Services Instruments and Products

Part II: Auditing Principles and Bank Laws

A. Auditing Principles (50–60%)1. Standards for the Profession of Internal Auditing

a. Independenceb. Professional Proficiencyc. Scope of Workd. Performance of Audit Worke. Management of the Internal Audit Departmentf. CBA Code of Ethics

2. Internal Control Structurea. Purpose of Internal Controlsb. Responsibility for Internal Control c. Audit Trailsd. Organizational/Departmental Structure

3. Evaluation of Internal Control Structurea. Responsibilityb. Segregation of Duties and Dual Controlc. Compliance with Policies and Proceduresd. Cost/Benefit of Controlse. Information Systems Processing

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4. Management and Organization of the Audit Functiona. Audit Department Charterb. Managing the Audit Departmentc. Auditor Trainingd. Communications with Management, Directors and Otherse. Audit Commi�ee

5. Internal Audit’s Relationship with the External Auditorsa. AICPA Statements on Auditing Standards (SAS)b. Objectives, Responsibility and Authorityc. Independence and Objectivity

6. Audit Techniquesa. Workpapers—Preparation and Reviewb. Statistical Samplingc. Confirmationsd. Audit So�waree. Flowchartingf. Work Programs/Questionnairesg. Integrated Auditsh. Use of Microcomputersi. Analytical Reviewj. Audit Evidencek. Compliance and Substantive Testing

B. Bank Laws and Regulations (40–50%)1. Overview of the Regulatory Environment

a. Federal Reserve Systemb. Office of the Comptroller of the Currencyc. FDICd. State Regulatory Systemse. Other

2. Consumer Protectiona. Truth in Lending—Reg Zb. Equal Credit Opportunity Act—Reg Bc. Electronic Funds Transfer Act—Reg Ed. Fair Credit Reporting Acte. Fair Debt Collection Practices Actf. Community Reinvestment Act—Reg BBg. Consumer Leasing

3. Mortgage Lendinga. Home Mortgage Disclosure Act—Reg Cb. Fair Housing Actc. Real Estate Se�lement Procedures Actd. Other Real Estate Owned

4. Bank Organizationa. Bank Holding Company Act—Reg Yb. Transactions with Affiliates—FRB Sections 23 A&B

5. Monetary Policya. Borrowing by Depository Institutions—Reg Ab. Reserve Requirements—Reg Dc. Interest on Deposits—Reg Q

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6. Bank Operationsa. Bank Protection Act � Reg Pb. Edge Act � Reg Kc. Depository Institution Management Interlocks Act � Reg Ld. Loans to Executive Officers � Reg Oe. Bank Secrecy Actf. Foreign Corrupt Practices Actg. Credit by Banks for Purchase of Margin Stocks � Reg Uh. Collection of Checks and other Items � Reg Ji. Availability of Funds and Collection of Checks � Reg CC

7. Othera. Tax Equity and Federal Responsibility Act (TEFRA)b. Financial Institution Reform, Recovery and Enforcement Act (FIRREA)c. Bank Bribery Actd. Trust � 12 CFR Part 9e. FDIC Bank Improvement Act of 1991f. Miscellaneous

Part III: Auditing Practices

A. General Practices (20–40%)1. Application of Audit Techniques

a. Statistical Samplingb. Confirmationsc. Audit So�wared. Analytical Reviewe. Flowchartingf. Auditor’s Use of Microcomputersg. Risk Analysish. Computer Assisted Audit Techniques

2. Evaluating the Internal Control Structurea. Internal Control Developmentb. Input/Processing/Output Controlsc. Segregation of Dutiesd. Separation of Processing and Developmente. Reconciliation of Input to Outputf. Control of Data Filesg. Authorization of Transactionsh. Physical and Data Security Access Controli. End-User Computing - Including Microcomputersj. Contingency Planning

3. Communications with Management, Directors, and Othersa. Board of Directors/Audit Commi�eeb. External Auditors and Regulatorsc. Auditee/Client

4. Audit Processa. Audit Planning and Preliminary Surveysb. Development of Audit Work Programsc. Development of Audit Work Papersd. Review and Evaluation of Findingse. Report of Findingsf. Maintenance of Continuing/Permanent Work Papers and Filesg. Maintenance of a Key Indicator Program

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B. Auditing Specific Bank Applications (60–80%)

Risks/Exposures, Control and Audit Objectives, and Audit Procedures1. Assets/Income

a. Cash and Cash Itemsb. Proof & Transitc. Interoffice Accountsd. Due from and Due to Bankse. Investment Securities and other Investment Vehiclesf. Commercial Loans/Leasesg. Real Estate Mortgage and Construction Loansh. Installment Loansi. Loan Interest and Fee Incomej. Allowance for Loan-losses and Charged off Loansk. Fixed Assets and Depreciation/Other Real Estate Owned

2. Liabilities and Owners Equitya. Checking Accountsb. Money Orders, Dra�s, and Official Checksc. Savings Depositsd. Time Depositse. Capital Accounts & Dividends

3. Other Servicesa. Payroll and Employee Benefitsb. Funds Transferc. Collectionsd. Safe Deposite. Night Depositoryf. Travelers Checksg. Savings Bondsh. Customer Repurchase and Reverse Repurchase Agreementsi. Customer Securities Safekeepingj. Off-Balance Sheet Itemsk. Trustl. Credit Cards

Part IV: General Business

A. Business Law (30 - 40%)1. Uniform Commercial Code

a. Article 1 � General Provisionsb. Article 2 � Salesc. Article 3 � Commercial Paperd. Article 4 � Bank Deposits and Collectionse. Article 5 � Le�ers of Creditf. Article 8 � Investment Securitiesg. Article 9 � Secured Transactions

2. General Commercial Lawa. Wills, Estates and Trustsb. Insurancec. Guaranty and Suretyshipd. Partnershipse. Agencyf. Contractsg. Bankruptcyh. Antitrust

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B. Economics (15–25%)1. Macroeconomics

a. Economic Systemb. Business Cycles, Growth and Inflationc. Fiscal Policies and Theories

2. Forecastinga. Business Conditions and Trendsb. Business Cyclesc. Economic Indicators

3. Money Marketsa. Role of Money and Commercial Banksb. Monetary Management Theoriesc. Role of Interest Ratesd. Short-term Savings and Debt Instrumentse. Bond and Stock Markets

C. Management Issues (25 - 35%)1. Bank Management

a. Asset/Liability Management1) Sources2) Products3) Matching of products for funding needs

b. Competitive Strategies1) Products2) Marketing3) Customers

c. Human Resources/Personnel1) Training and development2) Recruiting3) Ethics

d. Planning1) Policies and Strategies2) Budgets and Standards

e. Organizing1) Theories of Management2) Methods

f. Communicating with Management1) Wri�en2) Oral

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Volume 7: Introduction

Business Law (Part IV, A)

The profession of bank internal auditing is a dynamic and creative enterprise. Professionals in this field must demonstrate considerable intellectual flexibility to remain effective in the constantly changing banking industry.

The Auditing Practices skill set constitutes the entire Part 3 of the CBA examination. This part tests a candidate’s knowledge of the application of audit techniques as well as the review and audit of both automated and manual systems of internal control. Additionally, candidates are tested on their knowledge of the audit process and the auditor’s relationship with internal and external sources.

This part of the examination complements Part 2 of the exam (Auditing Principles) in that it tests candidates on their application of audit knowledge, rather than the mere concepts. Consequently, because they are so closely linked, Parts 2 and 3 have been included in this volume of the review manuals. It is recommended that these parts be studied together.

This reference manual is organized to directly correspond to the common body of knowledge as well as to past examinations.

Important NoteThe material in this publication was believed to be accurate at the time it was wri�en. Due to the evolving nature of laws and regulations within the Auditing field, BAI makes no guarantees as to the accuracy or completeness of the information contained in this publication. The regulations and standards are continuously being updated and amended. Therefore, BAI strongly recommends referring to the following web sites in order to obtain the most up-to-date information and materials pertaining to Statement of Financial Accounting Standards, GAAP statements and FASB statements and other supplemental study materials.

Accounting• Financial Accounting Standards Board www.fasb.org (www.fasb.org/ct)• American Institute of CPAs www.aicpa.org• U.S. Securities and Exchange Commission www.sec.gov

Auditing• American Institute of CPAs www.aicpa.org• U.S. Securities and Exchange Commission www.sec.gov• Public Company Accounting Oversight Board www.pcaobus.org• The Institute of Internal Auditors www.theiia.org

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Scope: Volume 7 constitutes Business Law, which makes up 30 to 40% of Part 4 of the CBA exam. Volume 8 makes up Economics, which make up 15 to 25% of Part 4 of the CBA exam. Volume 9 addresses Management Issues, which makes up 25 to 35% of Part 4 of the CBA exam

Chapter One

Uniform Commercial Code

Chapter TopicsThe following topics are addressed in this chapter: 1.1 Article 1 - General provisions 1.2 Article 2 - Sales 1.3 Article 3 - Commercial paper 1.4 Article 4 - Bank deposits and collections 1.5 Article 5 - Le�ers of credit 1.6 Article 8 - Investment securities 1.7 Article 9 - Secured transactions

Chapter ObjectivesA�er completing this chapter, you will be able to:• explain the general purpose of the Uniform Commercial Code (UCC)• describe many of the integral definitions contained in Article 1 of the UCC• explain the essential elements for a sales contract• describe the rules for passage of title• explain the methods and effects of acceptance and rejection of goods in a sale• describe the different warranties • identify the ways in which a contract may be breached and remedies available• name the different types of commercial paper and roles/responsibilities of parties• list the requirements for negotiability of an instrument and characteristics of non-negotiable

instruments • summarize the rules regarding endorsements• explain the concept of holder in the due course• explain the bank and customer relationship• describe responsibilities/ liabilities of banks and collection processes • explain usage of le�ers of credit and distinguish between different types • summarize the obligations of an issuer of a le�er of credit• describe an issuer's lien and liabilities with regard to investment securities • explain the general rules in regard to terms of securities• summarize purchaser liability rules

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• explain the concept of a secured transaction • identify the circumstances in which security interests a�ach • summarize the methods and importance of perfection• describe the function of a financing statement • identify the rights, duties and remedies of parties to a secured transaction • explain the ability of parties to dispose of collateral property a�er default• distinguish between the different types of collateral

SECTION 1.1: ARTICLE L—GENERAL PROVISIONS

Purpose of the Uniform Commercial CodeThe Uniform Commercial Code (UCC) has been the most important business development in unifying state legislation with regard to commercial transactions. The purpose of the code was to collect all aspects of these transactions into one body of law. It governs the sale of goods (tangible personal property). The code was dra�ed by the Commissioners on Uniform State Laws during the 1940s. Pennsylvania enacted the Code in 1952, and over the next few years it was enacted by every state and territory except Louisiana and Puerto Rico.

The provisions of the code may be changed by agreement among the parties except when specifically forbidden by it. For example, good faith, diligence, reasonableness and care may not be disclaimed. It should also be remembered that in the code, words in the singular include the plural, and words in the plural include the singular. Also, words of the masculine gender include the feminine and neuter, and words of the neuter gender may refer to any gender.

The code is supplemented by the principles of law and equity, unless these principles are in contradiction to it. These principles include the law merchant and the law relative to the capacity to contract, principal and agent, estoppel, fraud, misrepresentation, duress, coercion, mistake, bankruptcy, or any other validating or invalidating cause.

The remedies of the code are to be liberally administered so that the aggrieved party may be put in as good a position as if the other party had fully performed. However, extreme care should be taken when awarding consequential\special or penal damages except as specifically provided in the code.

Article 1 (and General) Definitions1. actions (with regard to a judicial proceeding)—Actions include recoupment,

counterclaim, setoff, suit in equity, and any other proceedings in which rights are determined.

Purpose of Article 1• Simplifies and clarifies the law governing commercial transactions.• Permits the expansion of commercial transactions through custom, usage,

and agreement of the parties.• Makes the law uniform throughout the states and territories.

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2. aggrieved party—A party entitled to pursue a remedy.

3. agreement—The bargain of the parties in fact as found in their language or inferred from other circumstances, including course of dealing, usage of trade, or course of performance. (Whether an agreement has legal consequences is determined by the code provisions, if applicable. Otherwise, it is determined by the law of contracts.)

4. bank—Any person engaged in the business of banking including a savings bank, savings and loan association, credit union and trust company.

5. bearer—The person in possession of a negotiable instrument, document of title, or security payable to the “bearer” or the “endorsed in” blank.

6. bill of lading—A document evidencing the receipt of goods for shipment issued by a person engaged in the business of transporting or forwarding goods.

7. branch—includes a separately incorporated foreign branch of a bank

8. burden of establishing a fact—The task of convincing the triers of the fact that the existence of the fact is more probable than its non-existence.

9. buyer in ordinary course of business—A person, who in good faith and without knowledge that the sale to him is in violation of the ownership rights or security interest of a third party in the goods, buys in ordinary course from a person in the business of selling goods of that kind. A person buys in the ordinary course if the sale to the person comports with the usual or customary practices in the kind of business in which the seller is engaged or with the seller’s own usual or customary practices.

Buying may be for cash, by exchange of other property, or on secured or unsecured credit and may include receiving goods or documents of title under a preexisting contract for sale. Only a buyer that takes possession of the goods or has a right to recover the goods from the seller under Article 2 of the UCC may be a buyer in the ordinary course of business. This does not include a transfer in bulk. It also does not include security for—or total or partial satisfaction of—a money debt.

10. conspicuous—A term or clause wri�en, displayed or presented conspicuously, i.e., in such a manner that a reasonable person against whom it is to operate ought to notice it. Courts decide whether a term or clause is conspicuous or not. A term or clause may be made conspicuous by printing a heading in capital le�ers or, in the body, by printing that language in a larger or contrasting type or color.

11. consumer—An individual who enters into a transaction primarily for personal, family or household purposes.

12. contract—The total legal obligation which results from the parties’ agreement as determined by the code and supplemented by other applicable laws.

13. creditor—A creditor includes a general creditor, a secured creditor, a lien creditor and any representative of creditors, including an assignee for the benefit of creditors, a trustee in bankruptcy, a receiver in equity and an executor or administrator of an insolvent debtor’s or assignor’s estate.

14. defendant—A defendant includes a person in the position of defendant in a counterclaim, cross-claim or third-party claim.

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15. delivery—The voluntary transfer of possession of instruments, documents of title, cha�el paper or securities.

16. document of title—Documents of title include bills of lading, dock warrants, dock receipts, warehouse receipts or orders for the delivery of goods. They also include any other documents which in the regular course of business or financing are treated as adequately evidencing that the person in possession of them is entitled to receive, hold and dispose of the documents and the goods they cover. A document of title must profess to be issued by or addressed to a bailee. It must also profess to cover goods in the bailee’s possession which are either identified or are fungible portions of an identified mass.

17. fault—A fault is a default, breach, wrongful act or omission.

18. fungible goods—Goods of which any unit is, by nature or usage of trade, the equivalent of any other like unit including goods that by agreement are treated as equivalent.

19. genuine—Something is genuine if it is free of forgery or counterfeiting.

20. good faith—Good faith is honesty in fact and the observance of reasonable commercial standards of fair dealing.

21. holder—The holder is a person in possession of a negotiable instrument that is payable either to the bearer or to an identified person that is the person in possession. The person in possession of a document of title may also be a holder, if the goods are deliverable either to the bearer or to the order of the person in possession.

22. insolvent—A person who has ceased to pay his debts in the ordinary course of business (other than as a result of a bona fide dispute), or who cannot pay his debts as they become due, or who is insolvent within the meaning of the federal bankruptcy law.

23. insolvency proceedings—Insolvency proceedings include any assignment for the benefit of creditors or other proceedings intended to liquidate or rehabilitate the estate of the individuals involved.

24. money—A medium of exchange currently authorized or adopted by a domestic or foreign government. This includes a monetary unit of account established by an intergovernmental organization or by agreement between two or more countries.

25. organization—In the code, an organization is defined as a person other than an individual.

26. party (as distinguished from third party)—A party is a person that has engaged in a transaction or made an agreement subject to the code.

27. person—In the code, a person is an individual; corporation; trust; business trust; estate; partnership; limited liability company; association; joint venture; government; governmental subdivision, agency or instrumentality; public corporation; or any legal or commercial entity.

28. present value—The amount as of a date certain of one or more sums payable in the future, discounted to the date certain by use of either an interest rate specified by the parties—if that rate is not manifestly unreasonable at the time the transaction is entered into—or a commercially reasonable rate that takes into account the facts and circumstances present at the time the of the transaction.

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29. purchase—To purchase is to take by sale, lease, discount, negotiation, mortgage, pledge, lien, security interest, issue or reissue, gi� or any other voluntary transaction which creates an interest in property.

30. purchaser—A purchaser is a person that takes by purchase.

31. record—A record is information that is inscribed on a tangible medium or that is stored in an electronic or other medium and is retrievable in perceivable form.

32. remedy—A remedy is any remedial right to which an aggrieved party is entitled with or without resort to a tribunal.

33. representative—A representative is a person empowered to act for another including an agent; an officer of a corporation or association; and a trustee, executor or administrator of an estate.

34. right—A right is the same as a remedy.

35. security interest—Security interest is an interest in personal property or fixtures which secures the payment or the performance of an obligation. This includes any interest of a consignor and a buyer of accounts, cha�el paper, a payment intangible, or a promissory note in a transaction that is subject to Article 9. Security interest does not include the special property interest (see definition below) of a buyer of goods upon identifying those goods in accordance with Article 2 of the code. However, the buyer may acquire a security interest by complying with Article 9. For example, under Article 2 or 2A, the right of a seller or lessor of goods to retain or acquire possession of the goods is not a security interest, (except where a seller has shipped under reservation). Yet, a seller or lessor may also acquire a security interest by complying with Article 9. The retention or reservation of title by a seller of goods notwithstanding shipment or delivery to the buyer is limited to a reservation of a security interest. Unless a lease or consignment is intended as security, reservation of title thereunder is not a security interest. Whether a transaction in the form of a lease is intended as security is to be determined by the facts of each case and is governed by explicit Article 1 provisions.

36. send—In this case to send is meant in connection with a properly addressed writing, record or notice which is deposited in the mail or delivered for transmission by any of the usual means of communication and with postage or cost of transmission provided. In the case of an instrument, properly addressed means to an address specified thereon or otherwise agreed upon. If neither of those apply the instrument may be to any address reasonable under the circumstances. The receipt of any writing or notice within the time it would have arrived if properly sent has the effect of a proper sending.

37. signed—Something is signed if it uses any symbol executed or adopted by a party with present intention to authenticate a writing.

38. state—A state means a state of the United States, the District of Columbia, Puerto Rico, the United States Virgin Islands, or any territory or insular possession subject to the jurisdiction of the United States.

39. surety—A surety is a guarantor or other secondary obligor.

40. term—A term is the portion of an agreement which relates to a particular ma�er.

41. unauthorized signature—A signature is unauthorized if it is made without actual, implied or apparent authority. This includes a forged signature.

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42. warehouse receipt—A warehouse receipt is a receipt issued by a person engaged in the business of storing goods for hire.

43. writing—Writing is printing, typewriting or any other intentional reduction to tangible form. The word ‘wri�en’ has a corresponding meaning, pursuant to Section 1-301 of the code:

Any document authorized or required by the contract to be issued by a third party shall be prima facie evidence of its own authenticity and genuineness and of the facts stated in the document by the third party. Every contract or duty within the code establishes an obligation of good faith in its performance or enforcement.

44. knowledge—Knowledge in the code means actual knowledge, and knows has a corresponding meaning. Under the code words like discover, learn, etc., refer to knowledge rather than reason to know.

45. notice—Under the code, a person has notice of a fact if (1) they have actual knowledge of it, (2) they have received a notice or notification of it; or (3) from all the facts and circumstances known to the person at the time in question, he or she has reason to know that it exists.

A person receives a notice or notification when it either comes to that person’s a�ention, or it is duly delivered (in a form reasonable under the circumstances) to the place of business through which the contract was made (or to another location held out by that person as the place for receipt of such communications). A person notifies or gives notice or notification to another person by taking such steps as may be reasonably required in order to inform the other person in ordinary course, whether or not the other person actually comes to know of it.

Qualifying the above language about notice, the code indicates that notice, knowledge or a notice or notification received by an organization is effective for a particular transaction from the time it is brought to the a�ention of the individual conducting that transaction or from the time it would have been brought to the individual’s a�ention if the organization had exercised due diligence. An organization exercises due diligence if it maintains reasonable routines for communicating significant information to the person conducting the transaction and there is reasonable compliance with the routines. Due diligence does not require an individual acting for the organization to communicate information unless the communication is part of the individual’s regular duties, or the individual has reason to know both of the transaction itself and that the transaction would be materially affected by the information.

46. reasonable time—When the code requires an action to be taken within a reasonable time, any time which is not manifestly unreasonable may be fixed by agreement. A reasonable time depends on the nature, purpose and circumstances of an action. An action is taken reasonably when it is taken at—or within—the time agreed. If no time is agreed upon, it is within a reasonable time.

47. usage of trade—A usage of trade is a practice or method used with such regularity in a place, vocation or trade as to justify an expectation that it will apply to the transaction in question. The existence and scope of such a usage are to be proved as facts. If such a usage is embodied in a wri�en trade code or similar writing, the court will interpret the writing.

48. course of dealing—Like a usage of trade, a course of dealing in a previous transaction between parties establishes a common basis of understanding for interpreting their

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expressions and other conduct. A course of dealing between parties and any usage of trade give particular meaning to and supplement or qualify the terms of an agreement. The express terms of an agreement and an applicable course of dealing or usage of trade should be interpreted wherever reasonable as consistent with each other. Where they are not consistent, express terms control both the course of dealing and usage of trade. However, it should be remembered that a course of dealing controls usage of trade.

A contract for the sale of personal property is not enforceable by action or defense beyond $5,000 in amount or value of remedy unless there is some writing. This wri�en information must indicate that a contract for sale has been executed between the parties at a defined or stated price, must reasonably identify the subject ma�er and must be signed by the party against whom enforcement is sought or by his authorized agent. This does not apply to contracts for the sale of goods, securities or security agreements. (See definitions below).

A clause in a contract that allows one party in interest to accelerate payment or performance or to require collateral or additional collateral “at will” or “when he deems himself insecure” means that he shall have power to do so only if he—in good faith—believes that the prospect of payment or performance is impaired. The party against whom the power is exercised has the burden of establishing lack of good faith.

48. value—Except as provided in other portions of the code, a person gives value for rights if the person acquires them (1) in return for a binding commitment to extend credit or for the extension of immediately available credit (whether or not drawn upon and whether or not a charge-back is provided for in the event of difficulties in collection); (2) as security for (or in total or partial satisfaction of) a preexisting claim; (3) by accepting delivery under a preexisting contract for purchase; or (4) in return for any consideration sufficient to support a simple contract.

SECTION 1.2: ARTICLE 2—SALES

Purpose of Article 2Article 2 of the UCC deals with contracts for the sale of goods. It is important to remember that much of Article 2 may be varied by agreement of the parties and is supplemented by course of dealing and usage of trade.

Article 2 DefinitionsArticle 2 has some specific definitions that are particularly relevant to the subject ma�er contained in that article, in addition to the definitions contained in Article 1 that have general applicability. Although these definitions apply to other articles, they are most appropriately listed in Article 2. • goods—Goods include all items which are moveable and personal property of a tangible,

physical nature. They also include the unborn young of animals, growing crops and standing timber to be cut. Things a�ached to realty such as minerals or buildings are considered to be goods if they are to be severed from the land by the seller. Money, investment securities, intangible property, contract rights and accounts receivable are not considered goods.

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• future goods—Future goods are goods that are not in existence at the time of the agreement or have not been identified.

• sale—In a sales transaction, title to the goods is exchanged for a price. The responsibilities of the two parties (buyer and seller) involved are measured by the contract. The seller tenders the goods, while the buyer accepts the goods and pays the price.

• merchant—A merchant is a person who deals in the goods being sold or who holds himself out as having knowledge or skill peculiar to the goods involved in the transaction.

• returned goods—The buyer may have the privilege of returning the goods delivered to him. In a consumer purchase, where the goods are delivered for use, the transaction is called a sale on approval. It is called a sale on return when the goods are delivered for resale. This distinction is important, because goods delivered on approval are not subject to the claims of the buyer’s creditors until the buyer has indicated acceptance of goods. Goods delivered sale on return are subject to the claims of the buyer’s creditors while in the buyer’s possession. This distinction is also important in cases where goods are lost, stolen, damaged or destroyed.

The Sales ContractThree sources supply the terms of a sale contract: (1) the express agreement of the parties; (2) the course of dealing, usage of trade and course of performance; and (3) the code and other applicable statutes.

The general rule in sales law is that the parties are free to contract regarding most basic terms—quality, price, quantity, delivery, payment, etc. Frequently, the contract can override the applicable code section(s) with a few exceptions. As mentioned above the code obligations of good faith, diligence and due care cannot be disclaimed. In addition, a liquidated damages clause cannot be a penalty, nor can a consequential damages’ limitation be unconscionable.

Express elements required for sales contracts:1. parties—All parties involved or affected must be described.

2. price—If a price is omi�ed, the contract will be enforced at a reasonable price.

3. time for performance—If time is omi�ed, then reasonable time is implied. If the contract states time is of the essence, then delay in performance is a material breach, which means the non-breaching party can terminate performance and sue for damages.

4. subject ma�er—Typically, before an agreement is considered enforceable, the quantity must be included. If parties estimate the quantity involved, a quantity unreasonably disproportionate to the estimate will not be enforced. For the most part, if no mention of quantity is found, the contract is unenforceable. If, however, an estimate is not agreed on a quantity in keeping with normal or other comparable prior output or requirements may be implied.

Additional concepts in sales contractsIn addition to these elements of the sales contract, there are two concepts of ownership that are fundamental to sales transactions: the notion of identification and the concept of title. If something is identified, it means designated as the specific goods that will be utilized in the transaction. On identification of goods to a contract, a special property interest (see definition

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below) in the goods is created on behalf of the buyer. This interest may be created before the passing of title or delivery or possession of the goods.

Special property interest means the buyer has (1) an insurable interest in the goods, (2) the right to inspect the goods at a reasonable time and at the buyer’s expense, (3) the right to sue for damages caused by any third party who wrongfully destroys or damages the goods, and (4) the right to demand the goods upon offering the full contract price, if the seller becomes insolvent within ten days of the buyer’s first payment. If insolvency occurs before the first payment, this right does not adhere.

The second concept is that of title, since a sale involves the passing of title from the seller to the buyer. The parties can determine by their contract how title will pass. If the transfer of title is not specified in the contract, and the location of title becomes an issue, the code sets forth specific provisions regarding to whom the title shall pass. Most o�en title passes to the buyer at the time and place at which the seller completes his performance as to physical delivery of the goods.

Rules for Title PassingThere are specific rules that apply to the passage of title in the sales context.• Usually, title passes when the seller completes performance with respect to physical

delivery.• If a shipment contract, title passes at the time and place of shipment.• If a destination contract, title passes when the seller tenders the goods to the buyer at the

destination point.• If the seller has no duty to move the goods, title passes on the delivery of documents of title.

For example, if the goods are in a warehouse and the seller delivers the warehouse receipt to the buyer, title passes at the time and place the warehouse receipt is delivered.

• With future goods, identification occurs when the seller ships the goods or specifies them as the goods to which the contract refers.

The general rule is that the title acquired by a purchaser of goods is only as good as the title of the transferor. When the seller has no title, the purchaser receives no title. The original owner of the goods retains the title and may recover the goods.

If a transferor transfers title to a buyer where: (1) the transferor is deceived as to the identity of the purchaser, (2) the delivery is in exchange for a bad check, (3) it was agreed to be a cash sale or (4) the delivery was procured through fraud, the buyer receives a voidable title. This means that the seller may void the buyer’s title to the items he has received. If, however, the buyer with voidable title sells to a good faith purchaser for value of the items, the good faith purchaser receives full title and it ceases to be voidable by the original transferor.

Methods of Accepting Goods; Rejection; Effect of Acceptance and RejectionBefore payment or acceptance of goods, the buyer has the right to inspect the goods at a reasonable time and place and in any reasonable manner. If the buyer makes payment prior to inspection and the subsequent inspection reveals defects, the buyer still has the right to pursue remedies. The buyer must cover the inspection expenses. If the goods are non-conforming and the buyer rejects them, the buyer can recover the inspection expenses from the seller.

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If the goods are non-conforming, the buyer may reject all of the goods, accept all of the goods or accept part of the goods. If the buyer notifies the seller of the breach within a reasonable time, he may still pursue remedy for damages for breach of contract even if the goods are accepted. To maintain the right to reject defective or non-conforming goods, the buyer must notify the seller within a reasonable time a�er the goods are tendered or delivered. The buyer forfeits his right to reject defective goods if he possesses the goods for an unreasonable time. The buyer should give detailed information regarding the reason for the rejection.

However, a buyer who rejects received goods must hold the goods with reasonable care long enough for the seller to recover them. Since the buyer has a security interest in the goods in his possession, he has the right to resell them. Therefore, a buyer of defective goods can reject and resell the goods, deduct all expenses relating to care, resale, etc., and send any le� over money to the seller.

Finally, if the rejection is for a relatively minor deviation from the contract, the seller has the right to cure. Cure allows the seller to correct the defective performance. The seller must notify the buyer of his intention to cure.

There are three methods of accepting goods:

1. A�er a reasonable opportunity to inspect the goods, the buyer indicates to the seller that the goods are conforming or that he will keep them in spite of the non-conformity.

2. The buyer fails to make an effective rejection of the goods.

3. The buyer acts in a manner inconsistent with the seller’s ownership.

Revocation of GoodsUnder special circumstances, the buyer may revoke his acceptance. This can happen if the defect was not immediately discoverable when the goods were accepted or because the buyer assumed that the seller would substitute conforming goods. The buyer must notify the seller of revocation and revocation can occur only if the non-conformity substantially impairs the value to the buyer. In this case, the buyer is placed in the same position relative to the goods as if he had rejected them in the first place.

A buyer who does not receive the goods he bargained for may cover. Cover means to purchase the needed goods from another source to substitute for those due from the seller. The buyer may collect from the seller the difference between the cost of the substitute goods and the contract price plus any incidental or consequential damages. In arranging cover, a buyer must act reasonably and in good faith, but he does not have to obtain the substitute goods at the cheapest price available.

A buyer who does not receive any goods from the seller or who receives non-conforming goods does not have to cover but may sue for damages. The amount of damages is the difference between the contract price and the market price when the buyer learned of the breach plus any incidental or consequential damages. The buyer may deduct damages from the amount he owes the seller but the buyer must notify the seller of his intention to deduct damages.

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WarrantiesSeveral warranties may be involved in a contract and may be implied or expressly stated:

1. warranty of title—The seller warrants good title, rightful transfer and freedom from any security interest or lien of which the buyer has no knowledge. This warranty can only be disclaimed by specific language or in circumstances which make it clear that the seller is not vouching for the title. A seller who is a merchant warrants the goods to be free of any rightful claim of infringement, (i.e., an act or claim that interferes with an exclusive right of an owner). An infringement may occur when the buyer furnishes specifications to the seller for the manufacturer of the goods. In this case the seller does not warrant against infringement, and the buyer must protect the seller from any claims arising from such an infringement.

2. express warranties—Express warranties include any affirmation of fact or promise which is not just sales talk or an opinion and which becomes part of the bargain. The buyer does not have to prove reliance on this affirmation and the seller does not have to intend to create a warranty. A seller warrants the goods to be of the same general quality of the sample, model or of his description.

3. implied warranties—Implied warranties arise as a ma�er of law and are legally present unless clearly disclaimed or negated. Liability for the breach of an implied warranty is based on the public policy of protecting the buyer of goods. There are two kinds of implied warranties.1) If the seller is a merchant who deals in goods of the kind involved in the contract,

an implied warranty of merchantability is created. This warranty means that the goods are fit for the ordinary purpose for which goods of this type are used and will pass without objection in the trade. This warranty applies to new and used goods in most states unless the warranty is modified or excluded.

2) An implied warranty of fitness for a particular purpose is created when the seller knows of the particular use of the good and knows the buyer is relying on the seller’s skill or judgment to select or furnish suitable goods. The implied warranty of fitness is applicable to both merchants and non-merchants. The warranty does not arise if the buyer’s knowledge is equal or superior to the seller’s. The good is warranted for the particular expressed purpose, and the seller may be liable if the good fails to so perform.

DisclaimersWarranty liability may be escaped or modified by disclaimers. However, a disclaimer inconsistent with an express warranty is not effective and the express warranty is enforceable.

Implied warranties can be disclaimed in writing if the language makes it plain that there is, in fact, an implied warranty. A disclaimer of merchantability must include the word “merchantability.” The disclaimer clause of the contract must be set forth in a conspicuous manner, such as larger type or a different color ink. A disclaimer set forth in the same type and color as the rest of the contract is not effective.

The parties to a contract may limit the remedies available in the event of a breach of warranty. These remedies may be in addition to or in substitution of the remedies provided

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by the code. Some provisions may allow a seller to cure a defect or cancel a transaction by refunding the purchase price and without further liability. Clauses limiting a seller’s liability cannot be unconscionable. Consequential damages for personal injury related to consumer goods cannot be limited. Damages for commercial loss, on the other hand, can be.

Common Methods of Breaching a ContractThe four common methods of breaching a contract are:

1. anticipatory repudiation by the buyer or the seller

2. failure of performance (buyer fails to pay or seller fails to deliver)

3. a rightful or wrongful rejection by the buyer

4. a rightful or wrongful revocation of acceptance by the buyer

Adequate AssuranceAdequate assurance is a concept applicable to both parties in a sales transaction. Either party may become concerned about the other’s future performance. The buyer could fall behind in payments or the seller could deliver defective goods to other buyers. A party who is concerned about the performance of another party can demand—in writing—that the other party offer convincing proof that he will perform. The insecure party may then suspend performance while waiting for assurance. The contract is repudiated if assurance is not provided within a reasonable time, not to exceed 30 days.

Remedies for the Buyer and the SellerThe code provides four remedies for the buyer and the seller in a breach of contract. The following is a list of the remedies on an equivalency basis and in the order of importance.

Seller’s Remedies Buyer’s Remedies1. resell the goods and recover damages2. cancel the contract3. recover damages for non-acceptance 4. sue for the actual price of the goods

1. cover (buy same goods elsewhere) and recover damages2. reject the contract3. recover damages for non-delivery4. sue to get the goods (specific performance or replevin)

Buyer’s Right to Specific Performance and ReplevinThe buyer has the right to specify performance if the goods are unique and other circumstances make it equitable that the seller renders the required performance. In addition, a buyer must be unable to cover to obtain the specific performance. Unique goods are typically goods that are not practically available from other sources.

The statutory remedy of replevin allows the buyer to reach the goods in the hands of the seller. If the goods related to a contract have been identified and the buyer has been unable to make cover a�er a reasonable effort to do so, the buyer may replevin the goods from the seller.

Insolvency of Seller or BuyerIf the seller becomes insolvent, the buyer may reach the goods in the hands of the seller

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only if (1) the existing goods have been identified in the contract and (2) the seller becomes insolvent within ten days a�er receiving the first installment payment from the buyer. Without these circumstances, the buyer is just a general creditor of the seller. If the buyer discovers a�er replevin that the goods do not conform to the contract, the buyer may reject them.

On discovering that a buyer is insolvent, a seller may refuse to make any further deliveries, demand payment for all goods previously delivered under the contract, and/or stop any goods in transit to the buyer and recover them from the carrier. If an insolvent buyer receives goods on credit, the seller can reclaim the goods by demanding them within ten days of their receipt by the buyer.

Seller’s Rights on Buyer’s DefaultThe seller may stop goods in transit or withhold delivery if the buyer has:

1. wrongfully rejected a tender of goods

2. revoked acceptance

3. failed to make a payment on or before delivery

4. repudiated either a part of the goods or the whole contract

It must be remembered that once the goods are in the buyer’s possession, the seller can reclaim the goods only in the case of insolvency. If, on the other hand, the seller is in possession of the goods when the buyer breaches, the seller can resell them. Furthermore, if only part of the goods have been delivered, the undelivered portion can be resold. The seller then has a claim against the buyer for the difference between the price the buyer had agreed to pay (contract price) and the resale price. Also, if the buyer breaches or repudiates the contract prior to the identification of the contract goods, the seller may resell the goods. This is the case as well if the goods are unfinished—the seller can resort to the remedy of resale—but only if he can show that the unfinished goods were intended for that particular contract. The code requires that the seller use reasonable commercial judgment in determining which course of action will mitigate his damages.

If resale is not a sufficient remedy, the seller may sue for damages when the buyer refuses to accept the goods or repudiates the contract. Damages are equal to the difference between the market price at the place for tender and the unpaid contract price plus any incidental damages incurred as a result of the buyer’s breach. If this measure of damages does not put the seller in as good a position as he would have had if the buyer had performed, the measure of damages will include the profit the seller would have made from full performance by the buyer plus incidental damages.

If the buyer fails to pay for the goods when due, the seller may sue for the contract price of the goods if:• the buyer has accepted the goods• the goods were destroyed a�er risk of loss passed to the buyer• the resale remedy is not practicable

In cases such as specially manufactured goods where the right to resell is not available, the seller may collect the purchase price. If the seller sues for the price, the goods are treated as

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if they belong to the buyer even if the goods are in the possession of the seller. If the seller obtains a judgment against the buyer, the seller may still resell the goods prior to collection of the judgment. If the seller does resell the goods, he must apply the proceeds toward satisfaction of the judgment. If the buyer pays any balance due on the judgment, the buyer is entitled to any goods not resold.

Notice of BreachA buyer must give a notice of breach (i.e., notice of any alleged breach of express and implied warranties) within a reasonable time a�er the facts comprising the breach are discovered or should have been discovered using reasonable care. All remedies are barred if the required notice is not given. Any notice of alleged breach may be oral or in writing. Wri�en notice is preferred. The only requirement is that the buyer notifies the seller of the defect in the good.

The three reasons behind the notice requirement are:

1. The seller has the right to cure. This allows the seller to minimize his loss and the buyer’s damages.

2. The seller has time to arm himself for negotiation and litigation.

3. The seller is provided some psychological protection. The seller can stop worrying about potential liability a�er a reasonable amount of time.

SECTION 1:3: ARTICLE 3—COMMERCIAL PAPER[B]Definitions: Negotiable Instruments & Commercial Paper

A negotiable instrument has the capacity to pass like money from person to person and is used as a medium of exchange. It is also a special type of wri�en contract that represents credit and functions as a money substitute. Negotiable instruments developed out of the commercial need for an instrument that would be readily accepted in lieu of cash and that would, therefore, be freely transferable. This is because it became necessary to shield the transferee from most of the defenses that the primary party (maker) might have against the payee so that the primary party could not assert the defenses against the person to whom the instrument was transferred. Each party who transfers the instrument is required to assume liability to pay in the event that the maker or other primary party fails or refuses to pay. The key to this section of the law is the ability or legal power of a transferor, under certain circumstances, to transfer be�er rights than he possesses.

Commercial paper is a term used to describe certain types of negotiable instruments. Commercial paper consists of two basic types of negotiable instruments: dra�s and notes. A dra� is a wri�en order to some other entity to pay money to a third party. Three parties are involved in the consummation of a dra�. The party addressing and signing the dra� is the drawer. The drawee is the party directed to pay the sum certain in money to the third party. The third party is referred to as the payee. An example of a dra� is a check. A check is an order by the drawer directing the drawee (bank) to pay money to the payee of the check. A note is a wri�en promise to pay (other than a certificate of deposit) by a party—the maker—a sum certain in money to the order of another party—the payee or the bearer of the note. Hence this form of commercial paper includes promissory notes, bank certificates of deposit,

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and cashier’s checks.

Requirements of A Negotiable InstrumentThe terms wri�en on the face of an instrument determine its negotiability. Four basic requirements must be met for an instrument to be considered negotiable.

1. must be in writing and signed by the drawer or maker

2. must contain an unconditional promise or order to pay a sum certain in money

3. must be payable on demand or at a definite time

4. must be payable to order or to bearer1) The first requirement is that the instrument must be in writing and must be signed by

the drawer or maker. The signer may use his own name, an assumed name, a rubber stamp, initials and last name or a recognized symbol, as long as the method used is intended by the drawer to be a signature. The signature is not required to be at any particular location on the instrument.

2) The second requirement is that the instrument must contain an unconditional promise or order to pay a sum certain in money, though the exact word “promise” does not have to be used. The mere wri�en acknowledgement that a debt exists (an IOU) is not a promise, and the instrument is, therefore, non-negotiable. A dra� must contain an order to pay. The language must signify more than a request or authorization to pay; it must be a direction to pay.

The promise or order must also be unconditional. A promise or order is conditional if the instrument states that it is subject to or governed by another agreement, or if the instrument states that it is to be paid only out of a specified fund. However, an instrument is not rendered conditional if the instrument states the consideration or the transaction from which the instrument arose or states that the instrument is secured by a mortgage or other security interest.

Therefore, in this area, a fine distinction must be drawn between language that imposes the terms of another agreement (conditional promise, non-negotiable) and language that is simply informative (unconditional promise, negotiable). The requirement that the instrument be payable in a sum certain in money means that the instrument may not be payable in cha�els (barley), but it may be payable in foreign or domestic currency depending upon the individual instrument. If the principal sum to be paid is definite, negotiability is not affected by the fact that the instrument is to be paid with interest, in installments, or with a discount or addition for early or late payment.

3) The third requirement of negotiability is that the instrument must be payable on demand or at a definite time. An instrument is payable on demand if it so states, if it is payable on sight or presentation, or if no time of payment is stipulated. The language “payable on demand” is normally used in notes. The words “at sight” are used in dra�s. A negotiable instrument that does not specify a due date is o�en referred to as demand paper. An example of demand paper is a check.

An instrument is payable at a definite time if the instrument states that it is payable (1) at a fixed period a�er presentation, (2) prior to a stated date, or (3) at a fixed

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time a�er a stated date. Instruments are also payable at a definite time if the definite time is subject to acceleration (if provided for in the instrument), or if the definite time is subject to an extension at the option of the holder or to extension to a further definite time at the option of the maker or acceptor. An instrument will be deemed non-negotiable if the instrument is payable only on the occurrence of an event or act uncertain as to the time of occurrence, e.g., a promise to pay Joe $250 upon John’s death.

4) The fourth requirement of negotiability is that the instrument must be payable to order or to bearer. Bearer paper means that payment will be made to anyone who pos-sesses or bears the instrument. Bearer paper can be negotiated by delivery without endorsement. The UCC states that an instrument is bearer paper if it is payable (1) to bearer, (2) to the order of bearer, (3) to a specified person or bearer, or (4) to cash or the order of cash.

Order paper is created when the instrument states that payment will be made to the order of a designated payee or to anyone that such a payee may order or direct. Order paper can be negotiated only by both endorsement and delivery.

An instrument may be payable to the order of two or more payees together, for example, “Joe and John,” or in the alternative, “Joe or John.” If the instrument is payable to “Joe and John,” further transfer requires endorsement by both Joe and John. If the instrument is payable to “Joe or John,” further transfer requires endorsement by either Joe or John, not both parties. An instrument may be payable to the order of a trust, fund or estate. An instrument may also be payable to the order of an officer.

Additional Characteristics of Negotiable InstrumentsAdditional wording o�en does not affect the negotiability of an instrument. If the drawer includes a provision saying that by endorsing or cashing the instrument the payee acknowledges full satisfaction of an obligation by the drawer, this does not affect negotiability. In addition, the omission of language stating the consideration for which an instrument was given will not affect the instrument’s negotiability. The dating of an instrument is also not an essential requirement of negotiability. Also, an instrument may contain terms that are handwri�en, typed, or printed. Where the instrument contains discrepancies, handwri�en terms control typed and printed terms, and typed terms control printed terms. An instrument may also contain a discrepancy between the words and the figures. The words control, unless the words are ambiguous, then the figures control.

When an instrument provides for the payment of interest but does not state an interest rate, the rate is set at the judgment rate at the place of payment. The judgment rate is specified by statute. Interest starts at the date of the instrument or, if it is undated, from the date of issue.

An incomplete instrument cannot be enforced. However, an instrument can be completed by any individual in accordance with the authority or instructions given by the party who signed the incomplete instrument. Unauthorized completion, on the other hand, is treated as a material alteration of the instrument, though a holder in due course (see below) can enforce the instrument as completed. In this case, the individual who signed the incomplete instrument must bear the loss because he made the wrongful completion possible. However,

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an individual who is not a holder in due course is subject to the defense of improper completion.

An instrument may be transferred by either negotiation or assignment. The transfer of an instrument vests in the transferee the rights that the transferor possesses. Negotiation is a particular type of transfer by means of which the transferee becomes a holder. With negotiation, a transferee may obtain greater rights than were held by the transferor. For example, if an instrument is payable to bearer and it is stolen by a thief or found by a finder and they transfer the instrument to another person, the person to whom it is transferred may receive full rights as if it had been transferred directly from the issuer. An individual is a holder if he is in possession of an instrument drawn, issued or endorsed to him, his order, to bearer or in blank.

If the instrument is bearer paper, only delivery is required for negotiation. However, if the instrument is order paper, both endorsement and delivery are required. For the negotiation to be effective, the endorsement must convey the entire instrument or any unpaid balance on the instrument. The endorsement will still be effective even if the endorser adds to his endorsement words of assignment, waiver, guarantee, or limitation or disclaimer of liability.

Liability of Commercial PaperThe liability of an individual in a commercial paper transaction is predicated either on the instrument itself or on the underlying contract. A person is not liable unless his signature appears on the instrument or unless his signature has been placed on the instrument by his duly authorized agent.

The location of a person’s signature usually will denote the capacity in which the person signed. Endorsers normally sign on the back of the instrument, and makers and drawers generally sign in the lower right-hand corner on the face of the instrument. Ambiguous signatures that fail to show the capacity of the party who signed the instrument are treated as endorsements. When an agreement requires two signatures, the drawee (bank) may not pay on only one signature, even if the signature is properly authorized.

Duly authorized acts by an agent will bind the principal. An agent who fails to name his principal or who lacks the authority to bind his principal will be liable to third parties. An agent will also be liable if he fails to exhibit his representative capacity. The agent’s liability to third parties is based on the premise that a purchaser of commercial paper is entitled to rely on what appears on the face of the instrument. There are two exceptions to the rule that an authorized agent’s signature does not bind the principal. The principal must assume liability if (1) he ratifies the transaction or (2) if he is stopped from asserting lack of authority.

Characteristics of a Non-negotiable Instrument

1. If it is not payable to order or to bearer

2. If it is payable on the occurrence of an uncertain event

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Parties to Commercial PaperThe parties to commercial paper transactions may be subdivided into primary and secondary parties. Primary parties consist of the makers of notes and the acceptors of dra�s and are the parties who will actually pay the instruments. Secondary parties consist of drawers of dra�s and checks and endorsers of any instrument. Drawers and endorsers have a secondary responsibility: an obligation to pay if the primary parties do not pay provided certain precedent conditions are fulfilled.

A primary party engages that he will pay the instrument according to its terms at the time of execution. An important factor to be remembered is that the drawee bank is not liable on a check until acceptance. Certification is the usual method of accepting a check. On certification, the bank becomes the principal debtor because the bank appropriates from the depositor’s account the necessary funds to pay the instrument. If a check is duly presented for payment to the payor bank otherwise than for immediate payment over the counter, the check is dishonored if the payor bank makes timely return of the check or sends timely notice of dishonor or non-payment under Article 4 provisions (4-301&4-302), or becomes accountable for the amount of the check under Section 4-302.

Secondary PartiesDrawers, endorsers, accommodation parties, and guarantors are all considered secondary parties. The drawer engages that on the dra�’s dishonor and any necessary notice of dishonor or protest (see definition below), he will pay the amount of the dra� to the holder or to any endorser.

Unqualified endorsers are secondarily liable on instruments by virtue of their contract of endorsement. An endorser who adds the words “without recourse” to his endorsements is required to pay only if the instrument is properly presented to the primary party, is dishonored and if notice of dishonor is provided to the endorser. The endorser obligates himself to pay the instrument according to its terms. Therefore, an endorser of an altered instrument assumes liability on the instrument as altered.

An individual who lends his name and credit to another party by signing an instrument is referred to as an accommodation party. The accommodation party may sign as a maker, endorser, acceptor, co-maker or co-acceptor, but his primary function is that of a surety. The accommodation party is liable in the capacity in which he signed.

A guarantor is one who contracts to answer for the debt, default and miscarriage of another. The words of guarantee determine the liability of the guarantor. If the words “payment guaranteed” are added to the guarantor’s signature, the guarantor is obligated to pay the instrument (if it is not paid when due) without prior resort by the holder to other parties on the instrument. The words “collection guaranteed” means that the guarantor is liable only a�er the holder has a�empted to collect from all other parties. If the words of guaranty on the instrument are unclear, they will be deemed to constitute a guarantee of payment. If an endorser guarantees payment, he waives the conditions precedent of presentment, notice of dishonor and protest.

The secondary liability of parties, such as drawers and endorsers is o�en referred to as conditional liability. The term conditional refers to the required conditions precedent that

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must be satisfied to establish secondary liability. As stated earlier, the conditions precedent are presentment, dishonor, notice of dishonor and, in some circumstances, protest. Failure to comply with the conditions precedent will result in either the partial or complete discharge of the secondary parties.

Classes of EndorsementsIn general, endorsers of commercial paper warrant that the instrument has not been materially altered and that all signatures are good. There are two basic classes of endorsements: blank or special.

A blank endorsement is simply the endorser’s (customer’s) signature. A blank endorsement converts order paper to bearer paper. A special endorsement specifies the party (endorsee) to whom or to whose order the endorsement makes the instrument payable. Further negotiation requires the endorsee’s signature. Bearer paper when specially endorsed becomes order paper. Blank or special endorsement can be restrictive or qualified.

EndorsementsBlank

RestrictiveQualified

SpecialRestrictiveQualified

A restrictive endorsement restricts the endorsee’s use of the instrument and does not prevent further transfer or negotiation of the instrument. A restrictive endorsement is o�en used when a check is deposited in a bank for collection (“For deposit only, Paul Jones”). Restrictive endorsements are substantially limited as applied to banks that are involved in the deposit and collection of negotiable instruments.

The UCC provides that any restrictive endorsement may be disregarded by an intermediary or payor bank that is not a depository bank, except that of the bank’s immediate transferor. This limitation does not affect any rights the restrictive endorser may have against the depository bank, or his rights against parties outside the bank collection process.

An example of a qualified endorsement is when the transferor disclaims any liability on the instrument by including the words “without recourse” in his endorsement. This type of endorsement does not prevent the transferee from being a holder in due course. An example is “Pay to John Smith without recourse, Paul Jones.”

Holder in Due CourseA third party who rightfully and legally possesses an instrument may be an assignee, a transferor, a holder, or a holder in due course. If the instrument is a simple contract, the third party is an assignee. If the third party possesses a negotiable instrument that has been improperly negotiated, the party is a transferee with the status of an assignee.

According to the UCC, a holder is a party in possession of a negotiable instrument issued, drawn, or endorsed to his order, to him, to bearer or in blank. A holder in due course has a special status and a preferred position in the event there is a claim or a defense to the instrument. The distinct benefit of negotiability is the ability to transfer the instrument to a holder in due course.

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Value, Consideration and Good FaithThere are three requirements that must be met before a holder becomes a holder in the due course. The holder must have acquired the instrument (1) for value; (2) in good faith; and (3) without notice that is overdue, has been dishonored, or any other person has a claim to or defense against it.

Value does not have the same meaning as consideration in the law of contracts for Article 3 of the UCC. In fact, value is any consideration sufficient to support a simple contract for all of the UCC except in Article 3 and 4. In Article 3, an executory promise will not meet the value requirement to be a holder in due course. Purchase of an instrument for less than its face value by a holder may still qualify the party as a holder in due course for the instrument’s full amount. However, if the promise to pay is negotiable in form (a negotiable note), it does establish value.

If a party accepts an instrument when he knows—or has reason to know—of a claim or defense, the party has not acted in good faith. Case law commonly provides that a person has reason to know if he possesses information from which an individual of ordinary intelligence will conclude that the fact exists; or if there is such a strong probability that it exists, then an individual exercising reasonable care will assume that it exists.

Here are a few examples:

1. Instruments that are incomplete in some material respect at the time of their purchase provide sufficient notice to the purchaser, and the purchaser is then not a holder in due course.

2. A person who purchases an instrument with notice that it previously has been dishonored cannot qualify as a holder in due course.

3. A purchaser of an overdue instrument is charged with knowledge that some defense may exist; therefore, he cannot meet the requisites of a holder in due course.

4. A purchaser of demand paper cannot qualify as a holder in due course if he has reason to know that he is purchasing it a�er a prior demand for payment has been made, or if he takes it more than a reasonable length of time a�er its issue. A reasonable or unreasonable length of time is determined on the basis of the a�endant facts and circumstances. However, a check is presumed to have a reasonable time period of 30 days a�er its initial issue.

Real and Personal DefensesA real defense is a type of defense that is good against any possible claimant, so the maker or drawer of a negotiable instrument can raise it even against a holder in due course. Examples are: fraud in fact, forgery of a necessary signature, etc.

A personal defense, on the other hand, is an ordinary defense in a contract action—such as failure of consideration or non-performance of a condition—which argues that the maker or drawer of a negotiable instrument is precluded from raising against a person who has the rights of a holder in due course.

WarrantiesSecondary parties are also subject to unconditional liability for breach of implied warranties.

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Warranties are made when an instrument is transferred or presented. The party presenting the instrument warrants that no endorsements are forged and that to his knowledge the signature of the maker or drawer is genuine. The presenter also warrants that the instrument has not been materially altered.

By endorsing the instrument, the transferor warrants that he has good title to the instrument, that the signatures appearing on the instrument are genuine or authorized, that the instrument has not been materially altered, and that no defense of any party is good against him.

Presentment and DishonorPresentment means a demand made by—or on behalf of—a person entitled to enforce an instrument (1) to pay the instrument made to the drawee or a party obliged to pay the instrument or, in the case of a note or accepted dra� payable at a bank, to the bank; or (2) to accept a dra� made to the drawee. Presentment may be for acceptance or for payment. Presentment for acceptance does not apply to promissory notes. However, it is o�en required in the case of dra�s. The drawee of a dra� is not bound until acceptance of the dra� by the drawee. Presentment for payment is normally sufficient and presentment of an instrument for acceptance is not required. Failure to make a proper presentment for payment results in the complete discharge of an endorser.

Presentment may be made in person, by mail or through a clearinghouse, (an association of banks or other payors who regularly clear items.) Presentment by mail is effective on the date the mail is received. The party to whom the instrument is presented may without dishonor require the instrument’s exhibition, reasonable identification of the individual making presentment, and evidence of the individual’s authority to present the instrument. Presentment also may be required at a location specified in the instrument.

If the party to whom the instrument is presented refuses to accept or pay the instrument, then the instrument is dishonored. The presenting party then has recourse against all endorsers and other secondary parties if notice of dishonor is provided to these secondary parties.

The holder has an immediate right of recourse against the secondary parties who receive a prompt notice of the dishonor. Failure to provide prompt and proper notice of dishonor may result in the discharge of the endorsers. The UCC permits any party who may be required to pay the instrument to notify any party who may be liable on it.

Generally, notice of dishonor must be given before midnight of the third business day a�er dishonor. However, banks must provide notice before midnight of the next banking day following the day on which a bank receives the item or notice of dishonor (i.e., the midnight deadline). Notice may be conferred in any reasonable manner including oral notice and notice by telephone or mail. Wri�en notice is effective when sent even if it is not received, assuming proper address and postage.

An unexcused delay in making a necessary presentment or in giving notice of dishonor discharges all parties who are entitled to performance of the conditions precedent. Such an unexecuted delay completely discharges all endorsers. Drawers, makers of notes payable at a bank, and acceptors of dra�s payable at a bank are discharged to the extent of any loss

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caused by the delay. If the holder acts with reasonable diligence, and if the delay is not the fault of the holder, then any delay in making presentment, in giving notice of dishonor or in making protest will be excused.

ProtestProtest is a formal method of fulfilling the conditions precedent. Protest is required only for dra�s that are drawn or payable outside the U.S. The protest is a certificate which states that an instrument was presented for payment or acceptance and was dishonored, and explains why the instrument was not accepted or paid.

SECTION 1.4: ARTICLE 4—BANK DEPOSITS AND COLLECTIONS

Purpose of Article 4Article 4 of the UCC governs the collection by banks of checks and other instruments for the payment of money. This article provides the rules that govern the interrelationships of banks and banks’ relationships with depositors in the collection and payment of items.

Article 4 Definitions• deposit accounts—time deposits, demand deposits, savings deposits, passbooks, and share

dra�s (a Certificate of Deposit is not a deposit account)• depository bank—the first bank to take an item even though it is also the payor bank,

unless the item is presented for immediate payment over the counter• payor bank—the drawee of a dra�• intermediary bank—any bank to which an item is transferred in the course of collection

except the depository or payor bank• collecting bank—any bank handling an item for collection except the payor bank• presenting bank—any bank presenting an item to a payor bank

The Bank/Customer RelationshipA bank and its depositors have a legal relationship of debtor and creditor. A borrower has a debtor-creditor relationship with the bank. This dual relationship allows a bank to seize bank deposits under its right of setoff. Setoff gives the bank the right to deduct debts from a customer’s account if it becomes necessary.

When there are sufficient funds in a customer’s account, a bank has a duty to honor his checks. A bank may honor a check even if there are insufficient funds. This creates an overdra� for which the customer is indebted to the bank. An overdra� is a loan made outside the lending process. The bank is under no obligation to pay the overdra�.

Only the drawer has a right to stop payment on checks on his account. A drawer, drawee, or holder in due course on a certified check cannot issue a stop payment. A stop-payment order may be communicated to a bank by phone or in writing. When in writing a stop payment may be in the form of a le�er to the bank or on a bank’s stop-payment form. A bank must receive the stop-payment order in a time and manner that allows it to actually stop payment before taking any other action on the item. An oral stop order is effective for only fourteen calendar days unless confirmed in writing within that time. A wri�en stop order is binding

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for only six months unless renewed in writing.

If a bank honors a check with a stop-payment order on it, the bank is liable to the drawer of the check for any loss. The customer has the burden of establishing the amount of the loss, therefore, the drawer must have a valid reason to stop payment. The bank cannot disclaim its responsibility for not obeying stop-payment orders by having the customer sign an agreement not to hold the bank responsible. Further, a bank is liable to its customers for damages caused by a wrongful dishonor. The liability for a dishonor by mistake is limited to the actual damages proved. This can include consequential damages. With wrongful dishonor that is willful, punitive damages may be awarded along with the actual damages.

If a bank honors an altered check in good faith, then the customer‘s account can only be charged for the amount intended. If the customer’s negligence led to the alteration and the bank paid without being negligent, the bank can charge the customer’s account for the altered amount. If a bank honors a check that a customer signed when it was incomplete and then it is completed by another person, the customer’s account can be charged if the bank pays in good faith and does not know that the completion was improper.

A bank may pay, but is not obligated to pay, a check that is over six months old (i.e., a stale check) and may then charge the customer’s account. This six-month rule does not apply to certified checks, which are an obligation of the certifying bank. In paying stale checks, a bank must act in good faith and use ordinary care.

ResponsibilitiesBank customers are under a duty to examine their bank statement and canceled checks within a reasonable time a�er receipt. The customer should examine the canceled checks for forgeries and alterations.

The bank does not have the right to charge a customer’s account for forged checks, but the customer needs to give the bank prompt notification of a forged check. If the bank can prove that it would suffer a loss due to the lack of prompt notification, then the customer will be prevented from asserting the forgery or alteration against the bank. The bank cannot use the defense of lateness in examining and reporting, if the customer can establish that the bank was negligent.

Even if the bank was negligent, a customer cannot assert forgery of the drawer’s signature or alteration on a check a�er one year from the time the canceled check and bank statement were made available. For forged endorsements, the period is three years.

Audit Focus Point

During a review of checking account-related forged endorsement fraud losses, the auditor should be aware that the bank can be absolved of liability if it can establish that (1) it paid the check in good faith, (2) it paid the check in accordance with reasonable commercial standards.

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The Bank Collection Process

CollectionsA check, deposited or presented for payment in a bank other than the bank on which it is drawn, must be sent to the drawee bank for payment. The collection process involves sending the check through various banks that credit and debit accounts they maintain with each other. Regional Federal Reserve Banks play an important role in this process.

The beginning of the collection process is the deposit of a check into a customer’s account. The bank then provisionally credits the check. The check passes through the various collecting banks, which themselves provisionally credit the amount of the prior bank. The drawer’s account is debited when the check reaches the payor-drawee bank.

If the check is honored, se�lement is final. If the check is dishonored, the presenting bank will reverse its provisional se�lement and charge the item back to the account of the next prior collecting bank and so on back to the depository bank. The customer’s account is then debited for the check which is returned to the customer. The collecting banks must return the check or send notification of the fact by the midnight deadline. In most cases, a bank must take proper action following receipt of a check, notice or payment by midnight the next day.

A depositor has no right to withdraw against uncollected funds. In other words, the depositor cannot draw against an item payable by another bank until the provisional se�lement is final. However, even though a bank has no legal duty to do so, it may allow a customer to draw against uncollected funds.

If a customer forgets to endorse a check, the depository bank may supply the missing endorsement. The bank may endorse the item as deposited by a customer or credited to his account. Therefore, it is not necessary to return items to customers for endorsement. On the other hand, for someone who is not a customer, a bank cannot supply an endorsement.

Timing is an important factor in the process of check collection. A banking day is “that part of any day of which a bank is open to the public for carrying on substantially all of its banking functions.” In order to have time to process items, prove balances and make necessary entries, banks establish a cutoff hour of 2 p.m. or later. Items received a�er the cutoff hour are treated as being received on the next banking day.

A bank has the duty to use ordinary care in its collection operations or it may be liable to the depositor for any loss or damage sustained. A bank must take proper action before the midnight deadline following the receipt of a check, notice or payment. If a bank does not act reasonably, it is liable. The exception to this is if the bank is excused by ma�ers beyond its control, though excuses are usually difficult to establish.

Final PaymentOn final payment, the bank is obligated on the item. Final payment occurs when:• the item is paid in cash• the item is se�led without reserving the right to revoke the se�lement• the process of posting the item is complete• a provisional se�lement is made and not revoked within the prescribed time

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If a check drawn by a customer of a bank is deposited by another customer of the same bank (i.e. where the depository bank is the payor bank) the item becomes final on the opening of the second banking day following receipt of the item.

If a check is not paid, the bank is liable to the depositor if it:• retains a check presented to it by another bank• does not pay or return the check, or send notice of dishonor within the period of its

midnight deadline

SECTION 1.5: ARTICLE 5—LETTERS OF CREDIT

Purpose of Article 5Le�ers of Credit, governed by Article 5 of the UCC, has undergone significant development since the original dra�ing of that article. A le�er of credit is an idiosyncratic form of undertaking that supports performance of an obligation incurred in a separate financial, mercantile, or other transaction or arrangement. This section will make clear what a le�er of credit is and precisely what circumstances Article 5 encompasses.

Article 5 Definitions• le�er of credit—engagement by a bank or other person at the request of a customer

that the issuer (bank or other person) will honor dra�s or other demands for payment upon compliance with the conditions specified in the credit (may either be revocable or irrevocable—see below)

• documentary dra� or documentary demand for payment—honor conditioned upon presentation of a document (i.e., a paper such as a document of title, security, invoice, certificate, etc.)

• issuer—a bank or other person issuing a credit.• beneficiary—person entitled under the terms of a credit to draw or demand payment• advising bank—bank that gives notification of the issuance of a credit by another bank• confirming bank—bank that engages either (1) that it will itself honor a credit already

issued by another bank, or (2) that such a credit will be honored by the issuer or a third bank

• customer—buyer or other person who causes an issuer to issue a credit

Usage of Letters of CreditLe�ers of credit include:

1. a credit issued by a bank if it requires a documentary dra� or documentary demand for payment

2. a credit issued by a person other than a bank if it requires that the dra� or demand for payment be accompanied by a document of title

3. a credit issued by a bank or other person that conspicuously states that it is a le�er of credit or is conspicuously so entitled

A le�er of credit may be used alone instead of in conjunction with a documentary sale of goods. It also may function as a medium of payment or as a back up against customer

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default on financial or other obligations. Le�ers of credit used as back up are called standby le�ers of credit. They function like guarantees in that customer default triggers the issuer’s obligation. A bank, insurance company, finance company or other similar organization may issue le�ers of credit.

Formal requirements necessitate that a le�er of credit must be in writing and signed by the issuer. Confirmations must also be in writing and signed by the confirming bank. Any modifications of the terms of a le�er of credit or confirmation must be signed by the issuer or confirming bank.

Typically, a le�er of credit is established in two ways, either with regards to the customer or with regards to the beneficiary. When a le�er of credit is sent to the customer, or the le�er of credit or an authorized wri�en advice of its issuance is sent to the beneficiary, it is the former. When the beneficiary receives a le�er of credit or an authorized wri�en advice of its issuance, it is the la�er. The customer and beneficiary may agree on another time of estab-lishment of credit.

An ExampleLe�ers of credit are used in both international and domestic trade, but they originated in international trade. The following is an example of the use of a le�er of credit in inter-national trade:

ABC Co., a California company, wants to buy cloth manufactured in France by the French Co. ABC Co. sends a proposal to French Co. that says nothing about payment terms. French Co. replies that it will not sell on open credit, and ABC Co. answers that it will not pay in advance. The two companies agree to a documentary sale along with a le�er of credit.

ABC Co. would then obtain a le�er of credit from its bank. This le�er of credit would be issued by the bank showing French Co. as beneficiary with authority to draw dra�s on the issuing bank. Any irrevocable le�er of credit would commit the bank—the issuer—to pay a dra� drawn by French Co.—the beneficiary—on proper presentment of the dra� and any other required documents including the bill of lading. If the presented documents comply with the conditions stated in the le�er of credit, then the issuing bank must pay.

With the documentary sale, French Co. puts the goods on board a carrier and receives a negotiable bill of lading drawn to French Co. This bill of lading is the title to the goods. French Co. then draws a sight dra� (a dra� that is payable on the bearer’s demand or on proper presentment to the drawer) to its order showing the French Co. as the drawer and directing ABC Co. to pay the dra� on presentment.

This dra� is then sent with the le�er of credit, the bill of lading and any other necessary documents and mailed to French Co.’s agent (usually a correspondent bank) in California with instructions to deliver the bill of lading properly endorsed if and only if the le�er of credit issuer properly pays the sight dra�.

Types of Letters of CreditThere are two types of le�ers of credit: revocable and irrevocable. Once a revocable le�er of credit is established, it can be modified or revoked by the issuer without notice to, or consent by, the customer or the beneficiary. Once an irrevocable le�er of credit is established with the

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customer, it can only be modified or revoked with the customer’s or beneficiary’s consent.

Obligations of IssuersAn issuer has two obligations to its customer (1) good faith and (2) observance of any general banking usage.

An issuer’s obligation does not include liability or responsibility:• for performance of the underlying contract for sale or other transaction between the

customer and the beneficiary• for any act or omission of any person other than itself; or for loss or destruction of a dra�,

demand or document in transit or in the possession of others• based on knowledge or lack of knowledge of any usage of any particular trade

A beneficiary in transferring or presenting a documentary dra� or demand for payment warrants to all interested parties that he has complied with the conditions required by the le�er of credit.

An issuer must honor a dra� or demand for payment which complies with the terms of the applicable le�er of credit. This applies regardless of whether the goods or documents conform to the sale contract.

A bank that has been presented with a documentary dra� or demand for payment may defer honor until the close of the third banking day following receipt of the documents. Honor may be deferred even later if the presenter consents. If the bank does not honor the dra� within the specified time period, it constitutes dishonor of the dra� or demand. On dishonor, the bank must notify the presenter that it is holding the dra� or demand for return to the presenter.

If an issuer wrongfully dishonors a dra� or demand for payment, the presenter has the rights of a person in the position of a seller and may recover the face amount of the dra� or demand plus any incidental damages. If an issuer wrongfully cancels or repudiates a credit before presentment, the beneficiary can wait a reasonable time for performance by the repudiating party. He can also resort to a remedy for breach of contract and/or suspend his performance.

Transfers and AssignmentsLe�ers of credit can be transferred or assigned only if they are designated as transferable or assignable. Even if a credit is non-transferable or non-assignable, the beneficiary may assign his right to proceeds. The right to proceeds may be assigned prior to performance of the conditions of the le�er of credit but not a�er performance.

SECTION 1.6: ARTICLE 8—INVESTMENT SECURITIES

Purpose of Article 8Article 8 of the UCC establishes the rights and duties of the parties involved with both certificated and uncertificated investment securities. Article 8 sets forth the rules relating to the transfer of the rights that constitute securities and the establishment of those rights

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against the issuer and other parties.

Article 8 Definitions1. certificated security—a share, participation or other interest in the property of an

enterprise of the issuer; or an obligation of the issuer which is:a. represented by an instrument issued in bearer or registered formb. of a type commonly traded on securities exchanges or markets, or recognized in the

areas in which it is issued or dealt as a medium for investmentc. either one of a class or series; or by its terms divisible into a class or series of shares,

participation, interests or obligations

2. uncertificated security—a share, participation or other interest in property; an enterprise of the issuer; or an obligation of the issuer which is:a. not represented by an instrument and whose transfer is registered on books

maintained for that purpose by or on behalf of the issuerb. of a type commonly traded on securities exchanges or marketsc. either one of a class or series; or by its terms divisible into a class or series of shares,

participation, interests or obligations

3. registered form (re: certificated security)—a certificated security is in registered form if:a. it specifies a person entitled to the security or the rights it representsb. its transfer may be registered on books maintained for that purpose by or on behalf of

the issuerc. if the security so states

4. subsequent purchaser—a person who takes other than by original issue

5. clearing corporation—a. a person that is registered as a clearing agency under the federal securities lawsb. a federal reserve bankc. any other person that provides clearance of se�lement services with respect to

financial assets that would require it to register as a clearing agency under the federal securities laws but for an exclusion or exemption from the registration requirement, if its activities as a clearing corporation, including promulgation of rules, are subject to regulation by a federal or state governmental authority

6. custodian bank—A bank or trust company that is supervised and examined by the state or federal authority having supervision over banks and is acting as custodian for a clearing corporation[B]Issuer Liability Rules

Definition of IssuerWhen there are obligations on or defense to a security, the issuer is defined as the person who:• places or authorizes the placing of his name on a certificated security (1) to evidence that

it represents a share, participation, or other interest in property or an enterprise; or (2) to evidence his duty to perform an obligation represented by the certificated security

• (1) creates shares, participations, or other interests in property or an enterprise; or (2) undertakes obligations in which shares, participations, interests or obligations are uncertificated securities

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• creates fractional interests in his rights or property which are represented by certificated securities

• becomes responsible for or acts in place of any other person described as an issuer above

Definition of GuarantorA guarantor is an issuer to the extent of his guarantee. With regards to registration or transfer, pledge or release; the issuer is the person on whose behalf transfer books are maintained.

Rules for an ActionThe following rules apply in an action brought against the issuer of a security to enforce a right or interest that is part of the security:

1. Each signature on a certificated security (in a necessary endorsement, on an initial transaction statement or on an instruction) is admi�ed unless specifically denied in the initial pleading by the issuer.

2. If the effectiveness of a signature is at issue, the burden of establishing effectiveness is on the party claiming under the signature. The signature is presumed to be genuine or authorized.

3. If signatures on a certificated security are admi�ed or established, presentation of the security entitles the holder to recover on it unless the defendant establishes a defense or a defect related to the validity of the security.

4. If signatures on an initial transaction statement are admi�ed or established, any facts presented in the statement are presumed to be true at the time it was issued. The issuer is free to show that later events changed the stated facts.

5. A�er it is shown that a defense or defect exists, the plaintiff must establish the fact that the defense or defect is ineffective against him.

State LawThe law of the state in which the issuer is organized determines the rights and obligations of the issuer with respect to securities. The rights and interests related to securities of the same issue are considered fungible. Therefore, a person obligated to transfer securities does not have to transfer a specific instrument but may select any security of the proper issue, whether it is in bearer form or appropriately registered or endorsed. Another alternative is that the person may transfer an uncertificated security of the same issue.

Issuer’s LiensA lien on a certificated security in favor of the issuer is valid against the purchaser only if the issuer’s right to the lien is noted conspicuously on the security. If the security is uncertificated, a notation of the issuer’s right to the lien must be included in the initial transaction statement sent to the purchaser. If the purchaser’s interest is received other than by registration of transfer, pledge or release; the initial transaction statement must be sent to the registered owner or to the registered pledgee.

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Terms of SecuritiesIf a security is certificated, the terms of the security are stated on the security. With an uncertificated security, the terms of the security are included in the initial transaction statement sent to a purchaser. If the purchaser transfers, pledges or releases the uncertificated security; the transferee may obtain the initial transaction statement from the registered owner or registered pledgee.

A restriction on a certificated security should be conspicuously noted on the security. A restriction on an uncertificated security should be included in the initial transaction statement. If an issuer does not have a restriction in any of these manners, the restriction is ineffective against a person without actual knowledge of it.

An unauthorized signature on a certificated security or initial transaction statement is enforceable by a purchaser for value only if the purchaser does not know that the signer does not have the authority. If a certificated security or initial transaction statement includes authorized signatures but is incomplete in any other respect, any person may complete it by filling in the blanks. Even if the blanks are incorrectly completed, the security is enforce-able by a purchaser for value who had no notice of the incorrectness. In other words, a certificated security may be endorsed in blank and an endorsement may transfer only part of a certificated security. An altered certificated security or initial transaction statement is enforceable, but only according to its original terms.

A security may be endorsed in blank or special. A blank endorsement includes an endorsement to bearer. A special endorsement specifies to whom the security is to be transferred or who has the power to transfer it. A blank endorsement may be converted into a special endorsement. An endorsement may transfer only part of a certificated security. However, endorsement of a certificated security does not constitute a transfer until its delivery. If the endorsement is on a separate document, both the document and certificated security must be delivered.

A person who signs a certificated security or initial transaction statement as authenticating trustee, registrar, transfer agent, or the like warrants to a purchaser for value that:• the certificated security or initial transaction statement is genuine• the signer's participation in the issue or registration of the transfer, pledge or release of

the security is both within his capacity and within his scope of authority as granted by the issuer

• the security is in the form and within the amount the issuer is authorized to issue

Unless a purchaser's rights are limited, he will on transfer of a security, acquire the same rights as the transferor (or those rights which the transferor had authority to convey). A purchaser of a limited interest acquires rights only to the extent of the interest transferred.

Purchaser Liability RulesIf the buyer does not pay the sale contract price the seller may recover the price of:• certificated securities accepted by the buyer• uncertificated securities that have been transferred to the buyer or a person designated by

the buyer

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• other securities if efforts at their resale would be unduly burdensome or there is no readily available market for their resale

When presenting a certificated security for registration of transfer, for payment or for exchange, a person warrants that he is entitled to that registration, payment or exchange. A purchaser for value and without notice of adverse claims who receives a new, reissued or reregistered security warrants that he has no knowledge of any unauthorized signatures in a necessary endorsement.

A person who transfers a certificated security to a purchaser for value warrants several things:• The transfer is effective and rightful.• The security is genuine and has not been materially altered.• He has no knowledge of a fact which might impair the validity of the security.

A purchaser who receives a certificated security in registered form but without a necessary endorsement may become a bona fide purchaser only when the endorsement is supplied. Against the transferor, the transfer is complete on delivery and the purchaser has an enforceable right to have the necessary endorsement supplied.

Purchaser Legal RightsLegal rights in a security transfer to the purchaser are established when:• the purchaser or his representative acquires possession of a certificated security• the transfer, pledge or release of an uncertificated security is registered to the purchaser or

his representative• the purchaser's financial intermediary obtains possession of a certificated security specially

endorsed to or issued in the name of the purchaser• the purchaser's financial intermediary sends him confirmation of the purchase and also

identifies the security as belonging to the purchaser by a book entry or otherwise• at the time a third person acknowledges that he holds a security for delivery to the

purchaser• when appropriate entries regarding the purchase are made on the books of a clearing

corporation

Rules for Contracts for the Sale of SecuritiesA contract for the sale of securities is enforceable if:• there is a writing signed by the party against whom enforcement is sought indicating that a

contract has been made for the sale of a stated quantity of described securities at a defined or stated price

• delivery or transfer has occurred and the issuer does not send a wri�en objection within ten days

• the party against whom endorsement is sought admits in court that a contract was made for the sale of a stated quantity of described securities

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SECTION 1.7: ARTICLE 9—SECURED TRANSACTIONS

Article 9 ScopeArticle 9 applies to secured transactions (and excludes coverage of landlords’ liens, wage assignments, transfers of insurance policies and artisans’ liens). A secured transaction is a transaction in which a borrower or a buyer provides security in the form of personal property to a lender or a seller that an obligation will be fulfilled. The simplest type of secured transaction was historically referred to as a pledge. In a pledge transaction, a borrower gives the physical possession of his property (i.e., diamond ring) to a lender as security for a loan. If the loan is not repaid, the lender can sell the property to satisfy the obligation or debt.

A pledge is o�en unsatisfactory as a security arrangement because it requires the physical possession of the property to be transferred to the creditor. As a result of this inconvenience, security arrangements have developed that allow the debtor to retain the physical possession and use of the property. Such security arrangements are sometimes referred to as cha�el mortgages, conditional sales contracts, factors’ liens, and so forth. The UCC refers to all these security devices as security interests.

DefinitionsCertain terminology must be defined in the area of secured transactions.

security interest—an interest in personal property or fixtures that secures payment or performance of an obligation

secured party—a lender, seller or other person in whose favor there is a security interest

debtor—the party who owes an obligation and is providing the security

collateral—the personal property in which a security interest exists

Types of Collateral Collateral may be classified three ways: as tangible collateral (physical property or goods), as semi-intangible collateral (it has physical existence but is simply representative of a contractual obligation, i.e., negotiable instruments), and as purely intangible collateral (i.e., accounts receivable).

Tangible Collateral1. consumer goods—those goods bought primarily for personal, family or household

purposes

2. equipment—those goods that are used or purchased primarily for use in a business, in farming, in a profession, or by a non-profit organization or government agency (serves as a catchall for all other goods which defy classification)

3. inventory—goods that a person holds for sale or lease and that are to be furnished under a contract of service, including raw materials, works-in-process, finished goods, and materials used or consumed in a business

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(The primary test to be applied in the determination of whether goods are inventory is whether the goods are held primarily for immediate or ultimate sale or lease. A security interest in inventory automatically covers a�er-acquired inventory.)

4. farm products—include crops and livestock, supplies used or produced in farming operations, and the products of crops or livestock in their unmanufactured state (co�on, milk, wool, etc.) if such items are in the possession of a debtor who is engaged in farming operations

(Goods cease to be farm products and therefore must be reclassified when they are no longer in the farmer’s possession or when they have been subjected to a manufacturing process.)

Semi-intangible Collateral • documents of title—documents that in the regular course of business or financing are

treated as sufficient evidence that the person in possession of the document is entitled to receive, hold and dispose of the document and the goods it covers—including bills of lading and warehouse receipts

• cha�el paper—writing or writings that provide evidence of both an obligation to pay money and a security interest in or a lease of specific goods; a security agreement

• instruments—negotiable instruments, securities such as stocks and bonds, and any other writing that evidences a right to the payment of money and is not itself a lease or security agreement; may be negotiable dra�s, checks, certificates of deposit and promissory notes

All of these types of paper are in writing and are representative of obligations and rights.

Intangible Collateral• accounts—any right to payment for goods sold or leased or for services rendered, whether

or not earned by performance.• general intangibles—goodwill, patents and copyrights

The difference between intangible and semi-intangible collateral is that intangible collateral is not represented by an indispensable writing.

Agreement and AttachmentThe creation of a valid security interest between the debtor and the secured party requires an agreement and a�achment to the collateral. The security agreement is required to be in writing, unless the arrangement is a possessory one and the secured party is in possession of the collateral. The agreement must be signed by the debtor and must contain a description that reasonably identifies the collateral. A�achment is the creation of a security interest in property occurring when the debtor agrees to the security, receives value from the secured party and obtains rights in the collateral.

Elements for the A�achment of a Security Interest• The debtor possesses rights in the collateral.• The debtor has authenticated a security agreement or the secured party

has possession of the collateral.• There must be an obligation for value to be performed or given by the

creditor.

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To be enforceable, a security interest must a�ach to the collateral. Three elements must be present for the a�achment of a security interest. These events may occur in any sequence.

1. the debtor must possess rights in the collateral

2. the secured party must have given value

3. there must be an agreement between the debtor and the secured party that there should be a security interest.

Value and After-Acquired PropertyValue means that a secured party has provided the debtor with any consideration adequate to support a simple contract. A�er-acquired property is a concept involved in securities. The security agreement also may provide that certain property acquired by the debtor at any later time will become collateral. This property is referred to as a�er-acquired property. An a�er-acquired property clause severely binds the debtor. Therefore, the code places certain limitations on the effect of a�er-acquired property clauses in relation to crops and to consumer goods.

No security interest can be a�ached under an a�er-acquired property clause to crops that become such more than one year a�er the execution of the security agreement. This is also the case with consumer goods that are given as additional security unless the consumer obtains the goods within ten days a�er the secured party gives value.

Methods of PerfectionA creditor with a perfected security interest has priority over the claims of a bankruptcy trustee, unsecured securities and certain other transferees. Perfection normally involves filing a financing statement (see definition below) that puts the world on notice that the secured party has a security interest in the property.

The first and simplest method of providing notice of a security interest is for the secured party to take possession of the collateral. A second method of perfection is the filing of a financing statement. This filing must occur at the appropriate public office designated for that purpose.

A financing statement is a document containing the addresses of both the debtor and the secured party. The financing statement also contains a description of the collateral. However it must be remembered that a financing statement is not a substitute for the security agreement. The purpose of filing a financing statement is to provide notice that the secured party who filed it may have a secured interest in the collateral.

Unless the financing statement contains an expiration date of a shorter duration, the filing

Methods of Perfection

1. taking possession of the collateral

2. filing a financing statement

3. a�achment of the security interest

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is effective for a five-year period from the date of filing. A continuation statement signed by the secured party may extend the effectiveness for an additional five years. The code also provides for the filing of a termination statement to clear the public record when the secured party is no longer entitled to a security interest.

The third method of perfection requires only the a�achment of the security interest without any further action being required. This is o�en referred to as perfection by a�achment or automatic perfection.

Situations resulting in automatic perfection: 1. a purchase-money security interest in consumer goods

2. an assignment of accounts or payment of intangibles which does not by itself or in conjunction with other assignments transfer a significant part of the assignor’s similar accounts

3. a sale of a payment intangible

4. a sale of a promissory note.

The full list of automatic perfection situations is found in 9-309. Perfection by a�achment limits the protection furnished to the secured party. The secured party is protected against the claims of creditors of the debtor and from others to whom the consumer or farmer debtor may give a security interest in the collateral.

However, the secured party is not provided protection against the rights of a consumer or farmer who is a good-faith purchaser from the debtor. A good-faith purchaser is one who buys the collateral and is unaware of the existence of any security interest in the property.

Perfection With and Without FilingUnder 9-312(a), a security interest in instruments may be perfected by filing. This rule represents an important change from former provisions of Article 9, under which possession was the only method for perfection in the long term.

A security interest in certificated securities, negotiable documents or instruments is perfected without filing (or taking possession for a period of 20 days) if the secured party makes available to the debtor the goods (or documents representing the goods) for the purposes of ultimate sale or exchange; for loading, unloading, storing, shipping, manufacturing, processing; or for otherwise dealing with them in a manner preliminary to their sale or exchange.

A perfected security interest in a certificated security or instrument remains perfected for 20 days without filing if the secured party delivers the security certificate or instrument to the debtor for the purpose of ultimate sale or exchange; or for presentation, collection, enforcement, renewal or registration of transfer. A�er these 20-day periods end, compliance with ordinary provisions of Article 9 apply.

For several reasons, it may be necessary for a secured party with a possessory security interest to temporarily release possession of the collateral to the debtor. For such temporary releases, the requirement of filing is too cumbersome. The UCC provides relief by stating that a security interest remains perfected for a period of 21 days without filing where a

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secured party having a perfected security interest releases the collateral to the debtor. This provision applies to instruments, negotiable documents and goods in the hands of a bailee that are not covered by a negotiable document of title.

Only when the goods (or documents representing the goods) are released to the debtor for ultimate sale or exchange; for purposes such as storing, shipping and manufacturing; or for some other similar purpose will this provision apply. In the situation of a temporary release of an instrument to the debtor, the purpose must be to allow the debtor to present, collect or renew the instrument; to obtain registration of a transfer; or to make an ultimate sale or exchange.

A secured party who has not perfected his security interest has a very limited protection against third parties. Creditors must comply carefully with the statutes if the desired protection is to be obtained. An unperfected security interest will have priority over third parties who acquire the property with prior knowledge. However, a buyer in the ordinary course of business will take the property free of security interests created by the seller in the seller’s inventory.

Priority The following priority rules apply for perfection in a variety of situations.• If the conflicting interests are perfected by filing, the first to file will prevail, regardless of

the order of a�achment• Unless both interests are perfected by filing, the first to be perfected will prevail regardless

of the order of a�achment• If neither of the security interests is perfected, priority will be given to the first party to

a�ach• When perfection is by possession, the secured party is protected against all third parties as

long as possession is maintained

Rights and DutiesThe secured party has certain rights and duties in a secured transaction. These rights and duties are those established in the security agreement and those provided by the Code. A secured party who has a possessory security interest is required to exercise reasonable care of the collateral. Unless the security agreement specifies otherwise, all reasonable expenses related to the collateral are the responsibility of the debtor and are secured by the collateral.

The burden of accidental loss or damage is placed on the debtor except for the amount covered by insurance. The secured party may also repledge the collateral (use the collateral as security in his own financing), provided the repledge does not impair the debtor’s right to redemption.

The debtor may exercise certain privileges without violating the security agreement: He may collect or compromise accounts receivable or cha�el paper, and he may accept the return of goods or make repossessions. The debtor also may use, commingle or dispose of the proceeds. However, these privileges may be legally restricted by the provisions of the security agreement.

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RemediesThe debtor defaults under the security agreement when he fails to satisfy or pay the obligation that is secured or when he otherwise breaches the security agreement. The remedies available to the secured party are established by the terms of the security agreement and by the provisions contained in the code.

The basic remedy for the secured party is to repossess the collateral and dispose of it. The secured party may also retain the collateral as satisfaction of the debt and not sell it. The secured party may take possession of the property without judicial process provided he can do so without breaching the peace. If the collateral is accounts, cha�el paper, instruments or general intangibles; the code provides that the secured party may collect any amounts that become due on the collateral.

DispositionUnder 9-610, a�er a default, a secured party may sell, lease, license or otherwise dispose of any or all of the collateral in its present condition or following any commercially reasonable preparation or processing.

Every aspect of a disposition of collateral, including the method, manner, time, place and other terms, must be commercially reasonable. If commercially reasonable, a secured party may dispose of collateral by public or private proceedings; by one or more contracts; as a unit or in parcels; and at any time and place and on any terms.

This version of Article 9 specifies no time period for the disposition of collateral. This is to foster the Code’s policy to encourage private dispositions through regular commercial channels. Remember, however, that every aspect of the disposition must be reasonable and so an indefinite retention of the collateral where there is no good reason for such retention may be viewed unfavorably. Such action may not be deemed commercially reasonable.

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Practice Challenge QuestionsDirections: Circle T if the answer is true, or F if the answer is false.

1. T F The primary purpose of the UCC was to collect all aspects of commercial transactions into one body of law.

2. T F The provisions of the UCC govern the terms of relevant agreements and may not be varied in any way by agreement of the contracting parties.

3. T F Quantity is the only term that, if completely omitted, cannot be supplemented by the provisions of Article 2.

4. T F It is always true that the title acquired by a purchaser of goods is only as good as the title of the transferor.

5. T F Goods include the unborn young of animals, growing crops and standing timber.

6. T F Commercial paper consists of two basic types of instruments: drafts and bearer bonds.

7. T F Duly authorized acts by an agent will bind the principal. An agent who fails to name his principal or who lacks the authority to bind his principal will be liable to third parties. An agent will also be liable if he fails to exhibit his representative capacity.

8. T F The characteristics of a non-negotiable instrument are (1) it is not payable to order or bearer, and (2) it is payable on the occurrence of an uncertain event.

9. T F A bank and its depositors have a legal relationship of debtor and creditor. A borrower has a debtor-creditor relationship with the bank.

10. T F The beginning of the collection process is the writing of a check by a customer.

11. T F A letter of credit may function as a medium of payment or as a back up against customer default on financial or other obligations.

12. T F An issuer is free to dishonor a draft or demand for payment which meets all of its terms or conditions.

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13. T F A term may be made conspicuous by printing a heading in capital letter or printing language in the body of a form in a larger or contrasting type or color.

14. T F A security interest is an interest in personal property or fixtures which secures payment or performance of an obligation.

15. T F Perfection by attachment requires that the issuer of a security file with state authorities within 10 days.

16. T F The purpose of filing a financing statement is to provide notice that the secured party who filed it may have a secured interest in the collateral.

17. T F A contract for the sale of securities is enforceable if there is a writing signed by the party against whom enforcement is sought indicating that a contract has been made for the sale of a stated quantity of described securities at a defined or stated price.

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Directions: Circle the letter of the answer that most accurately completes the sentence.1. Under Article 5, what are the two obligations an issuer has to its customer?

a. general commercial reasonableness and general banking usageb. good faith and common sensec. standards of the uniform banking act and SEC filingsd. good faith and observance of any general banking usage

2. If the security is uncertificated, a _____ must be included in the initial transaction statement sent to the purchaser. a. receiptb. notation of the issuer’s right to the lienc. copy of the terms and conditions d. copy of the articles of incorporation

3. An issuer’s lien is_____.a. a certificated security on which the issuer’s right to the lien is conspicuously notedb. a lien in which the issuer is granted double recovery rights in the event of a defaultc. a lien where the issuer is forced to accept a partial interest in the security, but cannot seek legal recoursed. a lien where the issuer need not note his right to the lien in any way

4. Under 9-610, after a default, a secured party may sell, lease, license or otherwise dispose of any or all of the collateral in its present condition or following any _____ preparation or processing.a. commercially reasonableb. appropriatec. legally permissibled. pre-approved

5. In a typical situation, a secured party may _____ _____ as a remedy against a debtor who fails to pay or satisfy his obligation.a. adversely possess the collateral and sell it backb. repossess the collateral and dispose of itc. charge a double fee to the debtor and report himd. breach the peace and take other unrelated items to satisfy the debt

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6. The UCC permits notice of a fact when a party has (1) ______(2) received notice or notification of the fact, or (3) from all the facts and circumstances known to the person at the time in question, the party has reason to know the fact.a. actual knowledgeb. constructive knowledgec. a strong suspiciond. heard a rumor

7. When interpreting a contract, express terms, course of dealing and usage of trade should be interpreted as consistent with each other where _____. Where this is not possible, the express terms control both course of dealing and usage of trade.a. logicalb. reasonablec. unreasonabled. commercially prudent

8. Before payment or acceptance of goods, the buyer has the right to _____ the goods at a reasonable time and place and in any reasonable manner.a. seizeb. destroyc. inspectd. scrap

9. Revocation can occur only if the non-conformity “_______ the value to the buyer.” A buyer who revokes acceptance is placed in the same position relative to the goods as if he had rejected them in the first place.a. completely impairsb. substantially impairsc. partially impairsd. negligibly impairs

10. The UCC provides that any _____ endorsement, except that of the bank’s immediate transferor, may be disregarded by an intermediary or payor bank that is not a depository bank..a. restrictiveb. negotiatedc. commerciald. qualified

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11. In a contract action, a(n) _____ defense is an ordinary defense that the maker or drawer of a negotiable instrument is precluded from raising against a person who has the rights of a holder in due course.a. insanityb. realc. limitedd. personal

12. If a check drawn by a customer of a bank is deposited by another customer of the same bank (i.e., the depository bank is the payor bank), then the item becomes final on the opening of the _____ banking day following receipt of the item.a. firstb. secondc. thirdd. fourth

Write complete and thoughtful answers to the following questions. 1. Define commercial paper and explain its uses.

2. List the four requirements of a negotiable instrument.

3. List the different types of warranties supplied by Article 2, and briefly explain their significance.

4. Explain the essential elements for a sales contract.

5. What are the common methods for breaching a contract?

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6. Define protest.

7. What is a Holder in Due Course?

8. Define depository bank.

9. Define letter of credit below:

10. List and describe the various types of letters of credit

11. In the space provided below, list three of the rules that apply in an action brought against the issuer of a security to enforce a right or interest that is part of a security.

12. List the items that a seller of an investment security may recover if the buyer does not pay the sale contract price.

13. Define secured transaction.

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14. Define the term secured party.

15. List the three elements for the attachment of a security interest.

MatchingRead the directions for each matching exercise.

1. Below is a list of collateral terms and collateral descriptions. Match the letter and the definition to the correct term by placing the letter in the space provided.

Terms Description

1. Consumer goods service _____2. Inventory _____3. Document of title _____4. Chattel paper _____5. Instruments _____

a. Collateral that a person holds for sale or lease and that are to be furnished under a contract of service

b. Collateral that provides evidence of an obligation to pay money and a security interest in or a lease of specific goods

c. Collateral bought primarily for personal, family or household use.

d. negotiable collateral that evidences a right to the payment of money and is not itself a lease or security agreement.

e. Used in the regular course of business or financing and treated as evidence that the possessor is entitled to the goods

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2. Please indicate if the particular remedy is for a seller or a buyer. Indicate seller by placing an “S” in the blank, and buyer by placing a “B” in the blank.a._____ sue for the actual price of goods b._____ reject the contractc._____ cover and recover damagesd._____ cancel the contracte._____ recover damages for non-acceptancef._____ resell the goods and recover damagesg._____ recover damages for non-deliveryh._____ sue to get the goods

3. From the list below, indicate which items are the responsibilities of banks in the bank collection and deposit process by placing a “B” in the blank, and indicate which items are responsibilities of customers by putting a “C” in the blank.a. _____ examine bank statements b. _____ honor checksc. _____ examine cancelled checksd. _____ honor stop payments

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Chapter Two

General Commercial Law

Chapter TopicsThe following topics are covered in this chapter: 2.1 Wills, estates, and trusts 2.2 Insurance 2.3 Guaranty and suretyship 2.4 Partnerships 2.5 Agency 2.6 Contracts 2.7 Bankruptcy 2.8 Antitrust

Chapter Objectives A�er completing this chapter, you will be able to:• describe the validity requirements for a will and changes to a will• describe the roles and responsibilities of each of the parties involved in a will or trust• explain the overall estate administration process• identify cases in which a will or trust is fixed and irrevocable as well as situations in which

a will or trust can be modified or revoked• describe the three different types of property ownership• identify personal, business or property relationships which permit a person to take out an

insurance policy• describe the different types of insurance• identify typical insurance policy clauses and limitations • understand the insurance company’s legal rights to recover from those who cause a loss • identify circumstances concerning a voided policy or a lapsed policy• comprehend the relationship between parties in a guaranty/surety agreement and different

types of agreements• describe the guarantor’s rights and responsibilities• identify defenses that a guarantor can use to defeat a creditor’s claims• identify the different kinds of partnerships and contents of agreements• identify the rights, duties and powers of partners

Scope: Volume 7 constitutes Business Law, which makes up 30 to 40% of Part 4 of the CBA exam. Volume 8 makes up Economics, which make up 15 to 25% of Part 4 of the CBA exam. Volume 9 addresses Management Issues, which makes up 25 to 35% of Part 4 of the CBA exam

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• describe the steps in extinguishing a partnership: dissolution, winding-up and termination.• identify the different kinds of agents and principals and related duties• describe agent’s authorities and liabilities• identify tort liabilities and the liabilities of disclosed and undisclosed principals• explain the termination of an agency relationship• identify different types of contracts and the four required elements of a valid contract• identify the circumstances under which a contract can be voided or breached• describe the roles of third parties in an existing contract• identify different chapters or types of bankruptcy proceedings• identify property and debts that are exempted in bankruptcy• describe the role of the bankruptcy trustee and his duties and powers• explain the prioritization and payment (or discharge) of creditor’s claims• identify different acts that have been passed by Congress in the area of antitrust

SECTION 2.1: WILLS, ESTATES AND TRUSTS

ScopeAs parties manage their financial affairs, they make provisions for the future nonsale transfer of their property to others. Wills and trusts are used to direct a party’s property to other people upon certain events—most commonly the death of the party making the will or trust. In some cases, the provisions for future transfer of property from one party to another are completely fixed and nonrevocable. In other cases, the future transfer of property is dependent on contingencies and therefore could be delayed or even canceled.

Wills, Estates and Trusts—Definitions• will—A will directs the disposition of an individual’s property upon his death.• intestate—An individual who dies without a will is said to have died intestate.• testator/testatrix—An individual who makes a will is commonly referred to as a testator/

testatrix.• executor/executrix—The personal representative of a testator is called an executor/

executrix.• administrator/administratrix—The personal representative of an individual who dies

intestate is called an administrator/administratrix.• guardian—The personal representative of a living person who is a ward (generally a child)

is referred to as a guardian.• conservator—The personal representative of a living but mentally incompetent person is a

conservator.• community property—Community property states have statutes in which property rights

of married people are subject to special rules, which have particular implications upon death or divorce.

• trust—A trust directs the management, use and disposition of property of the individual who makes the trust—trusts can function before and a�er the death of the maker.

• se�lor or trustor—An individual who makes a trust is commonly referred to as a se�lor or a trustor.

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• trustee—The individual who manages the property in the trust is called a trustee.• beneficiaries—The individuals who use or receive the property in the trust are called

beneficiaries.

Wills

Executing a WillA will is a document that signifies an individual’s intention concerning disposition of his property on death. The will also may designate the deceased’s personal representative and may make provisions for the payment of taxes. The legal requirements for a valid will vary from state to state, however, some generalities do exist. For a will to be deemed valid:• It must have been executed by a person possessing testamentary capacity. Note: This includes a minimum age requirement and the minimum capacity to understand

the nature and the plan involved in creating the will. This also includes the absence of undue influence, (defined as influence that overpowers the mind of the testator and deprives him of his free agency in the execution of his will).

• It must be signed either by the testator or by someone in his presence and at his direction. Note: Oral wills are not recognized in many states.• It must be a�ested in the presence of the testator by two or more credible witnesses. Note: A credible witness is one who is competent to testify to support the will.

In most states an individual who is an interested party (i.e., who receives property under the will) is not allowed to receive more property as a result of the will than he would receive if no will existed. A witness is not allowed to profit on—or gain from—any property as a result of the will.

An otherwise properly executed will may be challenged on the grounds noted above as well as other more technical grounds.

Revocation of a WillWills may be revoked by several methods. Among the prevalent methods of revocation are physical destruction of the will, creating a will that revokes a prior one, making a later will inconsistent with a prior one, marriage and divorce. In several states, divorce only revokes the will to the extent of bequests or devises to the former spouse. Therefore, it is imperative that, upon a marriage or divorce, state law be consulted concerning the effect on the testator’s prior will.

Finally, state laws generally prohibit partial revocation of a will except by a duly signed and a�ested instrument. Substitutions, additions, alterations, deletions and interlineations on the face of the will are, therefore, ineffective, and it shall be enforced as originally executed. In most states, a will that is totally revoked by any method can be revived only by the re-execution of the will. Another option is through a wri�en instrument declaring the revival, but it must be executed in the same manner as a new will.

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Estates

Settling an EstateThe statutes of the individual states determine the steps to be taken by the executor or administrator in the se�lement of an estate. A petition informing the court of the death of the deceased and appending a copy of the will (if there is one) is normally required to be filed. The court then sets a date for a hearing at which time the will may be presented for probate. If an individual dies intestate, the petition should be signed by someone entitled under the laws to serve as administrator of the estate. All interested parties are entitled to notice of the time and place of the hearing.

At the hearing, evidence is requested by the court and normally supplied by the a�esting witness as to the proper execution of the will. If there is a chance that someone is going to contest the will, it is usually happens at this point in the process. If the court deems that the will was properly executed, it is then admi�ed to probate, and an executor (chosen by the testator) is appointed. If no will exists and the individual entitled to administer the will so requests, then the court itself can appoint the administrator. The executor or administrator then files an oath of office and an appropriate bond to guarantee the faithful discharge of the duties of personal representative.

A�er the appointment of the executor or administrator, public notice of the death must be provided to his creditors through public newspapers. The executor or administrator then collects all of the deceased’s personal property, takes inventory and files the inventory listing with the court.

Administering the Estate: Distributing the propertyDuring the administration period, the executor or administrator must file all required tax forms. The personal representative must also a�empt to collect all outstanding receivables of the deceased. A�er the payment of all outstanding debts and taxes, the representative can then distribute the remaining property.

If the deceased had a valid will, the executor must follow its direction. If the deceased died intestate, the court determines who are the legal heirs as of the date of death and the administrator of the estate distributes the property accordingly. In most states, these heirs are the deceased’s spouse and children, if any.

It is important for the executor of an estate to know if the deceased ever lived in a community property state because this could affect the distribution of property. In community property states, the laws regarding spousal property rights can actually override and therefore change a will’s distribution of property. Even if the deceased did not live in a community property state at the time of death, community property law may still apply to real estate located in that state. In this case, the laws of that state may affect the deceased’s property ownership rights and could restrict or even prohibit the transfer the property.

State law generally provides a spouse certain rights that cannot be denied by a will. The right to support during the administration of the will is one of these rights. Also, a majority of state laws allow the spouse to renounce a will and to take a statutory share in lieu of its provisions. This is commonly called the Widow’s Right of Election. In these states, one’s

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spouse can never be completely disinherited.

Property Ownership RightsThe three methods by which two or more people may own property together are tenancy in common, joint tenancy and tenancy by the entirety. The first two methods are applicable to both real and personal property. Tenancy by the entirety applies only to real estate held by spouses. Some states have modified these methods, so each state’s law should be consulted.

Tenancy in CommonIf a party to a tenancy in common dies, his share of the property passes to his estate and is distributed by either the executor of the will or the administrator of the estate. If a party to property held in joint tenancy dies, the deceased party’s interest automatically passes to the surviving joint owner(s). With joint tenancy, title passes to the survivor free of the claims of anyone else except for any taxes due and does not pass through the estate administration process.

Joint TenancyFor two or more parties to establish valid joint tenancy of property, the law requires:

1. unity of time—The joint tenants’ ownership must be created at the same time.

2. unity of title—The joint tenants must have the same estate created in the same manner.

3. unity of interest—Each owner must have equal shares of the property.

4. unity of possession—Each owner has the right to possess all of the real estate subject to the owner’s rights of possession.

Tenancy by the EntiretyTenancy by the entirety can exist only between a husband and wife with regards to real estate. Tenancy by the entirety can be terminated only by divorce, joint transfer to a third party, or a transfer by one spouse to the other.

Devises and Bequests of PropertyA devise is a gi� by will of real estate. A bequest is a gi� by will of personal property. Devises and bequests are further subdivided into specific, general and residuary. A gi� of particular property so identified as to distinguish it from other property is a specific legacy or specific devise. A general legacy may be satisfied by the delivery of any property of the general type described. A residuary gi� is a gi� that includes all the personal property that is not included in the specific or general bequests or devises. This is depicted below.

Devises and Bequests

Specific legacy“my home at 123 Fake Street…”

General legacy“one half of my coin collection…”

Residuary gift“one quarter of my estate…”

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Trusts

Types of TrustsThe law recognizes four types of trusts: express private trust, charitable trust, resulting trust and constructive trust. However when used alone the term trust generally refers to an express private trust.

Express Private TrustsAn express private trust is a fiduciary relationship with respect to property. The individual who creates the trust is referred to as the se�lor, creator or trustor. The se�lor’s intention to create a trust must be clear. A trust involving real estate must be in writing.

Once the trust is effective, the person having legal title to the property is the trustee. The trustee possesses the title to the property and manages the property for the benefit of another person referred to as the beneficiary. The trustee is under an absolute obligation to act solely for the good of the beneficiary.

There are two types of express private trusts: an inter vivos or living trust—a trust created by a transfer of property during one’s lifetime—and a testamentary trust—a trust that transfers property on one’s death.

Any property that has the capacity to be transferred may be held in trust. Property transfer is immediate and the beneficiary gets final complete legal title to the property (i.e., the beneficiary as defined in the trust document.) On the other hand, property transfer can be a trust-defined period of usage. This allows a trust beneficiary to use and/or collect income from the property for a period of time while the property title stays in the trust. This is then coupled with a later transfer of the property title. A�er the period of usage is over the property title is assigned to the designated trust beneficiary (either the same or a different beneficiary). In this way, a trust may have more than one beneficiary and may provide for successive trustees or beneficiaries.

For example, Abby owns property which produces an income. She has two sons, Ben (who is an adult) and Charlie (who is an infant). Anticipating her eventual death, she wants to provide for her young son, Charlie, so he is cared for while he’s a minor. But she also wants the property to be eventually split by both sons.

In this case, Abby puts all her property into a trust. At this point, Abby is the se�lor, the trustee and the beneficiary at the same time. Because she is the beneficiary herself, Abby can use her property as she likes and take the income from the property as well.

Abby dies and, pursuant to her trust documents, her best friend Be�y becomes the trustee. The trust property stays in the trust under Be�y’s management, however Be�y can’t use the trust property for her own good. Income from the trust property goes to Abby’s son, Charlie. This makes Charlie the beneficiary. When Charlie reaches a certain age (as set by Abby in the trust documents), the title to the property itself transfers to Ben and Charlie and the trust is terminated.

Charitable TrustsA charitable trust is a trust that can benefit an indefinite group and can have perpetual

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existence. Typical charitable trusts provide funds for religious groups or for educational and health purposes. The doctrine of cy pres (as nearly as) provides that if a particular charitable purpose cannot be fulfilled in the manner directed by the se�lor, the court can carry out the general charitable intention by prescribing the application of the trust property to another charitable purpose consistent with the original.

Resulting and Constructive TrustsResulting trusts and constructive trusts are created by operation of law. When the party with legal title to property is not intended to have it, a resulting trust is created by a court of equity. A constructive trust is created by a court of equity for the purpose of preventing unjust enrichment as in the case where a transfer of property is obtained by fraud or violation of some fiduciary duty.

Duties of the TrusteeThe most important thing to remember with regards to the duties of the trustee is that a breach of these duties creates liability to the trust beneficiaries. The trustee possesses the title to the property and manages the property for the benefit of the beneficiary. The trustee has powers to do as he sees fit. However, the trustee is under an absolute obligation to act solely for the good of the beneficiary, and not for his own good or purposes. Therefore, a trustee is liable to the trust beneficiaries for any losses due to a breach of trust or for any personal profit made due to a breach of his fiduciary responsibilities.

Rules for a Trustee• The trustee may not delegate his responsibility to another person. The trustee must

segregate trust property and may not commingle trust property with his own property.• The trustee also has a duty to diversify investments of the trust fund. In the area of

investment selection, the trustee must exercise the judgment of a prudent man (using the prudent man rule). The trustee is also responsible for reviewing assets for quality, diversification and appropriateness.

• The trustee possesses all the necessary powers to perform the duties of a trustee. These powers include the power to sell, to lease, to incur necessary expenses, to se�le claims and to retain investments. However, the trustee does not generally have the power to borrow money or to mortgage the trust assets.

Termination of a TrustOnce a trust is in effect, it typically cannot be revoked, changed or terminated except as provided for in the trust document that created the trust. However, there are some exceptional circumstances in which a trust can be terminated. • If it can be proven that the se�lor was defrauded or mistaken then he may be allowed to

revoke the trust. • When its purposes have been accomplished, a trust may be terminated. This requires that

complete determination of property distribution to all beneficiaries has been finalized and is fixed. If the trust contains any language which makes the property distribution contingent on an event which hasn’t yet occurred, then the trust cannot be terminated.

• If the purpose of the trust becomes illegal, a trust may be terminated

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• In some states it is possible for a trust to be terminated by the consent of all beneficiaries provided that all are of legal age and that the termination will not defeat the purpose for which the trust was created. Some states frequently require clear language within the trust before they will permit termination by beneficiaries. Other states require clear language specifically prohibiting the trust’s termination before they will block termination.

SECTION 2.2: INSURANCE

IntroductionInsurance is a way to anticipate risks that would cause significant losses and to provide for compensation upon the risks’ occurrence. In this way, an individual can be assured that even if the risk occurs and does cause a significant loss, he can recover assets to partially or totally offset the loss. Insurance is a contract whereby one party, the insurer, commits to compensate the other party, the insured, against risks of loss on specified property, etc., by specified risks or perils. The insured pays the insurer a stipulated consideration called a premium for this coverage, which provides protection against the risk of loss arising from events over which the insured has li�le control. Insurance distributes the cost of risk over a large number of individuals who are subject to the same risks so that those who actually suffer a loss may be reimbursed.

When an individual insures against a particular type of loss, he can name himself or other parties as beneficiary. In bank transactions with an individual, for example, the bank’s risk can be reduced or eliminated if the bank requires that the individual insures against specific risks and makes the bank the irrevocable beneficiary of the policy proceeds.

General Terms:• owner—the party who took out the policy and makes the payments• insured—the person whose life is being insured or the property that is being insured• beneficiary—the party who receives payment of the proceeds from the insurance policy• insurer—the party who contracts with the policy owner, i.e. the party who will pay for the

loss• event—the risk or peril which occurs and which results in loss

Note: Self-Insurance Compared to InsuranceRather than pay premiums for a policy from an outside insurance company, sometimes a party will choose to self-insure. Self-insurance is not true insurance, since it is only the advance financial preparation for possible losses and not a distribution of risk.

There are numerous types of self-insurance. One approach is the periodic se�ing aside of money into a fund to cover possible losses. Other ways to self-insure are book reserves, chronological stabilization plans and use of a captive insurance company. The advantage of self-insurance is the possible savings if losses are small or nonexistent. The disadvantages of self-insurance are both shortfalls due to incurring losses before a sufficient reserve is built up and overpayment from incurring losses greater than the cost of regular insurance premiums.

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Insurable InterestsInsurance compensates for substantial loss which the insured would directly suffer from an event. Therefore there must be a relationship between the policy owner, the insured and the event—this is called an insurable interest.

To have an insurable interest in property (such as fire insurance) the policy owner must have a legal interest in the insured property and a possibility of monetary loss. A legal interest may exist by owning the property or having an interest in the property such as a mortgage or a lease. The insurable interest is not required at the inception of the policy, but must be present at the time of the loss. An individual can insure only to the extent that he has an insurable interest. An individual with a contract to purchase property or in possession of property may have an insurable interest.

Note: Life insurance or property insurance which is wri�en without any insurable interest is considered a wager and the policy will not be valid. This prevents an unaffiliated person from simply be�ing that some other person will die or that the other person’s property will be destroyed. It also removes any financial incentive for criminal actions which could threaten the lives and property of others.

Types of InsuranceLife insurance, accident insurance, automobile insurance, fidelity insurance, liability insurance, malpractice insurance, term life insurance, ordinary life (whole life) insurance, limited payment life insurance, endowment policy, fire insurance and valued/unvalued policy are some examples of types of insurance available.

Life InsuranceWith life insurance, there must be a relationship so that the person taking out the insurance (the policy owner) has a legal right to the monetary loss upon the death of the insured. This insurable interest must exist when the policy is taken out, but is not necessary when the loss occurs.

There are two types of interest in life insurance.• Interest in one’s own life:

An insurable interest always exists in one’s own life. That is, everyone has an insurable interest in his own life, thus may insure his own life and may name anyone as beneficiary. Therefore, a beneficiary does not need an insurable interest.

• Interest in another person’s life: An insurable interest in another person’s life is automatically created by marriage and close blood relationships—so a person may validly insure his spouse’s life or his minor child’s life. The exception is that a parent does not have an automatic insurable interest in a child that has reached the age of majority. Some states require verification of a pecuniary link between the parties when insuring the life of a more remote family member such as an aunt or uncle (this is called economic expectancy). The insured’s consent to have his life insured is frequently required.

An insurable interest may also be created by business relationships, but it is typically capped by the value of the business relationship. A creditor has an insurable interest in the

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life of a debtor, but only to the extent of the debt. A partnership typically has an insurable interest in a partner’s life, but only to the extent of his share of the partnership. An employer may have an insurable interest in a key employee, etc. The insured’s consent to have his life insured is frequently required.

Types of Life Insurance• term life insurance—Term life insurance covers the insured for a fixed number of years. If

the insured dies within that term, then the life insurance policy pays. Term life insurance does not have a savings feature; therefore, it has no cash or loan value. It is typically less expensive than other types of life insurance and may be renewable at the end of each term.

• ordinary life or whole life insurance—Ordinary life or whole life insurance requires the insured to pay premiums over his life. A fixed sum is then paid to the beneficiary on the insured’s death. Whole life policies accumulate earnings which increase over the life of the policy. These earnings are called cash value and will be paid to the insured if the policy is surrendered. A policy’s cash value can also be used as collateral for loans. If a loan is outstanding at the time of the insured’s death, the beneficiary is not liable for the loan. The beneficiary will receive the face value of the policy less the loan and interest. Some whole life insurers pay dividends to the insured during the life of the policy.

• limited payment life insurance—Limited payment life insurance requires the payment of premiums over a fixed number of years, and the policyholder is insured for life. The premiums for limited payment life insurance are higher than for an ordinary life policy.

• endowment policy—With an endowment policy, the insured is required to pay premiums for a certain number of years. A predetermined amount is paid to either the insured’s beneficiary upon the insured’s death during these years or to the insured himself at the end of this period.

Other Types of Insurance• accident insurance—Accident insurance provides coverage against expense, suffering and

loss of earnings resulting from personal injury or property damage.• automobile insurance—Automobile insurance indemnifies against loss or damage to an

automobile from collision, the�, windstorm and fire, plus damage and personal injury caused to others. Most collision insurance has a deductible amount which the insured must pay. Some states have no-fault insurance which means that each owner’s insurance pays his expenses regardless of fault. Legal action is not permi�ed unless property damage and personal injury exceed a fixed threshold.

• fidelity or guaranty insurance—Fidelity or guaranty insurance insures against loss from dishonesty of employees or people in positions of trust.

• liability insurance—Liability insurance protects the insured against liability for accidental damage to people or property and typically includes the duty to defend the insured in a lawsuit brought by third parties. Intentional wrongs, such as fraud, are not included in this coverage. With liability insurance the insurer has no right against the insured for causing the loss, because the insurance is purchased to protect against the loss.

• malpractice insurance—Malpractice insurance is a form of personal liability insurance used by doctors, lawyers and other professionals. Malpractice insurance protects against liability for harm caused by errors or negligence in performing work, but does not protect against intentional wrongs.

• fire insurance—Fire insurance covers direct fire damage plus any indirect fire damage such as damage from smoke, water or chemicals. Fire insurance covers hostile fires but not

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damage from a friendly fire. Friendly fires include damage caused by smoke from a fire in a fireplace. Hostile fires are unintentional fires or fires that have le� the intended burning spot. A blanket fire insurance policy covers a class of property which may be changing, such as inventory, rather than a specific piece of property.

• valued policy—With a valued policy, the value of the property is predetermined and becomes the face value of the policy. A valued policy pays face value for a total loss and actual damages for partial destruction.

• unvalued policy—With an unvalued policy (open policy), the value of the property is determined at the time of the loss. An unvalued policy does have a stipulated maximum amount. With an unvalued policy, the insured recovers the fair market value of the destroyed property.

The Insurance ContractAn insurance contract is similar to a common law contract in that it requires an agreement, legality, capacity and consideration. Most insurance contracts are a unilateral contract where the insured prepays the premiums and the insurer promises to indemnify the insured against loss.

Insurance typically becomes binding at the time of the insurer’s unconditional acceptance of the application and communication of this to the policy owner. The application (from the policy owner) is the offer. The issuance of the policy (from the insurer to the owner) is the acceptance. If a company agent issues a temporary binding slip, the insurer is obligated between the time of application and issuance of the policy. The insurer may require that certain conditions be met before the policy becomes effective.

Voiding a PolicyThe insurer may void the policy if there is:

1. concealment—If the owner/insured failed to inform the insurer at the time of application of a fact material to the insurer’s risk that is concealment. In many states, any ma�er specifically asked by the insurer is automatically considered material. Therefore, failure to disclose or a misleading answer is concealment. The owner/insured is not required to disclose facts learned a�er making the contract.

2. material misrepresentation by insured—If a representation is substantially true, then it is acceptable.

3. breach of warranty—A warranty is a representation incorporated into the policy. It constitutes a condition that must exist before the insurer is liable and is typically assumed to be material.

Types of Clauses in an Insurance ContractBasically, four types of clauses exist:

1. incontestability clause—An incontestability clause means that a�er a certain period of time, typically two years, a policy cannot be contested because of concealment or misstatements. Some exceptions to this are nonpayment of premiums, no insurable interest, no proof of death or the risk is not covered by the policy.

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2. suicide clause—A suicide clause means that the policy will not cover the insured’s suicide for a certain period of time. Typically this time period coincides with the one used in the incontestability clause. A�er the time period expires, suicide is covered.

3. coinsurance clause—A coinsurance clause requires the owner/insured to bear a certain percentage of the loss when he fails to carry complete coverage. The amount of recovery from the insurer can be calculated as follows:

Formula recover = Actual loss xAmount of insurance

Coinsurance % x FMV of property

where FMV = fair market value

4. pro rata clause—A pro rata clause allows a person insured by multiple policies to collect only a proportionate amount of the loss from each insurer.

For example:

Company Amount of CoverageA $12,000B $20,000

Therefore, total coverage on the property is $32,000. Reported loss is $15,000. Company A is liable for $5,625, which is (($12,000/$32,000) x $15,000) of the loss, and Company B is liable for $9,375, which is (($20,000/$32,000) x $15,000) of the loss.

Other Contract ConditionsIn order for the beneficiary to collect, the owner/insured must give the insurer a timely statement of the amount of loss, cause of loss, etc. This statement must be completed within a certain specified period, i.e., 60 days. Failure to comply with the time requirement will excuse the insurer’s liability unless performance is made impracticable.

Most policies have a grace period which allows premiums to be paid within a certain period a�er payment is due without the policy lapsing. Even if the policy does lapse, some policies have a reinstatement provision which allows it to be reinstated within a certain period if the overdue premiums and interest are paid.

Limitations to CoverageCoverage limitations typically include intentional acts on the part of the owner/insured. Negligence or carelessness on the part of the insured is insurable and is generally not a defense for the insurer. Negligence on the part of the insured’s employees is also covered.

The policy cash value and policy proceeds cannot be a�ached by the policy owner’s creditors if the policy’s beneficiary is named irrevocably. In some states they cannot even be a�ached by the beneficiary’s creditors. On the other hand, if the named beneficiary is revocable, the policy owner’s creditors can a�ach the policy proceeds. In some cases, if the policy owner is in bankruptcy, his and/or the beneficiary’s creditors could even force the policy to be cashed out for its cash surrender value. However, if the beneficiary is the insured’s spouse, some states will not allow the beneficiary’s creditors to reach the proceeds.

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Termination ConditionsA life insurance policy may be terminated on expiration of a term policy, the owner’s failure to pay premiums, forfeiture or payment upon the insured’s death. Typically the insurer cannot cancel a policy. If an individual misstates his age either the premiums or the benefits will be adjusted accordingly. Misstatement of age is not material enough to void a policy.

Subrogation The rights of an insurance company to assume the injured party’s legal claims against third parties is called subrogation. A right of subrogation exists with accident, automobile collision, and fire insurance policies. However, no right of subrogation exists with life insurance policies.

Subrogation gives the insurer the right to step into the shoes of the owner/insured as to any cause of action against a third party whose conduct caused the loss. In other words, subrogation prevents the owner/insured from relinquishing his valid legal claim against third parties without the permission of the insurer. If the insured/owner grants a general release to the third party who caused the loss, then the insurer is released from his obligation to the insured/owner. Again, no right of subrogation exists with life insurance policies.

For example:

Dan owns a home and Edgar, his careless neighbor, causes the home to burn. Dan could sue Edgar to recover for the loss. If Dan has fire insurance, he would collect the policy’s proceeds and the insurance company could then sue Edgar in Dan’s place to recover for the loss. This is called subrogation. However, Dan cannot waive away Edgar’s liability. If he does, Dan can’t collect the policy proceeds.

Policy AssignmentSince life insurance policies are considered in the nature of an investment, they can be assigned. Life insurance policies may be assigned by the owner (the assignor). Assignment transfers the policy’s cash value, the ability to change beneficiaries, and the responsibility of making premium payments over to the new owner (the assignee). In the case of an irrevocable beneficiary, the owner cannot assign the policy without the beneficiary’s approval. Otherwise, once a life insurance policy is assigned, the current beneficiary could lose all rights if the assignee names a new beneficiary. Assignment typically requires notifying the insurer and adherence to various formalities.

Note: Proceeds from an in-process insurance claim are assignable even if the policy prohibits assignment of the policy itself. Fire policies are typically not assignable because of the risk. The property could be sold to someone who is not reliable. However, policy proceeds from a claim against an insurer may be assigned.

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SECTION 2.3: GUARANTY AND SURETYSHIP

PurposeSome individuals contract to share or assume the responsibilities of another person. In these cases, when the other person defaults on the responsibility, liability is instantly created for the individual who contracted to share the responsibility. Banks favor this sharing and assumption of responsibilities as it serves to reduce the risk of default.

Suretyship describes the relationship where one person agrees to be answerable for the debt or default of another person. It provides security for the creditor by a third person’s promise to be responsible for the debtor’s obligation. As a result, the creditor has an immediate and direct remedy against the surety, if the debtor does not pay or perform.

Guaranty and Suretyship Definitions• party—includes individuals and all types of business organizations• principal, principal debtor, or obligor—the party who borrows money or assumes direct

responsibility to perform a contractual obligation• creditor or obligee—the party entitled to receive payment or performance from the

principal or obligor• surety or guarantor—any party that promises the creditor to be liable in case of the

principal’s failure to pay or perform

Note: Today, the distinction between a surety and a guaranty has li�le significance. The general principals herein apply equally to sureties and guarantors. The two terms are used interchangeably.

Types of Guaranty Agreements

General versus Special guaranty agreements• general guarantor—A general guarantor’s promise is not limited to a single, specific

creditor. For example, a creditor can usually assign a principal’s performance to a second creditor. If a general guarantor secures the principal’s promise, then the creditor may similarly assign his rights regarding the guarantor’s performance to a second creditor.

• special guarantor—A special guarantor limits his promise to a single transaction and/or a specific creditor. A special guarantor’s promise cannot be assigned to a new creditor.

Continuing versus Restricted guaranty agreements• restricted guaranty—A restricted guaranty agreement is for a specified single transaction or

specified group of transactions.• continuing guaranty—A continuing guaranty agreement covers a contemplated series of

ongoing transactions over a period of time.

Absolute versus Conditional guaranty agreements• absolute guaranty—An absolute guaranty agreement comes into effect upon the default of

the principal. At that point the creditor may go directly to the guarantor to collect. In fact, a creditor can initiate action against the guarantor at the same time it is initiated against the principal.

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• conditional guaranty—A conditional guaranty agreement requires that the other acts (additional to the default of the principal) occur before the guarantor can be held liable.

Examples of a condition might be (1) requiring the creditor to follow certain collection steps, (2) requiring advance notice to the guarantor, or (3) requiring an independent evaluation of the principal’s performance to substantiate that default does indeed exist.

Compensated versus Uncompensated Guaranty AgreementsA guarantor’s promise to a creditor is contractual in nature and thus its validity and enforcement both depend upon the consideration exchanged between the two parties. In the case of both compensated and uncompensated guaranty agreements, the guarantor’s promise benefits the creditor since the creditor is concerned about the principal’s ability to perform his promise. This benefit is the consideration gained by the creditor. Naturally, this raises the concern about the consideration existing and flowing to the guarantor. Some guarantors are compensated and some are not.

Uncompensated GuarantorsAn uncompensated guarantor (e.g., a cosigner on a loan) doesn’t receive pay or anything else in direct exchange for his contract with the creditor. This could raise concerns about the contract’s validity. In uncompensated guarantor situations, the consideration given to the principal by the creditor is regarded as sufficient contractual consideration in exchange for the guarantor’s promise. However, because the guarantor is not compensated, both the legal interpretations and enforcement of the contract are eased. For example, even though the uncompensated guarantor must perform as promised, in recognition of the guarantor’s lack of compensation, the law typically protects the uncompensated guarantor against unexpected or enlarged liabilities beyond those specified in the agreement. Also, ambiguous provisions of agreements with an uncompensated guarantor are typically construed in favor of the unpaid guarantor. This is a result of the fact that ambiguous contract language is typically construed against the party writing it. With unpaid guarantors, the contract is usually framed by the creditor and only signed by the guarantor.

Compensated GuarantorsCompensated guarantors (e.g., bonding companies) receive some pay or other consideration in direct exchange for his contract with the creditor. This completely supports the contract’s legal validity and full legal enforcement. The consideration received by the guarantor is separate and distinct from the consideration promised to the principal. • The existence of compensation makes for firm legal enforcement of the contract against

the guarantor. Compensated guarantors are not as protected by the law as uncompensated guarantors, since they are viewed as being able to take care of themselves. Compensated guarantors typically frame their own contracts.

• As with an uncompensated guarantor, the compensated guarantor must perform as promised upon the principal’s default. However, in the case of a compensated guarantor, the law typically will fully and firmly enforce any unexpected liabilities or penalties beyond those specified in the agreement.

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• The existence of compensation also makes for very firm legal interpretations of the contract against the guarantor. Ambiguities in agreements with a compensated guarantor are construed against the compensated guarantor.

Other Examples of GuarantiesBusinesses relationships typically involve some level of trust and therefore risk. Typical standard formats for business bonds are:• Performance bonds—Performance bonds provide coverage against losses resulting from

the failure of a contracting party to perform the contract as agreed. With a performance bond, a bonding company acts as the guarantor. The bonding company promises to pay the party entitled to performance for losses resulting from nonperformance by the principal. The amount of losses covered is limited to the face value of the bond.

• Fidelity bonds—Fidelity bonds provide coverage for losses resulting from the dishonest acts of people. Fidelity bonds also have a stated maximum amount of losses to be covered.

Relationships Between a Creditor and a GuarantorAs in other contract relationships, the relationship between the creditor and the guarantor is fiduciary in nature and requires good faith and fair dealing. A creditor has a duty to disclose to the guarantor all information significant to the risk being assumed by the guarantor. The disclosure duty exists only if the creditor has reason to believe that the guarantor does not know the facts, and if the creditor has a reasonable opportunity to communicate them to the guarantor. If these factors exist, a creditor’s failure to inform a guarantor of relevant facts may release the guarantor from liability.

A guarantor’s promise to be liable for a principal’s obligation is created separately from and independently of the principal’s promise to perform for the creditor. A guarantor becomes liable to the creditor only when the principal defaults. Therefore, the guarantor is secondarily liable a�er the principal. Basically, a guarantor promises that the principal will perform as promised—if not, the guarantor will be liable for the debt.

Guaranty agreements usually result from an express wri�en contract between the guarantor and the creditor, whereby the guarantor assumes responsibility for the principal’s performance in the event of default by the principal. A guaranty contract requires consideration. In many cases this consideration is the same as that received by the principal.

Guarantor’s Rights and ResponsibilitiesGuarantors provide benefit to both the creditor and the principal by absorbing risk for them. Guarantors have responsibilities to both parties and are also entitled to certain rights from both parties.• The most important right of a guarantor who has completed performance is subrogation.

A guarantor who has performed the obligation of the principal is subrogated to the creditor’s rights against the principal. Therefore, if the creditor obtains a judgment against the principal, the guarantor receives the benefit of this judgment when he satisfies the principal’s debts.

• A guarantor may not avoid a contract because of misconduct on the part of the principal, even if the principal’s conduct induced him to become a guarantor. However, at the time of the contract, a creditor who is aware of the principal's misrepresentation has a duty to

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inform the guarantor. A creditor's failure to warn the guarantor may release the guarantor from liability.

• A guarantor becomes liable to the creditor as soon as the principal defaults. In most states, the creditor does not have to exhaust his remedies against the principal before seeking to recover from the guarantor. Even in states where there is such a duty, the guarantor can waive it in advance.

• The consent of the guarantor is required before a creditor may return collateral received from the principal. Since this is a loss of subrogation for the guarantor, he is released to the extent of the collateral's value.

• In the following three situations, the guarantor is entitled to notice before the creditor may take legal action against him.

1. A guaranty agreement is of a contractual nature and, therefore, may include a clause requiring the creditor to give the guarantor notice of the principal's default within a certain period. The courts will enforce such a clause requiring notice. Failure to notify the guarantor of the principal's default discharges the guarantor's liability.

2. A guarantor who is a drawer or endorser of commercial paper is entitled to notice. Any drawer of a dra� or check; or any endorser of a note, dra�, check or certificate of deposit becomes liable on the instrument if presentment for payment or acceptance occurred within a reasonable time, dishonor occurred and notice of dishonor was given within the time allowed. Therefore, an individual who becomes a guarantor as an accommodating party is entitled to be notified of the principal's default.

3. A guarantor who only guarantees collection is entitled to notice. A collection guarantor is not entitled to immediate notice that the principal had defaulted, but he should be kept appraised of what actions are being taken to collect from the principal. A collection guarantor is discharged to the extent that he suffers from a lack of notice.

Guarantor’s and Principal’s Defenses which can defeat a Creditor’s claimsThere are situations in which the contract itself is void and therefore the principal is not required to perform. There are other situations in which the principal has a valid excuse for not performing and thus cannot be considered to be in default of the contract. These situations can eliminate the guarantor’s liabilities.

For example:• a release of the principal by the creditor, thus ending the contract itself• a modification of the creditor-principal relationship (e.g., a large change in the contract, the

creditor’s acquisition of the principal, etc.)• nonperformance by the creditor which prevents the principal from performing (e.g., failure

to make progress payments, failure to provide required materials, etc.)• contract defenses that the principal can assert against the creditor in order to void the

contract (e.g., lack of a primary obligation, undue influence, duress, fraud, illegality, mutual mistake, impossibility, and lack or failure of consideration, etc.)

As a general rule, a guarantor may also use any defense that the principal can use to reduce his liability to the creditor as well. The guarantor can be protected by these defenses whether the principal is relieved of liability or not.

However, the following contract defenses are exceptions to this general rule:

1. The principal's lack of capacity does not relieve the guarantor of his liability.

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2. The principal's discharge in bankruptcy does not relieve the guarantor of his liability.

3. If the principal's performance is excused due to the statute of limitations running out, the guarantor is not relieved of his liability.

Rule of ReleasingAs a general rule, when a creditor voluntarily releases the principal’s liability, the guarantor is usually released as well. This is based on the fact that the surety is liable only on the principal’s default. The principal cannot default if the creditor releases his claim against the principal. Therefore, the guarantor cannot be held liable either.

Exceptions to the Rule of ReleasingThe following are exceptions to the general rule of releasing:

1. If a guarantor consents to a principal’s release, the guarantor is not released.

2. If a creditor releases a principal but reserves rights against a guarantor—and the guarantor knows but does not object—the guarantor is not released.

3. A release obtained by a principal’s fraud (e.g., a bad check) does not release the guarantor if the creditor rescinds the release prior to the guarantor ‘s reliance.

4. An extension of time for performance agreement must be a binding, enforceable contract if it is to affect the guarantor ‘s liability. Therefore, it must be for a definite time and supported by consideration. The creditor’s mere grant of an extension of time for performance has no impact on the guarantor’s liability. This conduct does not injure the guarantor, since he is free to perform at any time and pursue all available remedies upon the principal’s default.

5. If the creditor and principal formalize an agreement to extend the time of performance to a definite time, a nonconsenting, uncompensated guarantor is released from liability. A nonconsenting, compensated guarantor is relieved only to the extent that he is injured by the extension. If the guarantor consents to the extension, these general rules do not apply.

Rule of Discharge• Any other material modifications in the creditor-principal agreement typically discharge

the guarantor. A modification agreed upon by the creditor and principal acts as a novation (see Section 9.6, Contracts for a definition) and releases the guarantor from liability.

Exceptions to the Rule of Discharge1. A guarantor who consents to the modification is not discharged.

2. A nonconsenting, uncompensated guarantor is not discharged to the extent the modification benefits the guarantor.

3. A compensated guarantor is not discharged if the modification does not materially increase the guarantor 's risk.

Rule of ReimbursementA principal owes a guarantor the duty to perform and not to default. A�er the guarantor has satisfied the creditor’s claim, the guarantor has the right to be reimbursed by the principal.

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Exceptions to the Rule of Reimbursement1. If the principal informs the guarantor of a valid defense that can be asserted to deny the

creditor’s claim, and if the guarantor fails to use the defense, the guarantor is not entitled to reimbursement by the principal.

2. If a guarantor performed for the creditor a�er a principal had already performed or had been released, the guarantor is not entitled to reimbursement by the principal. However, in this case the guarantor does have the right to have the value of his performance returned from the creditor.

Coguarantors or SubguarantorsAny contract may have two or more guarantors called coguarantors or subguarantors. Coguarantors are jointly and severally liable to the creditor. This means that the creditor may sue them jointly or separately. A subguarantor promises to be liable if the guarantor defaults, in other words he is a guarantor’s guarantor. Typically, a subguarantorship is created by agreement of the parties, and a coguarantorship is created by implication.

SECTION 2.4: PARTNERSHIPS

PurposeBank transactions are based upon an accurate understanding of the financial status of each party, specifically the party’s assets and liabilities. It is essential to develop clear comprehension of all obligations (liabilities) that can ensue from a partnership.

Partnership Definitions• partnership—A partnership is an association of two or more people to carry on as

co-owners of a business for profit. Competent parties agree to place their money, property or labor in a business and to divide the profits and losses. Each person could be personally liable for the debts of the partnership. Express partnership agreements may be oral or wri�en.

• general partner—A general partner is liable for all partnership liabilities plus any unpaid contributions.

• limited partner—A limited partner is obligated to the partnership to make any contribution stated in the certificate, even if he is unable to perform because of death, disability or any other reason.

• silent partner—A silent partner does not participate in management• secret partner—A secret partner may advise management and participate in decisions, but

his interest is not known to third parties.• dormant partner—A dormant partner is both silent and secret.

Essential Elements of a PartnershipThe basic essential elements of a partnership are: a common interest in the business and management, and a share in the profits and losses. Most partnerships start with a pool of the partners’ capital. The partnership then conducts business using that capital, paying out costs and salaries. the remaining funds are profits and are returned to the partners in proportion

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to the amount of capital each has put into the pool. Typically, profits do not stay within the partnership but are flowed out to the partners.

Different Forms of Partnerships

General Partnerships Limited PartnershipsLimited Liability

Partnerships (LLP)Limited Liability

Companies (LLC)All partners are general partners.

one or more general partners with one or more limited partners

one or more general partners with one or more limited partners

All partners are considered members.

All partners manage the partnership together.

General partners manage; limited partners have less say.

General partners manage; limited partners have less say.

Either members manage or they select a manager.

If partnership obligations exceed partnership assets: all partners are personally obligated to pay partnership debts or tort liabilities (fraud, malpractice, etc.)

If partnership obligations exceed partnership assets: only general partners are personally obligated to pay partnership debts or tort liabilities (fraud, malpractice, etc.)Limited partners are only obligated to the extent of their existing contributions to the partnership.Note: Each partner is obligated to pay his own tort liabilities, whether a general or limited partner

If partnership obligations exceed partnership assets: no partner is personally obligated to pay partnership debts or tort liabilities (fraud, malpractice, etc.) Every partners’ personal wealth is protected and creditors can be left uncompensated. Note: Each partner is obligated to pay his own tort liabilities, whether a general or limited partner.

If partnership obligations exceed partnership assets: no partner is personally obligated to pay partnership debts. Every partners’ personal wealth is protected and creditors can be left uncompensated.

When a general partner dies or retires, partnership must be dissolved. (It can be restarted again without him.)

When a general partner dies or retires, partnership must be dissolved. (It can be restarted again without him.) Death or withdrawal of a limited partner is less disruptive: partnership can buyback his interests.

When a general partner dies or retires, partnership must be dissolved. (It can be restarted again without him.) Death or withdrawal of a limited partner is less disruptive: partnership can buyback his interests.

When a partner dies or withdraws, the partnership does not need to be dissolved.

The Partnership AgreementThe partnership agreement is called the articles of partnership and contains items such as the names of the partners and the partnership, its purpose and duration, the capital contributions of each partner, the method of sharing profits and losses, the effect of advances, any salaries to be paid the partners, the method of accounting and the fiscal year, the rights and liabilities of the partners on the death or withdrawal of a partner, and the procedures to be followed on dissolution. The Uniform Partnership Act or other partnership statutes are also a part of the agreement.

Provisions of a Partnership Agreement• profit-and-loss provision—Unless the agreement states otherwise, each partner has a right

to share equally in the profits of the business and a duty to contribute equally to the losses.

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Capital contributed by the partners represents a liability of the business to the contributing partners. If the partnership agreement specifies the division of profits but fails to mention losses, the losses are divided in the same proportion as the profits.

• partnership capital provision—The capital of a partnership consists of the total credits to the capital accounts of the various partners. These credits must be for permanent investments in the business. The partnership is obligated to return this capital to the partners at the time of dissolution. The partnership agreement determines the amount that each partner is to contribute plus the credit to be received for contributed assets.

• special authorization for one partner to admit new limited partners—If there is no special provision then the default position is that the partners will unanimously decide.

• firm name—The parties involved in a partnership select a name subject to two statute limitations in most states:

a. A partnership may not use the word “company” or other language that would imply the existence of a corporation.

b. If the name is other than that of the partners, there must be compliance with the assumed name statutes. These statutes require public notice as to the actual identity of the partners.

Note: The firm name is considered an asset and may be sold, assigned or disposed of in any manner agreed on by the partners. Most states allow partnership to sue or be sued in the firm name. Partnerships may also declare bankruptcy as a firm.

• provisions relating to goodwill—In evaluating the assets of a firm, goodwill is typically considered. Goodwill can be sold or transferred.

• provisions relating to partnership property—O�en the property classified as partnership property is determined by agreement between the parties. If there is no express agreement, the classification of partnership property is determined by the conduct of the parties and the way the property is used in the business. Most property acquired with partnership funds is partnership property.

• death provisions—These provisions regarding the disposition of partnership property upon death of a general partner.

• salary provisions—These provisions are to determine the salaries for partners who work within the business operations of the partnership.

• buy and sell provisions—All partnerships should provide for the contingency of death or withdrawal of a partner. Buy-sell agreements are used to cover this contingency. The provisions of such an agreement should be agreed upon before either party knows whether he is a buyer or a seller.

Buy-sell agreements provide a method whereby the surviving partner(s) can buyback (i.e. purchase) the interest of the deceased partner, or the remaining partner or partners can purchase the interest of the withdrawing partner. The agreement states the method to be used in determining the purchase price, as well as the time and method of payment and whether a partner has the option or the duty to purchase the interest of a dying or withdrawing partner. Generally, buy-sell agreements are funded by the partnership’s purchase of life insurance on each partner’s life.

Rights, Duties And Powers Of PartnersThe duties, rights and powers of partners are both expressed (in the agreement) and implied (created by law). The statutory law in most states is the Uniform Partnership Act.

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Partnership Rights

Control of the PartnershipUsually, general partners have more management influence over the business than the limited partners. All partners of the same type (general, limited) have an equal legal right in management and conduct of business, even if their capital contributions are not equal. The partners may agree to place management within the control of one or more partners (managing partners) or may hire nonpartners to manage. Each partner has the right to review and copy partnership financial and business records (on-site).

Ordinary ma�ers are decided by a majority of the managing partners. If the partnership consists of two persons who are unable to agree, and if the partnership agreement makes no provision for arbitration, then dissolution is the only remedy.

Matters requiring Unanimous Consent• changing the essential nature of the business by altering the original agreement or reducing

or increasing a partner's capital• embarking on a new business• admi�ing new general or limited partners (note: some partnership agreements allow for

admission of additional limited partners by nonunanimous decision)• modifying a general or limited partnership agreement• assigning partnership property to a trustee for the benefit of creditors• confessing a judgment• disposing of the partnership's goodwill (or the partnership’s name or other significant

assets)• submi�ing a partnership agreement to arbitration• performing an act that would make impossible the conduct of the partnership business

Note: Engaging a new client does not require the unanimous consent of the partners.

Financial Returns from the PartnershipPartners are not entitled to payment for services rendered in conducting the partnership’s business, but they may receive a salary. The payment of a salary to a partner requires either an express agreement stating such or may be implied from the partner’s conduct.

Capital contributions are not entitled to draw interest; a partner’s earnings on his capital investment are his share of the profits. Interest may be paid on advances to the partnership above the amount of originally contributed capital. Profits that are not withdrawn but are le� in the partnership are not entitled to draw interest. A partner has the right to assign his profit income from the partnership to another party, but he cannot sell or assign his rights to the partnership property.

Partnership DutiesIt must be remembered that a breach of these duties creates a liability to the partnership.• Each partner has the duty to give the person responsible for record keeping any

information necessary to efficiently and effectively carry on business. • Each partner must not impede the partnership’s ordinary business.

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• Each partner must act in accordance with the partnership agreement.• Each partner has the duty to communicate known facts to the other partners and have the

facts added to the partnership records.

Any inside or outside knowledge possessed by one partner and not revealed to the other partners is still considered notice to the partnership and the partnership is liable as if all partners had known the information. Therefore, A partner who possesses knowledge and does not reveal it to the other partners has commi�ed an act of fraud against the partnership and against the partners.• Each partner has a duty to refrain from using partnership property for personal use

or benefit, even though each has an equal right to possess partnership property for partnership purposes.

Possession of partnership property for nonpartnership purposes requires the other partner's permission. A partner cannot transfer partnership property or use partnership property in satisfaction of his personal debts.

Note: Property includes physical assets as well as manpower and informational resources. Using partnership information for personal gain (without permission) is a breach of this duty.• Each partner owes the others undivided loyalty, since a partnership is a fiduciary

relationship. Each partner must exercise good faith and consider the mutual welfare of all the partners in conducting business.

• Surviving partners, in the case of a partner's death, must wind up the affairs of the partnership in accordance with the partnership agreement and the applicable laws.

Partnership Powers • power to contract—The general laws of agency apply to partnerships, since a partner is

considered an agent for the partnership business. A partner may bind the partnership with contractual liability whenever he is apparently carrying on the partnership business in the usual manner. Otherwise, a partner cannot bind the partnership without the authorization of the other partners.

Implied powers to contract

a. to compromise, adjust, and se�le claims or debts owed by or to the partnership

b. to sell goods in the regular course of business and make warranties

c. to buy property within the scope of the business for cash or on credit

d. to buy insurance

e. to hire employees

f. to make admissions against interest

g. to enter into contracts within the scope of the firm

h. to receive notices• power to impose tort liability—The law imposes tort liability (for an explanation of

tort liability see section 9.5 Agency) on a partnership for all wrongful acts or omissions of any partner acting in the ordinary course of the partnership and for its benefit. The partnership has the right of indemnity against the partner at fault.

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• powers over property—Partners have implied authority to sell to good-faith purchasers personal property that is held for resale and to execute the necessary documents to transfer title. To sell the fixtures and equipment used in the business requires the other partners’ authorization. The right to sell a business’ real property is implied only if it is in the real estate business. Other transfers of real property require partnership authorization.

• financial transactions—Partnerships are divided into trading and nontrading partnerships to determine the limit of a partner’s financial powers.

A trading partnership engages in the business of buying and reselling merchandise. Each partner has an implied power to borrow money and to extend the credit of the firm, in the usual course of business, by signing negotiable paper.

A nontrading partnership engages in the production of merchandise from raw materials or sells services. In these partnerships, a partner’s powers are more limited. A partner does not have the implied power to borrow money.

Acts of NonpartnersActs of nonpartners who have apparent authority may bind the partnership. Usually, when dealing with an outside party only a partner can make commitments that are binding on the partnership. However, an important caveat exists when an individual who is not a partner conducts himself as though he has authority and makes commitments with an outside party. With regards to an outside party, partnership liability may be predicated on the legal theory of estoppel. If a person (by words spoken or wri�en, or by conduct) represents himself as a partner in an existing partnership, then that person is an apparent partner and is liable to any party to whom such representation has been made.

The apparent partner may even be liable if credit is extended to the partnership. Some courts claim that if a person is held out as a partner and he knows it, he should be chargeable as a partner unless he takes reasonable steps to give notice that he is not. Other courts claim that there is no duty to deny false representation of partnership if the apparent partner did not participate in making the misrepresentation.

Extinguishment of a PartnershipExtinguishment can occur two ways:

a. through restructuring—If the partners are restructuring (i.e., adding or subtracting a partner and adding or subtracting that partner’s finances,) then the enterprise is still going to continue doing business, albeit with changes in the finances and people involved.

b. permanently—If the partners cease doing business together and the entire enterprise is stopped, then the enterprise is permanently extinguished and the people leave with their shares of the partnership finances. Some of the people could then get back together, although typically they do not.

Steps in Extinguishment1. dissolution—Dissolution is the legal destruction of the existing partnership relation. It

can be the beginning of the end (“b” above) or a step in restructuring the partnership (“a” above). This destruction occurs whenever any partner ceases to be a member of the

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firm or a new partner is admi�ed. However, dissolution itself does not actually terminate the partnership; it specifies the time when partners cease to do business as they have in the past and (in the case of one partner exiting and the others remaining) start a new partnership structure. Dissolution is the only step in scenario “a” above. Dissolution is the first of three steps in scenario “b” above.

2. winding up—Winding up is the process of reducing the assets to cash, paying off the creditors and distributing the balance to the partners. This is done a�er dissolution only when the partnership plans to cease all partnership operations. (See scenario “b” above.)

3. termination—Termination occurs when the winding-up process is completed. (See scenario “b” above.)

Step #1—Dissolution Remember, dissolution most o�en means that one or more partners are exiting the partnership; it doesn’t necessarily mean that the remaining partners will cease doing business together. Usually, dissolution ends the actual authority of any partner to act for the partnership except to wind up partnership affairs, liquidate the assets of the firm in an orderly manner or complete transactions begun but not finished. Dissolution also terminates the actual authority of a partner to bind the partnership, except as necessary to wind up the business. As far as third parties are concerned apparent authority exists until notice of termination is given.

There are three ways to dissolution most commonly occurs:

1. through an act of the partners—A partnership at will occurs when a definite term of duration of a partnership is not specified in the agreement. With this type of partnership, any partner may legally dissolve the partnership at any time and take his share of the partnership. All the partner would have to do is give notice to the other parties. The other partners o�en choose to continue doing business.

2. through a court decree—A court of equity may order dissolution under the following circumstances:a. a partner is unable to conduct business and to perform the duties required under the

contract of partnershipb. a declaration by judicial process that a partner is insanec. a breach of the partnership agreement, misappropriation of funds or commitment of

fraudulent acts by one of the partnersd. application of an innocent party, because the partnership was entered into as a result

of fraude. impossibility of carrying out the purposes of the partnership agreement due to the

gross misconduct and neglect or breach of duty by a partnerf. (in some states) any grounds that are equitable or in the best interests of the partners

3. through an operation of law—Dissolution by operation of law occurs when events make it impossible or illegal for the partnership to continue. These events include the death or bankruptcy of a partner, a change in the law or a revision that makes the continuance of the business illegal.

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Rights of Partners in a DissolutionIf the dissolution is caused in any other way than breach of the partnership agreement, each partner has the right to insist that all of the partnership assets be used first to pay firm debts. Remaining assets are used to return capital contributions and distribute any profits. A majority of the partners selects the method and procedures to be used in winding up.

If the duration of a partnership is fixed by agreement and one partner wrongfully withdraws, the remaining partners may continue the business under the same name for the remainder of the term. The remaining partners must se�le with the withdrawing partner for his interest in the partnership and for compensation. The partners may deduct from the amount due any damages caused by the wrongful dishonor.

A�er dissolution of a partnership the partners have no authority to create liability but existing liabilities are not discharged. A firm’s creditors are not bound by an agreement between the partners that one or more of the partners will assume the partnership liabilities and that the withdrawing partner will not have any liability. The only way a withdrawing partner may be discharged from existing liability is by agreement with the creditors. This agreement may be expressed or implied from the parties’ conduct.

If a firm’s assets are insufficient to pay its debts, third parties may lay claim to the partners’ individual property for all debts created while the partnership existed. However, creditors of the individual partners have first claim on their individual property.

Rights of the Withdrawing Partner• A withdrawing partner who has not breached the partnership agreement may on

dissolution require the partnership to cease doing business, (i.e., require that the partnership be wound up and terminated.) The partnership is then liquidated, and the assets distributed among the partners.

• A withdrawing partner may not require the partnership to cease doing business, (i.e., allow the business to continue or accept the fact that it has continued.) In this case, the value of the withdrawing partner's interest in the partnership is ascertained as of the date of dissolution. The withdrawing partner may then receive the value of his interest in the partnership plus any future interest. In lieu of interest, the withdrawing partner may receive the profits a�ributed to the use of his rights in the property of the dissolved partnership.

Parties Entitled to Notice of Dissolution:1. The firm's creditors, including former creditors, are entitled to actual notice of the

dissolution. If such notice is not given, withdrawing partners and the estate of deceased partners can be bound by transactions entered into a�er dissolution. Notice eliminates the apparent authority to bind the former firm and its partners. Notice of dissolution is required unless a partner becomes bankrupt, or the continuation of the business becomes illegal.

2. If the dissolution is caused by an act of the parties, public notice must be given. Notice by publication in a local newspaper is sufficient public notice.

Step #2—Winding UpA partner’s share of the partnership assets or profits may be determined in a suit for an accounting. These suits are equitable in nature and must be filed in a court of equity.

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Partners may make a complete accounting and se�le their claims without resort to a court of equity. An accounting is performed on the dissolution of a solvent partnership and winding up of its business. All firm creditors other than partners are entitled to be paid before the partners are entitled to participate in any of the assets.

A partner is entitled to a formal accounting in the following situations:• the partnership is dissolved• an agreement calls for an accounting at a definite date• one partner has withheld profits arising from secret transactions• an execution has been levied against the interest of one of the partners• one partner does not have access to the books• the partnership is approaching insolvency and all parties are not available

Step #3—Termination

Distribution of Partnership AssetsThe assets are distributed among the partners as follows:• Any partner who has made advances to the firm or has incurred liability for—or on behalf

of—the firm is entitled to reimbursement.• Each partner is entitled to return of his capital contributions.• Any remaining balance is distributed as profits in accordance with the partnership

agreement.

If a firm is insolvent and a court of equity is responsible for the distribution of the partnership assets, they are distributed in accordance with a rule known as marshalling of assets. The firm’s creditors may seek payment out of the firm’s assets and then the individual partner assets. The firm’s creditors must exhaust the firm’s assets before recourse to the partners’ individual assets.

The descending order of asset distribution of a limited partnership is as follows:

1. to secured creditors other than partners

2. to unsecured creditors other than partners

3. to limited partners in respect of their profits

4. to limited partners in respect of their capital contributions

5. to general partners in respect of any loans to the partnership

6. to general partners in respect of their profits

7. to general partners in respect of their capital contributions

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The asset distribution hierarchy of a limited partnership is shown below:

First priorityCreditors

SecuredUnsecured

Limited partnersCapital contributions

Loans

Last priorityGeneral Partners

ProfitsCapital contributions

Actions Against Other PartnersTypically a partner cannot maintain an action at law against the other partners, because the indebtedness among the partners is undetermined until there is an accounting and all partnership affairs are se�led. However, there are exceptions to this rule if: (1) the partnership is formed to carry out a single venture or transaction, (2) the action involves a segregated or single unadjusted item or account, or (3) the action involves a personal covenant or transaction entirely independent of the partnership affairs.

Admitting a New PartnerIf a partnership admits a new partner, the new partner is liable to the extent of his capital contribution for all obligations incurred before his admission. However, the new partner is not personally liable for such obligations, even if he is a general partner.

SECTION 2.5: AGENCY

PurposeBesides any routine personal liabilities, an individual may have additional liabilities arising from either acting as an agent for another person or from having an agent acting on his behalf. Having an agent or acting as an agent can create substantial tort or contract liabilities.

Types of Parties, Principals and AgentsThree types of parties are involved in agency arrangements: the principal (P), the agent (A) and the third party (T). Rather than perform some act or role himself, the principal instead contracts the agent to carry out the act or role for him. When the agent is carrying out the act or role, he frequently does business with another person. This other person is third party. In cases where the agent commits some wrong or has an accident, the person harmed is also called the third party.

For example:

P contracts A to sell his car. T is the person who buys the car from A.

P hires A to be his delivery van driver. T is the person that A runs over.

Main Definitions• agency—the fiduciary relationship that exists when one party acts on behalf of and under

the control of another

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1. power of a�orney—One common type of agency is the power of a�orney. This is a formal document for conferring authority on an agent. Frequently, a power of a�orney is signed by the principal in the presence of a notary public. The agent in this case is called an a�orney in fact. A general power of a�orney gives the agent the authority to act in most respects for the principal and has a broad scope of authority. However, it is not unreasonable or unlimited. A power of a�orney may also be narrowly wri�en and thus closely limit the permissible scope of the agent’s actions to a single aspect or transaction.

• agent—the party who acts for the principal

1. broker—an agent with special, limited authority to obtain a customer for an owner who wants to sell or exchange property

2. factor—an agent who has possession and control of another’s personal property and is authorized to sell that property

3. general agent—an agent who is authorized to conduct a series of transactions in the continuous service of the principal

4. special agent—an agent who is not in the continuous service of the principal

5. independent contractor—a person whose services are contracted for by another person. The independent contractor has a certain end result to accomplish and may determine the manner and methods used to obtain that result. Because he works under his own direction and not the principal’s, an independent contractor’s mistakes or misdeeds o�en do not implicate the principal.

• principal—the party who controls the agent and for whom the agent acts

1. disclosed principal—An agent for a disclosed principal reveals the principal’s identity.

2. undisclosed principal—The principal’s existence is a secret from the third party.

3. partially disclosed principal—The third party knows that a principal exists but does not know the principal’s identity.

Who can be a Principal?Typically anyone who may act for himself may also act through an agent. A principal must be legally competent (not insane, nor deceased). Some states hold that a minor cannot validly appoint an agent, and therefore, those agent’s actions are voided. Other states allow a minor to be a principal and to appoint an agent. However, any agreements made by the agent on the minor principal’s behalf are voidable (by the minor) as though the minor had made them himself.

Who can be an Agent?Anyone can be an agent provided that they actually consent to that role. An agent needs only to be appointed—either in writing or orally—by the principal. The agency may be either expressed or implied. If an agent is to negotiate a contract required to be evidenced by a writing under the statute of frauds, most states require that the appointment of the agent must also be evidenced by a writing. (For a more detailed review of the statute of frauds, see section 9.6-Contracts.)

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Implied Duties of a Principal• fiduciary duty—The principal must be loyal and honest in dealing with the agent.• duty to compensate in general—An agent is entitled to compensation for his services.

The amount of compensation is commonly stated in the contract. If not, the amount of compensation is the reasonable value of the agent’s services—taking into account past custom and practice.

• duty to compensate sales representatives—A salesperson is entitled to a commission on sales solicited and induced by him.

• duty to reimburse—A principal has the duty to reimburse the agent for any reasonable expenses incurred on behalf of the principal.

• duty to indemnify—A principal must hold an agent harmless or free from liability for certain tort losses, if the liability results from obeying the principal’s instructions.

Implied Duties of an AgentAn agent has a duty to always remain within the scope of his principal’s conferred authority. An agent who exceeds his actual authority and binds the principal to the third party is liable to the principal for any resulting loss or damages. In fact, any breach of a duty creates an agent’s liability.• duty of loyalty—Any fiduciary relationship is based upon the duty of loyalty. While

employed by the principal, an agent should not undertake a business venture that competes or interferes with the principal’s business nor make any contract for himself that should have been made for the principal. Breach of this duty can result in the principal’s enjoining the agent’s new business or recovering money damages or both. In addition, an agent may not enter into an agreement on the principal’s behalf if the agent is the other contracting party. The principal may rescind any transaction that violates the duty of loyalty. Any profit realized by the agent in such a transaction belongs to the principal. The principal may also collect an amount equal to any damages sustained as a result of the breach.

Note: An agent may not represent two principals in the same transaction if the principals have differing interests.

• duty to protect confidential information—An agent has a duty to protect the principal’s confidential information—usually called a trade secret. The important issue in cases involving trade secrets is whether the information sought to be protected is, in fact and law, confidential. This is determined by the conduct of the parties and the nature of the information.

• duty to obey instructions—An agent has a duty to obey all instructions issued by the principal as long as they fall within the duties outlined in the contract. An agent has no reason to question a procedure outlined by the principal, unless it is illegal or immoral. An agent may be liable to the principal for any loss that may occur due to his not following instructions. Failure to perform may result in discharge.

• duty to inform—Knowledge obtained by the agent, while acting within the scope of his authority, is considered notice to the principal and is binding on the principal. Therefore, the agent is required to disclose all material facts to the principal. An agent who fails to inform the principal can be liable to the principal for any resulting damages.

Note: Knowledge obtained by the agent while acting outside his scope of authority is not effective notice to the principal.

• duty not to be negligent—An agent has a duty to act in good faith and to exercise reasonable care and diligence in performing his tasks. Therefore, if the principal becomes

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liable because of negligent acts on the part of the agent, the principal may recover from the agent.

• duty to account—An agent must maintain proper records showing receipts and disbursements.

Agent’s Authority, Delegation of Authority and Liabilities

Agent’s AuthorityMost business contracts are entered into by agents on behalf of their principals. These contracts bind the third party and principal contractually. For an agent to create a binding contract between the principal and third party, the agent must have the actual, apparent or inherent authority or the principal must have ratified his actions.

An agent may be granted actual authority to act on behalf of a principal. On the other hand, the principal may allow the agent to believe himself to possess authority. A principal may bind himself by ratifying an unauthorized contract. Ratification requires that the principal—with knowledge of all material ma�ers—express or imply adoption or confirmation of a contract entered into on his behalf by a person with no authority to do so. The principal’s conduct, inconsistent with the intent to reject the contract, implies ratification.

Agent’s Delegation of AuthorityAn agent may delegate his duties to a third party called a subagent only if the agent’s acts require no discretion and are purely mechanical. The acts of the subagent are considered acts of the agent. In certain cases, the agent may have actual authority to appoint other agents for the principal. These subagents are considered true employees of the principal and are entitled to compensation from the principal.

Agent’s LiabilitiesAn agent acting within the scope of his authority is not liable to the principal. The one exception to this rule is when an undisclosed principal has se�led with the agent prior to the principal’s disclosure to the third party. In that case, the agent is liable to the principal to perform the contract as instructed. For example, when an agent enters into a contract for the purchase of real property from Mr. Jones without disclosing that he is acting for a principal, Mr. Jones can make claims against either the agent or the principal.

Undisclosed Principal/Agent LiabilitiesIt is not common for an agent to become bound to a third party, because the principal takes the agent’s place for liability purposes. However, an agent of an undisclosed principal may be liable to the third party:• if the principal se�les with the agent before becoming disclosed• if the third party elects to hold the agent liable instead of the principal a�er the principal's

disclosure• based on the way the agent signs the agreement or due to the language of the agreement• if the agent exceeds his actual and apparent authority and the principal does not ratify

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Other’s LiabilitiesA third party is liable to a disclosed principal for any contract created by an authorized agent. A third party must perform for an undisclosed principal if the contract is assignable and created by an authorized agent. If the third party does not perform, an agent for an undisclosed principal can enforce the contract and may sue in his own name.

Tort LiabilitiesIn the language of tort liability, a master is one who employs another person. A servant is a person who is employed with or without pay to perform personal services for a master and is subject to the master’s right or power of control. As described above, an independent contractor renders services but retains control over the manner of rendering such services.

If a person’s action causes injury to someone, a tort has been commi�ed and the person who commits a tort is personally liable to the person whose property or body is injured or damaged. If two people were responsible for the action, they can share liability for the injury. This is called joint and several liability.

An agent, servant or independent contractor is not liable for the torts, mistakes or misdeeds of the principal, master or employer. However, the opposite is not true. If an agent or servant commits a tortious act, then the principal, master or employer can be held jointly and severally liable for the torts (along with the agent).

Note: The agent is not relieved of liability for his tortious act even if the tortious act is commi�ed under the direction of a principal. In recognition of the principal’s lack of involvement, an independent contractor working autonomously is liable for his own mistakes or misdeeds and usually does not share liability with the principal.

Respondent superior is a concept which states that a master is liable to third persons for torts commi�ed by his servants within the scope of their employment and in pursuance of the master’s business. This concept imposes vicarious liability on employers as a ma�er of public policy, since it is assumed that the master is in a be�er position to pay for the wrong than the servant. The master is liable only when his business is being carried on or the wrongful act was authorized or ratified.

Determining if a tort is committed within the scope of employmentThere are several factors to take into consideration when determining whether a tort is commi�ed within the scope of employment. They include:• nature of the employment—What does the agent do for the employer? What was he doing

when the tort occurred?• right of contract (not only as to the ultimate result but also as to the means used to get

there)—How much latitude does the agent have in doing his work?• instrumentality—The instrumentality used in the tort could be the building where the tort

occurred, the materials used, or the vehicle or equipment used in commi�ing the tort.• furnishing the instrumentality—Was the instrumentality furnished by the employer or the

agent? • authorization—Was the agent’s use of the instrumentality authorized? • time—Did the tort occur during work hours or during a work task?

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ExceptionsMost courts inquire as to the intent of the servant and the extent of deviation from expected conduct involved in the tort. This means that in certain exceptional situations the master is not liable for torts commi�ed by the servant.

Such exceptions include:

1. frolics—A frolic occurs when a servant neglects his master’s business and pursues his personal interests.

2. intentional torts—The master is not liable if the intentional tort has nothing to do with his business and is prompted by a feeling of ill will toward the third party.

3. connectability—The master is not liable if the employee’s act has no reasonable connection with his employment.

4. destruction or illegality—The master is not liable if the employee’s act involves destruction or illegality of the agency’s subject ma�er.

Liability of Disclosed versus Undisclosed PrincipalsA disclosed principal protects his agent from liability as long as the agent is acting within his granted scope of authority. Thus, a disclosed principal becomes liable to a third party who enters into a contract with an authorized agent. Disclosed principals also become liable to third parties if they ratify an unauthorized contract. However, an agent who exceeds his authority becomes personally liable to the third party, if the principal does not ratify the contract. Any time prior to ratification, the third party may withdraw from the contract.

Undisclosed principals are liable to agents who enter into contracts within their actual authority. Neither apparent authority nor ratification can occur since these events arise from the principal-third party relationship, and there is no principal-third party relationship with an undisclosed principal. Undisclosed principals become liable to third parties only when the agent acted within the scope of actual authority and the contract is of the type that can be assigned to the undisclosed principal.

The law views the liability of partially disclosed and undisclosed principals as being the same. Therefore, any discussion of an undisclosed principal’s liability applies to a partially disclosed principal as well.

Termination of Principal-Agent RelationshipsThe agency relationship is terminated upon the death, bankruptcy or incapacity of either party.

Termination of the principal-agent relationship may also occur by:

a. mutual agreement—The parties may agree in their contract to terminate the relationship at a definite point in time or on completion of a task. The parties may also mutually agree to cancel their relationship.

b. unilateral action—Either party to an agency agreement may act independently in terminating an agency unilaterally. Either party has full power to terminate the agreement even though he has no right. If the termination occurs prior to the termination date stated in the agreement, it is considered a wrongful termination. The breaching party may become liable for damages suffered by the other party.

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c. termination at will—When the agency agreement does not state a definite time period, either the principal or the agent may terminate the relationship. Both parties have the legal right to terminate the relationship. In this case, there is no breach of contract and no liability is incurred.

ExceptionsExceptions to the termination of an agency agreement include:• agency coupled with an interest—This relationship exists when the agent has an actual

beneficial interest in the property that is the subject ma�er of the agency (i.e., a mortgage or security agreement.) This type of agency cannot be terminated unilaterally by the principal and is not terminated by events such as death or bankruptcy of the principal.

• agency coupled with an obligation—An agency coupled with obligation is created as a source of reimbursement to the agent. For example, an agent may have a right to sell a certain asset belonging to the principal and apply the proceeds on a claim against the principal. This type of agency cannot be unilaterally terminated by the principal, but does terminate on death, bankruptcy or incapacity of the principal.

Notice of TerminationA principal must give notice of an agency termination to all third parties who have learned of the agency. Notice may be given personally or publicly (constructive notice). The type of notice required depends on the third party’s relationship to the agent. If a third party has dealt with an agent and if the agent is terminated by the acts of the principal or agent, then the principal must give personal notice to the third party. If the agency is terminated by action of law, such as death, incapacity or bankruptcy, the principal is not required to notify third parties. These ma�ers usually receive public notice, and third parties become aware of the termination. In all cases, if the third party has not dealt with the agent public notice is sufficient. If proper notice is not given, the agent’s apparent authority will continue to exist.

SECTION 2.6: CONTRACTS

PurposeTwo or more parties intending to transact business can form a contract and therefore bind themselves and each other to their specific promises. A valid contract creates legally enforceable obligations. Legally enforceable obligations can be completely fixed and final. Some obligations may be contingent and depend on future circumstances, yet still be legally enforceable.

If an individual has formed contracts with other parties, his accrued fixed and contingent obligations could be a very substantial portion of his overall financial status. When assessing an individual’s financial status, all of his contractual commitments must be carefully reviewed and understood as current or future, fixed or contingent.

Definitions• contract—A contract is a commitment concerning the future conduct of the parties. The law

sanctions the commitment by pu�ing its legal enforcement machinery behind it.

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• offeror/promisor—An offeror or promissor is one of the parties to a contract, typically the one who initiates the final exchange of promises, (i.e., the one who makes the offer.)

• offeree/promisee—An offeree or promisee is one of the parties to a contract, typically the one who responds to the final exchange of promises, (i.e., the one who receives the offer and accepts or rejects it.)

• bilateral contract—A bilateral contract is a promise exchanged for another promise, in other words, mutual promises (Most contracts are of this type.)

• unilateral contract—A unilateral contract is a promise exchanged for an act of performance, (i.e., the offeror promises the offeree a benefit if the offeree performs some act.)

• option contract—An option contract is an offer that cannot be revoked for a certain time period so that the offeree can decide whether or not to accept it.

• express contract—When the parties state their agreement orally or in writing, it is an express contract.

• implied-in-fact contract—When the agreement is manifested only by the two parties’ conduct, but not in any writing, it is an implied-in-fact contract.

• implied-in-law or quasi contract—This is similar to an implied-in-fact contract. For example, when A’s conduct (mis)leads B to think they have a certain firm agreement and B relies upon that agreement. B then gives some benefit to A, but A refuses to honor the unspoken agreement.

Note: Courts permit the party who has conferred a benefit to recover the reasonable value of that benefit. This is to prevent the unjust enrichment of one party at the expense of another.

• valid—A valid contract adheres to the legal requirement for a contract and is enforceable in court by either party.

• void contract—A void contract is not a contract in the eyes of the law. There is no legal machinery to protect the bargain of the parties and it will not be enforced in court.

• voidable—A contract is voidable if one or more parties have the power to end it. The law will enforce the contract unless one party elects to disaffirm it.

• performance—Performance is the term used to describe what the promisee/offeree and promisor/offeror agree to do for one another.

• executed performance—An executed performance contract has been fully performed by the contracting parties.

• executory performance—An executory performance contract has yet to be performed by the contracting parties.

• mutuality of obligation—This requires that each party be bounded or neither party is bound. The doctrine of mutuality of obligation applies only to bilateral contracts.

• avoid—Avoid is a verb meaning to undo or make void an agreement or action.

Elements of a ContractAll these elements are required for a contract to be valid and enforceable:

1. offer and acceptance—A contract is basically a manifestation of the parties’ mutual assent reached through an offer and its acceptance. A wri�en agreement is only required in certain situations.

2. bargained-for consideration—This legally validates that there was some sort of exchange at the basis of the mutual assent.

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3. legal capacity to consent—In order to bargain and reach agreement, parties must meet some basic level of competence and legal responsibility.

4. legal purpose—Contracts enforced by the law cannot conflict with the law or be at odds with public policy.

First Element: An Offer and its Acceptance A conditional promise made by the offeror to the offeree is an offer. The promise is conditional because the offeror is not bound unless the offeree (1) performs an act, (2) refrains from performing an act, or (3) promises to do something or refrain from doing something. An agreement is reached when the offeree complies with the terms of the offer within the proper time period. For example, an application is the offer and issuing an insurance policy is acceptance. A wri�en agreement is needed to form a contract for the sale of real estate but it is not necessary in most other contracts.

How to Determine Whether an Offer Was MadeThis requires:• evaluating the language used—An offer requires words of present commitment or

undertaking.• definiteness of offer—This allows a court to be reasonably certain regarding the nature and

extent of assumed duties.• examining the addressee—The communication must sufficiently identify the offeree or the

class from which the offeree should emerge. No offer exists if the addressee is an indefinite group.

Duration of A Properly Communicated Offer A properly communicated offer continues in existence until it:• lapses or expires—If a definite expiration date is not stipulated, the offer remains open for a

reasonable time. Time is measured from the time the offeree receives the offer.• is rejected by the offeree—Even if an offer is open for a specified period of time, a rejection

will terminate the offer. Rejection terminates the offer on receipt by the offeror or his authorized agent. The effect of a counteroffer is to create a new offer and to reject the original offer.

• is terminated by operation of law—When an offer is terminated by operation of law, notice of this occurrence does not have to be given to the offeree or offeror. Events that by law terminate an offer include: the death or adjudged insanity of either party, the destruction of the subject ma�er of the offer, or illegality that occurs a�er the offer is made.

• is revoked by the offeror—An offer that is not irrevocable may be revoked by the offeror any time before acceptance, even if the offeror has promised to hold the offer open for a definite period. This revocation can be communicated to the offeree either directly or indirectly. A direct revocation is effective when received by the offeree. Indirect revocation occurs through some third party not associated with the offeror and becomes effective when the offeree becomes aware of it.

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Irrevocable OffersAn offer may be irrevocable because:• it is an option contract—An option contract occurs when the offeror sells his power to

revoke to the offeree. The offeree has obtained control of the revocability of the offer, at least for a specified time.

• of legislation—A merchant’s offer is irrevocable without consideration. A merchant must sign a writing that the offer will be held open. The offer is then irrevocable for the time stated in the offer or, if not stated, for a reasonable time.

Note: The time for the offer to be irrevocable cannot exceed three months.• of the conduct of the offeree—Once the offeree starts to perform or relies on the offer, the

offeror loses the power to revoke the offer.• of acceptance—This includes any indication by the offeree of his willingness to be bound

by the terms of an offer. Acceptance may take the form of performing an act (unilateral offer), communicating a return promise to the offeror (bilateral offer), or signing and delivering a wri�en instrument. An offer can be accepted only by the person to whom it is made. The offeror has the power to control both the manner (promise or performance) and mode or medium (phone, mail, telegram, etc.) of acceptance. Acceptance is effective at the time it is dispatched.

Second Element: Bargained-For Exchange of Consideration The contents of contracts are basically promises. A promise may be exchanged for another promise, for performance of an act, or for a forbearance of an act. The offeror (the promisor) says that he will do X if the offeree (the promisee) will agree to do Y. Keep in mind that while courts generally do not get involved in determining whether consideration is adequate, a contract so one-sided that it is unconscionable may be unenforceable.

Some examples:

Offeror/Promisor: “I promise to pay you $100 if you promise to paint my fence”

Offeree / Promisee: “I agree. I promise to paint your fence”

or

Offeror/Promisor: “I promise to paint your fence if you promise to pay me $100”

Offeree/Promisee: “I agree. I promise to pay you $100”

NOTE: Promises can be in different forms. (See later sections.)

Three elements must be present in the bargained-for exchange of consideration:

1. The promisee must suffer legal detriment. A legal detriment can be a promise to perform an act that one had no prior legal obligation to perform. It can also be to refrain from doing something that one could legally do and had no prior legal obligation not to do.

2. The promisor’s promise in question must induce the promisee’s legal detriment.

3. The legal detriment must induce the making of the promise.

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Defective PromisesA promise may be defective because:• it is illusory—An illusory promise is a statement that purports to be a promise but is not

because the promisor need not perform it. There must be a possibility that the promisor will incur legal determinant or the promise is illusory.

• the promisee is already bound to do what he promises to do—This is called a preexisting duty. No legal determinant occurs when one promises to do what one is already legally obligated to do or promises to refrain from doing what one legally cannot do.

• the promise is to forbear from suing, but the promisor has an invalid claim—Forbearance to assert an invalid claim is determinant if the claim is asserted in good faith and is not unreasonable.

Promissory EstoppelThe legal doctrine of promissory estoppel sometimes validates a promise even when bargained-for exchange of consideration is not present. Since there is no exchange of consideration, the promise isn’t actually a contract. The doctrine of promissory estoppel is the legal means used to enforce such promises almost as though they were contracts. If a promisor’s promise can be expected to induce a promisee to make a detrimental change in his position, then promissory estoppel forces the promisor to fulfill his promise. This is the law’s a�empt to provide equity (i.e., fairness).

Third Element: Legal Capacity to ConsentMinors (people below the age of majority, also called infants) and insane or intoxicated persons do not have the legal capacity to assent to contract terms. These parties can render an otherwise valid contract inoperative through the remedy of rescission.

Insane PersonsLegal capacity to contract refers to the mental state of a contracting party. A person cannot contract if he does not have a full understanding of his rights and does not have sufficient mental capacity to understand the nature, purpose and legal effect of the contract. A party without mental capacity to contract and who has not been adjudicated insane can avoid a valid contract. However, if a person is legally declared insane, then there is no question, the contract is automatically void.

If an insane person avoids a contract and the other party has treated him in good faith, then the insane person must return all consideration or benefit received. If the other party has not acted in good faith or the contract is unconscionable, the incapacitated party has to return only what is le� of the consideration.

Minors Any contracts made with a minor are voidable by that minor. However, only the minor may void the contract between himself and an adult—the adult is still obliged to the contract. The rights of minors in avoiding contracts vary from state to state.

On the other hand, a minor remains liable on any contract until he actually takes steps to disaffirm the contract. A purely executory contract can be disaffirmed by directly inform-ing the adult or by any conduct that clearly indicates the minor’s intent to disaffirm. If a

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minor disaffirms a contract, he can obtain return of his consideration or must return any consideration that he received from the other party.

One modification of the minor’s right to void his contracts involves necessities. Necessities are items needed for a minor’s subsistence as measured by age, station in life and any surrounding circumstances. Necessities include items such as medical services, education, food and lodging, and clothing. A minor is liable in a quasi contract for any of these necessities.

Quasi-contract liabilityThe two significant features of a quasi-contract liability are:

1. The liability is for the reasonable value of the necessities, not the contract price.

2. The liability exists only for necessaries actually furnished, not on executory contracts.

Note: Most state statutes do not allow minors to avoid contracts dealing with the purchase of life insurance or between the minor and a university. Some states do not allow married or emancipated minors to avoid contracts.

Fourth Element: Legal Purpose A contract without a legal purpose is unenforceable. A contract or provision of a contract is illegal if it is prohibited by statute, violates the rule of common law or is contrary to public policy. Contrary to public policy means that the contract is injurious to public interests; violates some established interest of society; contravenes the purpose of a statute; or interferes with the public health, safety, morals or general welfare.

In an illegal-contract case, the court typically leaves the parties as they are. Relief may be granted to a party to an illegal contract in the following three situations:

1. If a party is one of those people for whose protection the contract was made illegal, he may obtain restoration of what was paid or parted with or maybe even a legal remedy.

2. If a party is induced by fraud or duress to enter into an illegal agreement, the party is allowed restitution of what he has rendered by way of performance.

3. If a person repents before performing any illegal part of the contract, he may rescind the contract and obtain restitution for any past performance. This doctrine is called locus poenitentiae meaning a place for repentance. This doctrine operates within very strict limits.

Violating StatutesAgreements that violate statutes include:• violations of license requirements—Certain professionals are required to be licensed by

the appropriate body before they can contract with the general public. If the person is not properly licensed, the contract for the services is unenforceable. Frequently, the person receiving the service can refuse to pay the performing party.

• usury—The amount of interest that may be charged on borrowed funds is limited by state statute. If a lender’s contract a�empts to receive more than the maximum interest, the civil penalty in most states denies the lender the right to collect any interest. Criminal penalties are also involved in charging illegal interest.

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• contracts, agreements and activities in restraint of trade—Antitrust laws were established to protect the U.S. economic system from monopolies, a�empts to monopolize and activities that restrain trade. The Sherman Act provides three basic sanctions to prevent restraint of trade:

1. federal felony charges punished by fine (payable to the government), imprisonment or both.

2. government injunctions to prevent and restrain future or continued acts in violations of the act.

3. collection by the plaintiff of treble damages plus court costs and reasonable a�orney’s fees

Violating Public PolicyAgreements that violate public policy include:• agreements not to compete—An agreement not to compete restrains trade. Agreements

not to compete are commonly found in a contract for the sale of a business, in a contract creating a business or professional practice or in an employment contract. Such an agreement may be enforced unless the court determines that it is unreasonable to one or both parties or to the general public.

• contracts of adhesion and unconscionability—A contract of adhesion is a standardized contract entirely prepared by one party. The standardized items are submi�ed to the other party on a take it or leave it basis. These contracts are policed using the equitable principle of unconscionability. Unconscionability is determined by a judge.

Making a Valid Contract: Formality or Writing RequirementsIf the four elements described above are present, the contract will be valid. However, making the contract enforceable can require certain formalities.

The Statute of FraudsThe statute of frauds requires that certain types of contracts must be in writing to be enforced, including the following:• guaranty contracts—A guaranty contract occurs when a party agrees to guarantee the debt

of another. The guarantor is secondarily liable on the debt. This type of contract must be in writing when its main purpose of guaranteeing the debt is to benefit the debtor.

• contracts involving real estate—Any contract creating or transferring an interest in land requires a writing.

• contracts of long duration—A contract that cannot possibly be performed within one year from the time it is made must be in writing. This period is measured from the time an oral agreement is made to the time when the promised performance is to be completed.

• contracts for the sale of goods—A contract for the sale of goods for an amount of $500 or more requires a writing. Several provisions of the code relate to the statute of frauds.

• contracts for the sale of personal property other than goods—A writing is required for a contract involving the sale of securities, the sale of personal property other than goods or securities if the amount exceeds $5,000, or a secured transaction.

The statute of frauds requires only a note or memorandum that provides wri�en evidence of the transaction. This writing must be signed by the party seeking to be bound by the

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agreement (the defendant). It should also include the names of the parties, a description of the subject ma�er (real estate must be described with certainty), the price and the general terms of the agreement.

Exceptions to the Statute of Frauds

Common law exceptions to the statute of frauds are:• equitable estoppel or part performance—Equitable estoppel stops one party in an oral

contract from using the statute of frauds as a defense when the other party partly or fully performs. The statute of frauds requires that the performance must establish existence of an oral contract and must be substantial enough to warrant judicial relief such as specific performance of the oral contract.

• promissory estoppel—An oral promise may be enforceable if a party relies on it to his detriment. Promissory estoppel can be used to prevent an unfair use of the statute of frauds.

Code exceptions to the statute of frauds include:• wri�en confirmation between merchants—If a merchant contracts orally with another

merchant, he can satisfy the statute of frauds by sending a confirming writing to the other merchant. If the merchant receiving the writing objects to its contents, he must give wri�en notice within ten days a�er receipt. This contract is enforceable even though the confirmation is not signed by the person to be charged.

• specially manufactured goods—To fit into this category the goods must be specially manufactured for the particular buyer and be unsuitable for sale to others. In addition, the seller must have made a substantial beginning to manufacture or commitments to obtain the goods, and the circumstances must reasonably indicate that the goods are for the buyer.

• judicial admissions—An admission of the existence of the contract by the party resisting the contract will substitute for a writing. This admission is typically made by the defendant during court proceedings.

• part performance—Contracts are enforceable to the extent that the buyer has made payment for goods, or the seller has shipped goods which the buyer accepted.

The Parol Evidence RuleThe Parol Evidence Rule provides that statements, promises and representations made by the parties prior to signing the wri�en contract may not be considered. It prohibits the introduction of subsequent evidence that would alter a wri�en contract. The theory is that the wri�en contract integrates all prior negotiations, understandings, representations and agreements.

Exceptions Exceptions to the Parol Evidence Rule include:• oral evidence to establish modifications agreed upon a�er execution of the wri�en contract• evidence that the agreement has been canceled• evidence of fraudulent misrepresentation• lack of delivery of an instrument when delivery is required to give it effect• errors in pu�ing the contract into writing• the partial integration rule

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Note: The partial integration rule is defined as follows: If the parties intend the writing to be final on the terms as wri�en but not necessarily complete on all terms of the agreement.

• evidence which clarifies a contract ambiguity• evidence which a�acks the legal validity of a contract• any agreement a�er the writing that is signed by both parties

The code allows wri�en contracts to be explained or supplemented by a prior course of dealing between the buyer and seller, by usage of trade, or by course of performance. In resolving any inconsistencies in contract terms, express terms prevail over an interpretation based on course of performance, and course of performance prevails over an interpretation based on course of dealing or usage of trade.

The End of the Contract: Satisfactory Performance, Contract Breach, Voiding the ContractIdeally, every contract would be performed by the parties and they would go away satisfied. This is, in fact, the case with most contracts. In other cases, one of the parties does not perform and is considered to be in breach of the contract. A party being accused of breach of contract will frequently offer the defense that the contract is not valid and should be voided. Instead of being on the defensive, on occasion a party will seek to void a contract proactively rather than be forced to perform or wait for conditions that might qualify as a breach.

Satisfactory Performance of the Promise as Contracted: TenderIn the law of contracts, a tender is the presentation of performance. A person who makes a tender is ready, willing and able to perform the promise as it was contracted. Most contracts require that one of the contracting parties tender payment to the other. A bona fide, unconditional presentation of payment along with actual production of the money or its equivalent must be made.

Legal Effects of TenderSuppose A tenders payment to B who refuses to accept the tender.

If tender was proper, the valid tender has the following three important legal effects:

1. Interest stops accruing at the date of tender.

2. If the creditor later brings legal action and recovers only the amount tendered, he must pay the court costs.

3. Any security interest in property belonging to the debtor would be extinguished.

Contract BreachThere are two terms used when a contract is breached: refusal to perform or failure to perform. If a party is charged with either of these, he is said to be in breach of contract and will be liable for certain damages. However, a party can reply to these charges by saying that he had an inability to perform. All of these conditions are discussed below.

Inability to PerformIf a party is charged with breach of contract, he can offer the defense of inability to perform.

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This sometimes excuses his breach and therefore relieves him of liability.

Inability to Perform a Constructive ConditionAn express or constructive condition may create a situation where a party has an inability to perform. A constructive condition is part of the detailed interaction between two parties who have contracted. One party’s performance of a constructive condition triggers the other party’s duty to start performing his side of the bargain. For example, a contract to excavate a basement may naturally require (but not necessarily in writing) that one party remove the trees before the other party can do the excavating. A constructive condition is an implied-in-law condition; it is not wri�en in the contract but is read into the contract in the interest of good faith and fair dealing.

An express or constructive condition may be legally excused in one of the following ways:• hindrance, prevention and noncooperation—If one party to a contract makes it impossible

for the other party to perform, then nonperformance on the part of the other party is excused. If one party breaches a contract because the other party has been uncooperative, the uncooperative party is not entitled to the usual contract remedies.

• waiver—Waiver means either (1) a promise to relinquish the benefit of a condition to the promisor duty or (2) the decision to continue under a contract a�er the other party has breached. Waiver may occur before or a�er a breach. A waiver issued before a breach assures the other party that performance of the condition is not required. Retraction of a waiver may occur unless it is supported by consideration or the promise has substantially changed his position in reliance on the waiver.

• impossibility—Impossibility requires that performance be physically and objectively impossible. Actual impossibility discharges both parties from their duty to perform. Impossibility may take one of the following forms:

a. enactment of a law or governmental action that makes performance illegalb. the death or disabling illness of one of the contracting partiesc. destruction of any subject ma�er essential to the completion of the contractd. an essential element is missing at the time the contract is made

• commercial frustration—The doctrine of commercial frustration excuses performance when the essential purpose and/or object of the contract cannot be reached.

Refusal to Perform or RepudiationAnticipatory repudiation occurs before performance is due and may be express or implied. An express repudiation is a clear, positive, unequivocal refusal to perform. An implied repudiation occurs when the promisor makes it impossible for himself to perform.

Nonrepudiating Party’s RemediesThe nonrepudiating party has several remedies to choose from:• Treat the repudiation as an anticipatory breach and immediately seek damages for breach

of contract.• Wait until the time for performance and if the other party does breach, then exercise the

remedies for actual breach.• Treat the contract as still in force. This nullifies the repudiation. The injured party still has

his remedies which were available at the time of performance.

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A party may retract his repudiation as long as the other party has not materially changed his position in reliance upon the repudiation. Retraction requires only that the party give notice that he will perform a�er all.

Failure to PerformSimilar to refusal to perform, failure to perform (i.e., doing a very poor job) can be a breach. In addition, as with inability to perform, failure to perform can include constructive conditions. (See above.) Constructive conditions that have been poorly performed (or not performed at all) are a material breach of contract. The nonbreaching party may then choose to either rescind the contract and sue for damages or continue the contract and sue for damages.

Some constructive conditions have been substantially (yet imperfectly) performed and are an immaterial breach. In these cases only monetary damages, if anything, may be awarded to the nonbreaching party. In addition, the nonbreaching party still has the duty to perform.

An example of a substantially performed constructive condition is, for example, when one party removes the trees but leaves some small saplings and bushes. In this case the excavator is still expected to perform his side of the deal. The excavator can ask the other party for the extra costs related to the saplings and bushes. However, the excavator cannot use this as an excuse to end the contract.

Voiding a ContractIf one party is insisting that the other party honor an enforceable contract, the other party will need to have a basis for declaring the contract void. Fraud, mistake and duress are three common grounds for voiding a contract. Failure to read the contract is sometimes a�empted, but this rarely works to void a contract.

Fraud and MisrepresentationIf one party to a contract misrepresents a material fact, then the other contracting party may void the contract. An intentional misrepresentation is fraud; an unintentional misrepresentation is an innocent misrepresentation. In both cases the victim may avoid the contract, but if the misrepresentation is fraudulent the victim may also sue for dollar damages.

Determining FraudTo determine if a misrepresentation is fraudulent several elements must exist. First, there must be scienter—the intention to mislead. This refers to knowledge by a defrauding party that his representation is false. Second, there must be a false representation or the concealment of a material fact. Third, the injured party must have placed a justifiable reliance on the false statement or concealment. Fourth, damage must have resulted as a result of reliance on the misrepresentation.

Note: Innocent misrepresentation requires proof of all of the above elements except scienter.

MistakeIn the case of a mistake, the court may grant either a contract correction or avoidance of the contract. A mistake is an unintended act, omission or error arising from surprise, imposition,

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ignorance or misplaced confidence. The court will grant relief only if the mistake is material and genuine consent is not present.

A mistake may be bilateral or unilateral. A bilateral mistake refers to an identical mistake on the part of both contracting parties. If a bilateral mistake has a material effect on the agreed exchange of performances, then relief is appropriate. A unilateral mistake occurs when only one contracting party labors under a mistake. The mistaken party is not usually granted relief. Of course, an offeree who is aware of the offeror’s mistake cannot accept the offer and profit from it. The only remedy in such a case is rescission.

Duress and Undue InfluenceA party who agrees to a contract under duress or undue influence may rescind the agreement. Duress is a loss of free will due to some threat. Undue influence is a subtle pressure whereby one party overpowers the will of another through the use of moral, social or domestic force.

Failure to Read the ContractFailure to read the contract is rarely considered sufficient reason to void because a person who signs a wri�en contract is presumed to know the contents of the document. Therefore a person who signs a contract without reading it is still bound by the contract unless he can show that:

1. An emergency existed at the time of signing that excused the failure to read.

2. He was prevented from reading the contract by a misrepresentation on the part of the other party.

3. The two parties involved had a fiduciary or confidential relationship which was relied upon in not reading the contract.

Remedies: The Courts’ Response to Breached or Voided ContractsMoney damages, specific performance, rescission and restitution are the four basic remedies in contract law. Typically a party must elect one of these remedies to the exclusion of the others. Specific performance, rescission and restitution are called equitable remedies. Equitable remedies are allowed only if the remedy of money damages is not adequate under the circumstances.

Definitions• money damages—Money damages may be nominal damages, compensatory damages,

consequential damages, punitive damages or liquidated damages.• nominal damages—If the nonbreaching party suffers no compensable loss or fails to prove

the amount of loss, he can only recover nominal damages. Nominal damages are typically one dollar and symbolize the wrong done by the mere breach of contract.

• compensatory (or general) damages—Compensatory damages are designed to compensate the aggrieved party for his loss. These damages must be a direct, foreseeable result of a breach of contract—not a rare or fluke outcome of the breach. The injured party should be placed in the same position he would have occupied had the breach not occurred. In addition, the injured party must take reasonable steps to reduce the actual loss to a minimum.

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Note: If a contract is willfully and substantially breached a�er part performance has occurred, the nonbreaching party does not have to pay for the benefit, if the nature of the benefit is such that it cannot be returned. If the breach is unintentional, however, the nonbreaching party may have to pay for the benefit. If the nature of the benefit is such that it can be returned, the recipient must either return the benefit or pay for its reasonable value whether the breach is willful or unintentional.• consequential (or special) damages—Consequential damages arise from special

circumstances surrounding a contract and are not normally foreseeable. To recover these damages, evidence must be submi�ed that proves the breaching party knew that special circumstances existed and that these special circumstances would cause the other party to suffer additional losses in the case of a breach.

• punitive (or exemplary) damages—Punitive damages are awarded to one party in order to punish the other’s conduct. They are also awarded to deter others from the same conduct in the future. Punitive damages are most o�en awarded when the breach is fraudulent, oppressive or malicious.

• liquidated damages—Liquidated damages are stated within the contract as the money damages applicable in the case of a breach. The amount stated must bear a reasonable relation to the probable damage to be sustained by the breach.

• specific performance—When the court requires the breaching party to do exactly what he agreed to do under the contract, it is called specific performance. This is used in cases where the only adequate remedy may be to require the breaching party to perform the contract. This remedy is used in contracts where the subject ma�er is unique, such as contracts involving real estate and personal property.

• rescission—When the court disaffirms the contract and restores the parties to the position they occupied before making the contract, it is called rescission. A party who discovers facts that warrant rescission must do so within a reasonable time. Rescission may be used when a transaction is induced by fraud or mistake, when a minor wishes to withdraw from a contract, or when a breach is so substantial that the other party should not be required to perform.

• restitution—When the court requires a party who has been unjustly enriched to return an unfairly gained item or its value, it is called restitution.

Forms of Contract DischargeIf a contract is discharged, it is canceled and enforcement of its provisions is terminated.

Discharge may occur in one of the following ways:• Both parties complete the performance of their obligations as specified under the contract.• The parties work out an acceptable substitute to the original promised performances, (i.e.,

accord and satisfaction: Accord is an agreement whereby one party undertakes to perform, and the other to accept, something different than what the original contract stated. Satisfaction means that the substituted performance is completed.)

• There is a legal excuse from a contract performance.• There is a rescission of the contract.• There is a voluntary renouncement or waiver by one party. (In this case, no consideration is

required.)• There is cancellation of a wri�en contract and surrender by one party to the other. (In this

case, consideration or proof of gi� is required.)

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• Parties to a contract may substitute a new debt or obligation for an existing one or replace an original party to the contract with a new party. This is called novation. (See below for a definition.)

• The actual obligation is surrendered or destroyed (as with a negotiable instrument).• Time passes without litigation to enforce one's rights.• One of the parties enters bankruptcy.• There is a breach, but not an assignment. (See below for a definition.)

Third-Party Roles in Contracts: Beneficiaries, Novation and AssignmentBesides the two contracting parties, another party o�en becomes involved either because it is benefited by the promises between the two contracting parties or because it stands in the place of one of the contracting parties.• third-party beneficiary—When one party contracts with a second party for the purpose

of conferring a benefit upon a third party, this person is the third-party beneficiary. A third party beneficiary cannot enforce a contract unless the terms of the contract clearly indicate intent to benefit the third party. If a third party’s benefit is only incidental to the contract, he cannot sue. Most states require the beneficiary’s consent to rescind a contract a�er the beneficiary has accepted its terms. There are two types of third-party beneficiaries: donee-beneficiaries or creditor-beneficiaries. Both types may enforce a contract made on his behalf.

• donee-beneficiary—A donee-beneficiary is a third party for whom the promisee purchased the promise as a gi�.

• creditor-beneficiary—A creditor-beneficiary is a third party for whom the promisee has contracted for a promise to pay a debt.

• novation—A novation is an agreement whereby all concerned agree to substitute a new party for one of the original parties to a contract. In essence, a new contract is formed and the original contract is discharged. Since all parties consent to the substitution in a novation, the dismissed party is no longer liable. An effective novation requires agreement by the following parties:

1. remaining contracting party—The remaining contracting party must agree to accept the new party and release the withdrawing party.

2. withdrawing party—The withdrawing party must consent to withdraw and allow the new party to take his place.

3. new party—The new party must agree to assume the burdens and duties of the withdrawing party.

• assignment—When a party to a contract (assignor) transfers to a third party (assignee) his rights under the contract, it is an assignment. Unlike a novation, in an assignment contract one party may assign rights without the consent of the other contracting party. A�er assignment, however, the assignor has given up all interest in the contract rights. Furthermore, since all parties did not consent, the assignor still remains ultimately responsible for any duties that were transferred should the new party fail to perform them.

Assignment of ClaimsAn assignment of claims for money due or to become due under existing contracts is valid. If the debtor-obligor defaults, the liability of the assignor is determined by the reason for the assignment. If the assignment is security for a debt owed to the assignee by the assignor,

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the assignor must pay the assignee. If the assignment is a purchase of a debt, the assignor typically does not have to pay.

The assignor would have to pay only if the claim was sold with recourse. On assignment, the assignor warrants that (1) the claim is a valid legal claim, (2) the debtor-obligor is legally obligated to pay, and (3) there are no valid defenses to the claim. The assignor must pay the assignee if any of these warranties are breached.

Assignment LiabilityA�er assignment, the assignee owns the rights to a contract and is entitled to receive them. If the obligor performs for the original party (the assignor), the contract is not discharged. Since an assignee stands in the shoes of the assignor, the obligor can assert the same defenses against the assignee that are available against the assignor.

The liability of the assignee to third parties is made by studying the transaction. This will determine whether only the rights are assigned or both the rights and the duties. A general assignment of a contract that calls for the performance of affirmative duties by the assignor does not impose those duties on the assignee. However, an assignment of an entire contract carries an implied assumption of liabilities. If the assignee fails to perform, the obligee can sue either the assignor or the assignee.

The assignee should notify the debtor-obligor of the assignment because:• If the obligor does not know of the assignment, he may perform for the original contracting

party (the assignor). Therefore, the assignee cannot demand performance from the obligor. However, the assignor who receives performance under these circumstances can be forced to turn over any funds or property received from the obligor to the assignee. An obligor who has received notice must perform for the assignee, and any performance to the assignor would not relieve him of his obligation to the assignee.

• Notification protects innocent third parties. The assignor has the power, but not the right, to make a second assignment. Therefore, a party considering an assignment should communicate with the debtor to confirm that the right has not been previously assigned. The prospective assignee can feel free to accept the assignment if neither he nor the debtor is aware of a previous assignment. On assignment, he should give prompt notification to the debtor. Typically, the first assignee to give notice to the debtor will prevail over another assignee.

Exceptions to AssignmentExceptions to the general rules pertaining to assignment are as follows:

1. Contracts involving personal rights or personal duties may not be assigned. In these cases, the contract performance includes personal trust, confidences, skills, knowledge or experience. For this reason, such contracts cannot be assigned by one party without the consent of the other contracting party.

2. A contract that would place an additional burden or risk on one of the parties cannot be assigned without consent.

3. A party who has the right to purchase goods on credit may not assign this right to a third party unless the seller has security for payment.

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AntiassignmentAn antiassignment clause may be included in a contract. The language of an antiassignment clause determines how the court will interpret the clause:

a. If the clause prohibits assignments, the promisor has the power to assign, but a promise not to assign is created. Therefore, an assignment would be effective, but the obligor has a legal claim against the assignor for breach of his promise not to assign.

b. If the clause invalidates the contract, assignment would be effective, but the obligor can avoid the contract for breach of the promise.

c. If the clause makes an assignment void, no party has the power to assign.

SECTION 2.7: BANKRUPTCY

ScopeWhen a person, partnership, corporation or municipality has trouble paying its debts, bankruptcy may be the answer. Bankruptcy is an ancient law that has been in existence since the Roman Empire.

The goal of bankruptcy is to fairly resolve a debtor’s finances which have go�en out of control. As a result of bankruptcy, the debtor’s property is channeled to his debts. These are then either paid in full, reduced, delayed or sometimes eliminated. Once bankruptcy proceedings start, creditors are prohibited from a�empting to collect their debts and are expected to work through the proceeding for any payments.

Bankruptcy Definitions• bankruptcy—legal process by which a debtor’s property and debts are resolved• debtor—entity to which the bankruptcy case pertains• creditor—entity to whom the debtor owes money• claim—a debt or right to payment from the debtor that is held and asserted by the creditor.• impaired claim—a debt that the bankruptcy proceedings either decrease or delay.• unimpaired claim—a debt that is essentially unchanged by the bankruptcy proceedings.• secured debt—a debt which is accompanied by giving the creditor an interest in property. • order of relief—court order from the bankruptcy judge (when he decides that the debtor is

entitled to bankruptcy law protection) authorizing the bankruptcy, the trustee’s actions, the selling of assets and the payment of creditors

• trustee—person responsible for managing the debtor’s assets• estate—the pool of the property which is the source used to satisfy creditors• insider—the debtor’s relatives, partners, or (if debtor is a corporation) directors or

executives.

Types of BankruptcyIn some cases, bankruptcy is a reorganization/rehabilitation opportunity for the debtor so that he may regain mastery over his affairs (as in Chapter 11 and 13). Chapter 7 bankruptcies are more severe and require liquidation. All bankruptcies start with a petition, then a court’s order of relief is issued which authorizes the actual bankruptcy process.

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Five types of bankruptcy proceedings are identified by their chapter in the bankruptcy statute:

1. Chapter 7 - Liquidation

2. Chapter 9 - Adjustment of Debts of a Municipality

3. Chapter 11 - Reorganization

4. Chapter 12 - Reorganization for Farmers

5. Chapter 13 - Adjustment of Debts of an Individual with Regular Income

Chapter 7 involves liquidation which eliminates most of a debtor’s debts. The creditors’ claims are se�led using most of the debtor’s assets. Chapter 7 is the more drastic debt remedy in that the debtor loses most of his property and retains li�le control over the administration of the process. The debtor’s role is passive—a trustee makes a plan and then gathers the assets, converts them to cash and provides for any payments to creditors. In Chapter 7, not all debts are paid in full and many are not paid at all. Discharge relieves the debtor of the remainder of any debts that arose prior to the order of relief and still remain a�er distribution of the debtor’s property. A discharge of any remaining debt is not guaranteed, however it is frequently granted to individuals.

Chapter 7 is available to individuals, partnerships or corporations. It is not used by railroads, insurance companies, banks, savings and loan associations, homestead associations and credit unions. Stockbrokers and commodity brokers can only file under Chapter 7 (not the other chapters), since large indebtedness and substantial assets are involved. Because of this, Chapter 7 includes special provisions for stockbrokers and commodity brokers.

Chapter 9 applies to insolvent municipalities only and is not applicable to the CBA exam.

Chapter 11 is used when a debtor wishes to restructure his finances and a�empt to pay creditors over an extended time period. A commi�ee consisting of some of the debtor’s creditors is appointed by the court to represent the creditors’ interests. The commi�ee of creditors helps the debtor in preparing a reorganization plan. A trustee is typically appointed prior to the approval of the debtor’s reorganization plan. The trustee investigates the relevant aspects of the debtor and files a wri�en report with the court.

As with Chapter 7, Chapter 11 is available only to individuals, partnerships or corporations. However, unlike Chapter 7, the Chapter 11 debtor stays in charge and retains ownership of his assets. In Chapter 11 reorganization proceedings, the debtor files a reorganization plan with the court. This plan classifies claims. The plan specifies the treatment of impaired claims and denotes the unimpaired classes of claims. The plan provides a means for its execution and deals with all aspects of the organization of the debtor and its property and debts. It is required that all claimants receive as much as they would have otherwise received in liquidation proceedings. Those holding an interest in the debtor’s property vote to either accept or reject the proposed plan of reorganization. A hearing is held to determine whether the plan is fair and equitable. Once the plan is confirmed, it is binding on the debtor, equity security holders and creditors.

Chapter 12 is a new chapter of the U.S. Bankruptcy Code and was signed into law in

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November 1986. It is specifically designed for family farmers, because certain disclosure requirements and timetables of other bankruptcy codes were considered unworkable for them. To be eligible, a farmer cannot be more than $1.5 million in debt and $800,000 of that debt must come from farming. Chapter 12 also requires that at least half of the farmer’s gross income for the year before filing bankruptcy must come from the farm.

Chapter 12 shields the farmer from creditors and allows him to continue farming. The reorganization period is only 90 days, much less than other bankruptcy proceedings. Under Chapter 12, the farmer may sell some land on which a creditor has a lien without the creditor’s approval. An additional way Chapter 12 is unlike other bankruptcy proceedings is that creditors in these cases are not allowed to file their own competing reorganization plans for the indebted farmer.

Chapter 13 proceedings are used when an individual has small debts and a regular income significant enough that substantial repayment is feasible. With Chapter 13 the individual’s unsecured debts cannot exceed $100,000 and secured debts cannot exceed $350,000. Repayment preference in a personal bankruptcy is given to a creditor with a secured interest in property. The debtor retains possession of his property and his income is used to pay debts. The trustee controls and supervises the debtor’s income. The plan of adjustment of debts is confirmed if the court is satisfied that (1) the plan is proposed in good faith, (2) it is in compliance with the law, (3) it is in the best interest of the creditors, and (4) the debtor can make the payments the plan specifies.

Starting the Bankruptcy Proceedings: Voluntary and InvoluntaryVoluntary bankruptcy proceedings are started by the debtor. A husband and wife may instigate a joint case. This requires only one petition but both signatures. The petition includes a bankruptcy schedule which lists the debtor’s secured and unsecured creditors, all of his property, any property he claims is exempt and is a statement of the debtor’s affairs. A voluntary petition acts as an automatic order of relief and gives the debtor protection by the bankruptcy court. Once the bankruptcy judge decides the petition was properly filed and an order of relief is effective, an interim trustee is appointed.

An involuntary bankruptcy case is started when one or more of a debtor’s creditors files a petition. If the debtor has twelve or more creditors, the petition must be signed by at least three whose unsecured claims are not contingent and aggregate at least $5,000. If the debtor has fewer than twelve creditors, the petition must be signed by only one of them, but the $5,000 amount must still be met. The debtor may file an answer to the creditors’ petition in which he can deny any or all allegations. When an answer is filed, a trial is conducted based on the issues raised by the creditors’ petition and the debtor’s answer. If it is determined that the debtor is not paying his debts as they become due (or if the debtor does not answer the petition), relief is granted to the creditors and against the debtor. At that point, the debtor must still complete the same schedules as a debtor in a voluntary proceeding.

Note: Certain debtors are not subject to involuntary proceedings. Creditors are prohibited from commencing involuntary proceedings against farmers or not-for-profit corporations under either Chapter 7 or 11. Also, involuntary proceedings cannot be commenced against any debtor under Chapter 13.

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The Bankruptcy ProcessThe following sections discuss stages of the bankruptcy process:

Property Included and Exempted

Debts Included and Exempted

Trustee’s Duties and Powers

Reviewing Debtor’s Past Payments and Transfers

Allowing Creditor’s Claims

Prioritizing and Paying Creditor’s Claims

Discharge

Property Exempted from Bankruptcy The bankruptcy laws were enacted to give debtors who were in a tough financial situation a chance to start over. Almost all of the debtor’s assets become part of the bankruptcy estate from which the creditors are paid. The estate initially includes all legal or equitable property interests of the debtor. However, in order that the debtor will have some assets with which to start over, certain items are exempt. Exempt property cannot be recovered and required for use in paying the debts that arose prior to commencement of the bankruptcy case.

The exemptions are as follows:• the debtor's interest in real property used as a residence—up to $7,500• the debtor's interest in a motor vehicle—up to $1,200• the debtor's interest in furnishings, clothes, appliances, books, animals, crops, etc, that

are primarily held for the personal use of the debtor and his dependents—up to $200 a particular item, or $4,000 in aggregate value

• the debtors' interest in jewelry—up to $500• the debtor's interest in other property—up to $400, plus up to $3,750 of any unused real

property exemption• the debtor's interest in any implements, professional books, or tools of the debtor's (or his

dependents') trade• professionally prescribed health aids• unmatured life insurance contracts• the cash value of life insurance—up to $4,000• the debtor's right to payments from social security, unemployment compensation, alimony,

etc. (as reasonably necessary), and payments from pension or other similar plans• the debtor's right to receive life insurance policy proceeds on the life of someone on whom

the debtor was dependent—up to $7,500 • personal injury payments—up to $7,500

Note: Remember that federal and state laws vary and they influence the amounts and types of exemptions.

Debts Exempted from Bankruptcy In bankruptcy, almost all of the debtor’s debts are eligible for potential reduction or even

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discharge. However, certain debts cannot be discharged in bankruptcy and the debtor remains obliged for them.

They are:• consumer debts over $500 for luxury goods or services incurred within the last 40 days

before the order of relief• unscheduled debts• debts owed prior to a previous bankruptcy to which discharge was denied on grounds

other than the six-year rule.• debts incurred in obtaining property, services, credit or money through false pretenses,

misrepresentation or actual fraud• student loans if the loan is less than five years old• debts incurred as a result of an accident caused by driving under the influence• cash advances granted under a consumer credit plan and for an amount greater than $1,000

within twenty days of the order of relief• alimony, child support and separate maintenance• debts for fraud or defalcation while acting as a fiduciary or created by embezzlement or

larceny• liability for willful and malicious torts• certain taxes and custom duties• tax penalties if the tax is not dischargeable

Trustee’s Duties and PowersContinuing from the point where the court issues an order of relief, voluntary and involuntary proceedings are the same. Notification of the order of relief is given to all parties. Notification to creditors includes the date by which all claims must be filed, and a date for a meeting of the creditors and the debtor. This meeting allows the creditors to question the debtor under oath and to examine ma�ers that may affect the right of the debtor to have his obligations discharged. If the meeting is related to a liquidation case, the creditors elect a permanent trustee.

Trustees’ DutiesTrustees represent the estate and have the capacity to sue and to be sued. During the proceedings, trustees have the authority to hire any necessary professionals such as accountants or a�orneys and to invest or deposit the estate money. Typically, the trustee is responsible for filing the estate tax returns. The following are the duties as defined by law of a trustee in liquidation (Chapter 7) proceedings:• investigate the debtor's financial affairs including his (possibly fraudulent) past financial

transactions, payments or property transfers• furnish any information requested by a party in interest• if a business is operated: file appropriate reports with the court and taxing authorities• account for all property received• oppose the debtor's discharge (if advisable)• examine proofs of claim and object to the allowance of any improper claim• collect and reduce to money the estate's property

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• make a final report and file it with the court

Note: In Chapter 11 and 13 reorganization proceedings, the trustee has a less active role and the debtor retains more control of the property.

Trustees’ PowersThe trustee’s rights and powers with respect to the debtor’s property include:• a judicial lien on the property, as if he were a creditor• the rights and powers of a judgment creditor who obtained a judgment against the debtor

on the date the bankruptcy was adjudicated and who had an execution issued that was returned unsatisfied

• the right of a bona fide purchaser of the debtor's real property as of the petition date• the rights of an actual unsecured creditor to avoid any transfer of the debtor's property and

to avoid any obligation incurred by the debtor that is voidable under federal or state statute• the power to avoid certain liens of others on the debtor's property

Reviewing Debtor’s Past Payments and TransfersIn Chapter 7 liquidation proceedings, the trustee acts as an advocate for all of the creditors. The trustee is on alert to see if the debtor has filed bankruptcy in bad faith. (i.e., He is trying to escape his debts by hiding money with his friends or family.) The trustee does this by looking over the debtor’s past dealings to make sure there were no shady deals designed to hide funds.

Since the trustee is an advocate for all creditors he also is looking for signs of the debtor’s unfair preference of one creditor over the others. The trustee investigates to see if the debtor has funneled more money to one creditor to the detriment of the others. If the trustee does find a questionable past property transfer (either to hide money or to funnel money), the law allows the trustee to recover the property and put it back into the bankruptcy estate where it can be distributed properly.

Preferences in Debtor’s Past PaymentsOne aim of bankruptcy proceedings is to equally distribute a debtor’s property among his creditors. Therefore, any transfers that show partiality to one creditor over another can be recovered by the trustee.

Conditions for a Recoverable PreferenceThe following conditions must be met to constitute a recoverable preference:• An insolvent debtor must have made the transfer.• The transfer must have been made to a creditor to whom a debt was owed before the

transfer.• The transfer must have occurred within 90 days of the bankruptcy petition filing.• The transfer must have provided the debtor with a greater percentage of his claim than

he would have received under a distribution from the bankruptcy estate in a liquidation proceeding.

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Payments Not Considered PreferencesThe following payments are not considered preferences and, therefore, cannot be recovered:• payment of tax liabilities• payment of fully secured claims• payments in the ordinary course of business or the ordinary financial affairs of people not

in business (i.e., payment of utility bills)

Debtor’s Past Transfers of Property: Hiding property Some debtors try to hide assets by transferring them to others. Such property transfers may be seen as trying to undermine the bankruptcy laws and may be considered fraudulent under federal or state law.

Fraudulent intent is present when:• The transfer makes it impossible for the creditors to receive full payment or to use legal

remedies that would otherwise be available.• The debtor was insolvent on the transfer date or the debtor becomes insolvent because of

the transfer.• A businessperson makes a transfer which leaves him with an unreasonably small amount of

capital.• A transfer is made in anticipation of debts to be incurred in the future which may be

beyond the debtor's ability to repay as they mature.

Allowing Creditor’s ClaimsTo share in the distribution of a debtor’s estate, creditors must file a proof of their claims. Filed claims are allowed unless an objection is filed, whereupon the court conducts a hearing to determine the claim’s validity.

Disallowed ClaimsA claim may be disallowed if it meets any of the following criteria:• It is unenforceable because of usury, unconscionability or failure of consideration.• It is unmatured interest.• It is for unmatured alimony or child support.• It is for rent not yet due.• It is paid to an insider or a�orney and exceeds the reasonable value of the rendered

services.• It is for breach of an employment contract.

Prioritizing and Paying Creditor’s Claims

Priority ClaimantsThe general order in which priority claimants should be paid:

1. administrative expense claims

2. claims of persons who extend credit to the estate a�er the filing of a Chapter 11 involuntary petition and before a trustee is appointed or before the order for relief is entered

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3. wage, salary and commission claims—for money earned within 90 days of the filing of the petition or cessation of the debtor’s business, whichever occurred first —limited to $2,000 per individual (includes vacation, severance and sick pay, as well as regular earnings)

4. contributions to employee benefit plans—for services performed within 120 days before commencement of the case or cessation of the debtor’s business, whichever came first—limited to $2,000 (multiplied by the number of employees minus the claims paid under priority 3)

5. claims against debtors who operate either a grain storage facility or a fish produce storage or processing facility—limited to $2,000 per farmer or fisherman

6. claims of consumer deposits—limited to $900 per consumer

7. certain taxes due the government1) income taxes—for a taxable year that ended on or before the date of filing the

extension but cannot be older than three years2) employment, gi�, estate, sale and excise taxes—must precede the petition date and

cannot be older than three years

Order of Distribution for Remaining PropertyIn liquidation cases any available property is distributed first among the priority claimants as discussed above. Any remaining property is distributed in the following order until exhausted:

1. general unsecured creditors who file their claims on time

2. general unsecured creditors who tardily file their claims

3. holders of penalty, forfeiture or punitive damage claims

4. postpetition interest on prepetition claims

If any property remains, it is returned to the debtor. If the claims within a particular class cannot be paid in full, they are paid on a pro rata basis.

DischargeWhen all payments under the plan have been made and the bankruptcy estate is exhausted, the court may grant the debtor a discharge of any remaining debts. (A discharge is usually granted.) However, the debtor may waive the discharge if he wants to remain responsible for the debts. If a debt is discharged, then the debt is ended and the debtor is relieved of the debt and the creditor simply doesn’t get paid. If a debt is not discharged, the debtor stays liable for the debt.

An individual may be denied discharge on any of the following grounds:• commission of a bankruptcy crime—Bankruptcy crimes typically relate to the proceedings

and include such items as a false oath, the use or presentation of a false claim, or bribery in connection with the proceedings and withholding of records

• fraudulent transfers—Fraudulent transfers must occur within a year preceding the case or a�er the start of the case and include acts such as destroying, removing or concealing property with the intent to hinder, delay or defraud creditors or the trustee.

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• inadequate records—A debtor must maintain adequate records for determining his financial condition, unless failure to do so is justified.

• failure to explain—If a debtor fails to explain a loss or deficiency of assets, then discharge may be denied.

• refusal to testify or obey—If a debtor refuses to testify in the proceedings or to obey a court order, then discharge may be denied.

• connection with another bankruptcy—The discharge may be denied for any of the above, if within one year and in connection with another bankruptcy case of an insider (insiders include relatives and partners of the debtor or directors and officers of a corporation).

• prior discharge—The discharge may be denied if there was a prior discharge within the past six years.

• waiver of discharge—The discharge may be denied if the court approves a waiver of discharge.

SECTION 2.8: ANTITRUST

ScopeBusinesses, either on their own or working together, cannot defeat the competitive markets by banding together or by operating unfairly. The laws of antitrust and fair competition operate to make sure that the nation’s economic market isn’t harmed by such actions.

OverviewAntitrust laws are designed to prevent monopoly and to maintain competition. The scope of the federal antitrust statutes include: (1) the Sherman Antitrust Act, (2) the Clayton Act, (3) the Federal Trade Commission Act (FTC Act), (4) the Robinson-Patman Act, (5) Wheeler-Lea Act, and (6) Celler Antimerger Act.

The Sherman Act (15 USC ˜ 1-7) was modified and appended by the Clayton Act (15 USC ˜ 12-17 ). The sections added by the Clayton Act were then modified by the Robinson-Patman Act and the Celler-Kefauver Act. The FTC Act (15 USC ˜ 41, et seq) was modified by the 1938 Wheeler-Lea Act.

These federal statutes when combined with state legislation intend to promote and preserve competition in a free enterprise system and to prevent monopoly power. The coverage of these acts extends to interstate commerce among the several states, but not intrastate activity. All states have antitrust statutes applicable to intrastate activity.

The Sherman ActThe Sherman Act of 1890 is the primary tool of antitrust enforcement. The act declared that any combination, contract or conspiracy in restraint of trade made among the states or with foreign countries was illegal. The act also made it illegal to monopolize, a�empt to monopolize, or conspire to monopolize any portion of interstate commerce or any portion of trade with foreign nations. However, the Sherman Act did not state exactly what types of action were prohibited. The wording of the act is broad and general and leaves much discretion to the federal courts for interpretation.

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To other points regarding the act should be mentioned here. First, the Sherman Act requires proof of actual and substantial anticompetitive effect. Second, labor unions, agricultural cooperatives, fisherman’s organizations and export trade associations enjoy limited antitrust exemptions.

Two substantial provisions in Sections 1 and 2 of the act are described below:

Section 1: “Every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several States, or with foreign nations, is declared to be illegal.”

Section 1 is concerned with contract, combination and conspiracies in restraint of trade. Two or more persons working together (i.e., a combination) to fix prices or divide markets in order to achieve anticompetitive results, for example, would constitute a violation of Section 1.

Restraint of trade consists of horizontal and vertical types. A horizontal restraint is an agreement among competitors such as manufacturers, retailers and wholesalers. Examples of horizontal restraints include division of markets, price fixing, group boyco�s and exchange of market information. A vertical restraint is an agreement between persons standing in a buyer-seller relationship (i.e., a manufacturer and a retailer in the same line of products). Examples of vertical restraint include resale price maintenance; location, territory, and customer restrictions; tying arrangements; and exclusive dealing contracts.

Section 2: “Every person who shall monopolize, or a�empt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony.”

These two sections complement each other in achieving the goal of preventing monopoly and anticompetitiveness.

Violations of the Sherman ActViolations of both Sections 1 and 2 are felonies punishable for individuals by imprisonment of up to three years and fines up to $100,000, or both. Corporations are punishable by fines up to $1 million. Civil actions are more common than criminal proceedings and approximately 75% of these civil suits are se�led through consent decrees (a compromise between the government and the defendant). The Sherman Act also contains the seldom-used forfeiture remedy, where the property may be seized.

A final point: conduct that would violate the Sherman Act in the absence of union involvement is not immunized by the participation of the union. For example, a union may not band together with a nonlabor party, such as a contractor or manufacturer, to achieve a result forbidden by the antitrust laws.

The Clayton ActThe Clayton Act of 1914 was designed to strengthen and clarify the provisions of the Sherm-an Act. It defines specifically what constitutes monopolistic or restrictive practices, whereas the Sherman Act does not.

The Clayton Act makes price discrimination illegal unless it can be justified because of

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differences in costs. It also prohibits the use of exclusive or tying contracts when their use “substantially lessens competition or tends to create a monopoly.” Exclusive or tying contracts are contracts in which the seller agrees to sell a product to a buyer on the condition that the buyer will not purchase products from the seller’s competitors. The Clayton Act also made intercorporate stockholdings illegal if they tend to greatly reduce competition or to create a monopoly. In addition, the Clayton Act makes interlocking directorates (having the same individual on two or more board of directors) illegal if the corporations are competitive and if at least one of the corporations is of a certain minimum size.

Four Important Provisions of the Clayton ActSections 2, 3, 7 and 8 are of particular importance.• Section 2 prohibits certain types of price discrimination. This section was modified by the

Robinson-Patman Act in 1936.• Section 3 prohibits certain sales made on condition that the buyer not deal with the seller's

competitors.• Section 7 prohibits certain corporate mergers and was modified by the Celler Act in 1950.• Section 8 prohibits a person serving on the board of directors of two competing companies

(an interlocking directorate) if one or both companies are larger than a given size.

Violations of the Clayton ActNo criminal sanctions are imposed for violations of the Clayton Act. However, private remedies as well as legal and equitable relief are available. Legal relief is a private action for money damages. In a private action, the plaintiff must ordinarily prove both the existence of an antitrust violation and damages resulting from that violation.

The goal of the Clayton Act is to curb anticompetitive practices in their incipiency. Under the Clayton Act, simply showing a probable—rather than actual—anticompetitive effect can be enough cause for a violation of the act. This means that the Clayton Act is more sensitive to anticompetitive practices than the Sherman Act.

Mergers and the Clayton ActThe scope of the Clayton Act in mergers includes both asset and stock acquisitions. The act covers both mergers between actual competitors and vertical and conglomerate mergers having the requisite anticompetitive effect.

Rules of Mergers• horizontal merger—one between former competitors• vertical merger—a firm acquires a supplier or customer• vertically integrate backward or upstream—a business acquires a supplier• vertically integrate forward or downstream—a business acquires a customer• conglomerate merger—parties who were neither former competitors nor in the same

supply chain

The Federal Trade Commission ActLike the Clayton Act, the Federal Trade Commission Act was designed to prevent abuses and to sustain competition. The Federal Trade Commission Act declared as unlawful “unfair

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methods of competition in commerce.”

The act also established the Federal Trade Commission (FTC) in 1914 and gave it the power and the resources to investigate unfair competitive practices. The FTC Act authorizes the FTC to issue cease and desist orders prohibiting unfair methods of competition and unfair or deceptive acts or practices. These orders provide injunctive relief by preventing or restraining future unlawful conduct. One of the goals of the FTC is to enforce antitrust laws and to protect consumers.

Violations of the FTC ActNo criminal sanctions or private damage remedies are imposed for violations of the FTC Act. Most FTC investigations are se�led by a consent order procedure. However, a $10,000 per day civil penalty is imposed for violating cease and desist orders. In addition, although not explicitly empowered to do so, the FTC frequently enforces the Sherman Act indirectly and enjoins conduct beyond the reach of either the Sherman or Clayton Acts.

The FTC has a dual role in prohibiting unfair methods of competition and anticompetitive practices. The FTC Act supplements the Sherman and Clayton Acts. The FTC protects consumers who are injured by practices such as deceptive advertising or labeling, without regard to any effect on competitors.

Robinson-Patman ActCongress passed the Robinson-Patman Act in 1936 to protect small competitors by amending the price discrimination section of the Clayton Act. It was wri�en to protect independent retailers and wholesalers from unfair discriminations by large chain stores and mass distributors which were supposedly obtaining large and unjustified price discounts because of their purchasing power and bargaining position. As a result the Robinson-Patman Act is o�en called the chain store act. The act also makes it unlawful for sellers to grant concessions to buyers unless concessions are granted to all buyers on terms that are proportionally equal. The act reaches the quantity discount, a major form of price discrimination. Both the Department of Justice and the FTC can proceed against violators of the Robinson-Patman Act.

Details of the Robinson-Patman ActThe Robinson-Patman Act made it illegal:• to discriminate by granting unjustified quantity discounts which greatly reduce

competition or tend to create a monopoly among sellers or buyers• to pay brokerage fees if no broker is involved in a transaction• to grant or obtain larger discounts than those available to competitors who purchase the

same goods in the same amounts• for sellers to grant concessions to buyers unless concessions are created to all buyers on

terms that are proportionally equal

The Act applies only to sales, not to leases, agency/consignment arrangements, licenses or refusals to deal (selling to one firm while refusing to deal with another). The scope of Robinson-Patman Act applies to tangible personal property (commodities) and in the sale of services or intangibles such as advertising.

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Violations of the Robinson-Patman ActThe Robinson-Patman Act did not change any provisions for enforcement of the FTC Act. It simply addressed the circumstances arising from the growth of chain stores.• To violate the statute, the discrimination in price must be between different purchasers.• A mere showing that different prices were charged is enough to establish a prima facie

violation. Proof of a prima facie case of price discrimination does not necessarily result in a

liability. The seller may avoid the consequences of the discrimination by proving one of three defenses: (1) cost justification, (2) meeting competition, (3) or changing conditions. The burden of proving a defense is on the discriminating seller.

Wheeler-Lea ActIn 1938, the Wheeler-Lea Act was passed as an amendment to the FTC Act. The Wheeler-Lea Act makes “unfair or deceptive acts or practices” in interstate commerce illegal; thus, it is designed to protect consumers rather than just competitors. Now the FTC has the authority to prohibit false and misleading advertising and product misrepresentation that harms consumers (as opposed to focusing just on harm to competitors).

Celler Antimerger ActThe Celler Antimerger Act of 1950 also amended the Clayton Act by making it illegal for a corporation to acquire the assets—as well as the stock—of a competing corporation if the effect is to greatly reduce competition or to tend to create a monopoly.

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Practice Challenge QuestionsTrue or False Questions:

Circle T for True or F for False.

1. If someone dies without a will, state law determines who receives any property.

2. If someone dies with a will, state law does not ever change the will’s property distribution.

3. If two parties hold property as tenants in common, the surviving party automatically gets title.

4. In community property states, spouses cannot be totally disinherited.

5. A person can change his will by attaching a simple slip of paper with the desired changes.

6. Any sane person can make out a will.

7. If a real estate property is owned by two joint tenants one can keep the other off the property.

8. Once it is in effect, an irrevocable trust cannot ever be terminated or changed.

9. In a trust, property can be permanently given to a party.

10. In a trust, income from property can be given to a party for a time, then the title given later.

11. A trust settlor can also be the trust’s beneficiary and trustee.

12. In managing the property in a trust, the trustee has the power to do whatever benefits him

13. If a trust is irrevocable, only proof or fraud or mistake will allow changing it.

14. A charitable beneficiary can be changed if the will cannot fulfill its original charitable purpose.

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15. Paul turns his car over to Andrew to sell. Paul is the principal. Andrew is the agent.

16. Phyllis wants to sell an expensive painting anonymously. She retains Angela to sell the painting. Phyllis is the undisclosed principal and Angela is the agent.

17. Pat contracts Arthur to do whatever Arthur feels is necessary to bring his undeveloped land to a specific flat finished grade. Pat is the principal. Arthur is an independent contractor.

18. Peter is a building owner. He hires a rental management firm to handle all rentals in the building for a fee. Peter is the principal. The rental management firm is the agent.

19. An agent cannot release any part of his responsibility to a subagent.

20. A salesman is liable if one of the watches he sells for the principal turns out to be stolen.

21. Both the principal and the independent contractor are liable for the contractor’s negligence.

22. Power of attorney allows an agent to do anything he wants with the principal’s property.

23. A principal can still be bound even if an agent exceeds the authority given by the principal.

24. A company which had authorized Mr. Apt to be its agent must inform their past customers when Mr. Apt’s agency role is terminated, otherwise Mr. Apt could continue to bind the company.

25. An executory contract is one that hasn’t yet been performed completely.

26. Performing a service for a person who accepts them is part of a quasi contract.

27. Failing to complete even the tiniest step in a contract is automatically a breach.

28. A promise to donate a large amount of money cannot be enforced.

29. A contract cannot be enforced by anyone except one of the parties who made the contract.

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30. Liquidated damages is a contract clause which sets the monetary damages for breach.

31. Unwritten contracts are never enforceable.

32. A three-year contract to perform services must be in writing in order to be enforced.

33. A six-month contract to perform services must be in writing in order to be enforced.

34. A patient can sue for breach of the contract made by her caregivers and her husband.

35. A fire insurance policy’s proceeds from a claim cannot be assigned.

36. A fire insurance policy holder cannot waive a lawsuit against the person who started the fire.

37. A fire insurance policy on property can only be taken out by the property’s actual owner.

38. If several property damage policies cover the same property, claims for losses can be prorated among the policies.

39. A life insurance company has the right to file a lawsuit against the person who killed the insured.

40. life insurance policy’s cash value is immune from attachment by the policy owner’s creditors.

41. A life insurance policy with an irrevocable beneficiary usually requires approvals before its assignment.

42. A life insurance policy pays regardless of the method or circumstances of the insured’s death—even suicide.

43. Once a life insurance policy is assigned, the new owner usually must make future premium payments.

44. Once a life insurance policy is assigned, the new owner can usually change the named beneficiary.

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45. If the insured person lies about an illness on the policy application, and later dies from that illness, the policy may be voided.

46. If an insurance policy payment is late, then the policy is canceled and the insurance is no longer in force.

47. General partners have less personal risk that limited partners.

48. Both general partners and limited partners have the same say in business operations.

49. If another partner commits a tort, general partners have personal liability too.

50. Withdrawal of a limited partner is less disruptive than withdrawal of a general partner.

51. Adding a new limited partner is easier than adding a new general partner.

52. More general partners means more people controlling and binding the partnership.

53. More limited partners means more people controlling and binding the partnership.

Multiple Choice QuestionsCircle the le�er that best completes each sentence or answers each question.

1. A witness to a will usually can receive:a. nothing at all from the estateb. no more than his regular statutory amountc. payment just for signing the document

2. As tenants in the entirety, a husband and wife can hold:a. only their real estate propertyb. all their propertyc. all their property, plus property they share with other family members

3. In making a will, one must always:a. sign it oneselfb. give property to one’s spousec. get it witnessed

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4. In settling an estate with a will, distributing the property to heirs:a. always comes firstb. follows the payments of debts and taxesc. happens before the probate court proceedings

5. Which of these are not valid insurable interests for fire or property damage:a. Policy Owner = A, Insured = home that A is contracted to buyb. Policy Owner = B, Insured = building leased by B c. Policy Owner = C, Insured = C’s neighbor’s housed. Policy Owner = D, Insured = D’s mortgaged property

6. Which of these is not a valid insurable interests for life insurance:a. Policy Owner = a partnership, Insured = one of the partners b. Policy Owner = a mother, Insured = her grown sonc. Policy Owner = movie studio, Insured = the stars of film in productiond. Policy Owner = a bank, Insured = a mortgage debtor to the bank

7. The proceeds of a life insurance policy (with an irrevocable beneficiary):a. can be attached by the policy owner’s creditors b. can be attached by the beneficiary’s creditorsc. can be attached by the insured’s creditors d. can be attached by the insurance company’s creditors

8. Which of these is not a typical clause in an insurance contract?a. claims must be prorated among policies covering the same propertyb. a coinsurance policy requires the property owner to help pay for damagec. within certain time limits, proceeds cannot be collected upon the insured’s suicide d. a single missing or late payment results in policy cancellation

9. A car loan with the borrower’s parent as cosigner is:a. a restricted, uncompensated guarantyb. a continuing, compensated guarantyc. not a guaranty

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10. A guaranty agreement requiring that the creditor perform certain steps before holding the guarantor responsible is called:a. an absolute guarantyb. a conditional guarantyc. an uncompensated guaranty

11. A person who promises to perform upon another person’s default is a:a. creditorb. principalc. guarantor

12. If a principal defaults on payment, and the guarantor refuses to pay, the creditor may sue: a. the principal, but only if the guarantor has defaulted firstb. both the principal and the guarantor c. only the guarantor

13. A guarantor can defend himself against a creditor’s claims for payment if:a. the contract was void all along due to the principal’s fraudb. the principal went bankruptc. the contract was void all along due to the creditor’s fraud

14. If the principal and creditor change their contract to twice the work and money as before:a. The creditor must wait twice as long after default to collect from the guarantor.b. The guarantor is not liable for any default unless he consented to the change.c. Nothing changes in the guarantor/creditor/principal relationship.

15. If the principal has not yet performed when a guarantor satisfies the creditor’s claim: a. The guarantor can then seek reimbursement from the principal.b. The guarantor can then seek reimbursement from the creditor.c. The guarantor can’t be reimbursed.

16. If the principal had already performed when a guarantor satisfies the creditor’s claim: a. The guarantor can’t be reimbursed.b. The guarantor can then seek reimbursement from the principal. c. The guarantor can then seek reimbursement from the creditor.

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17. If a creditor lies about the principal to a guarantor securing the principal’s performance:a. The principal is no longer liable for default.b. The guarantor can be released from securing the principal’s performance. c. The contract between the creditor and principal is void.

18. In a general partnership, any single partner acting alone has the right to:a. review partnership booksb. commit to a new field of businessc. sell partnership equipmentd. enroll a new general partner

19. In a general partnership, approval of all other partners is required for:a. making any contracts with regular customersb. all hiring and firing of employeesc. approving a partner’s personal use of partnership assets d. determining routine business priorities

20. When a limited partnership is dissolved, wound-up and terminated:a. Partners can still bind the partnership by making contracts with others.b. General partners are refunded their capital contributions before limited partners.c. All existing liabilities are automatically extinguished.d. Creditors are paid before partners.

21. All of these items are in the partnership agreements except:a. any salaries and profit arrangement among partnersb. an ongoing list of all current partnership assetsc. capital contribution amounts from each partnerd. the name of the partnership

22. Both the principal and the agent are liable for a. the principal’s defective merchandiseb. the agent’s fraud in carrying out the principal’s businessc. the agent’s independent criminal actsd. for damage done during the agent’s frolic

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23. A bar owner can also be held liable for:a. his bartender’s onsite sale of liquor to minorsb. local vandalism done by the bar’s after-hours contract security servicec. his janitor’s theft of liquor and subsequent after-hours drunk drivingd. injuries caused by his bouncer’s road rage en route to the bar

24. Under respondent superior, a bakery is not likely to be liable for:a. price and schedule commitments made by its wholesale salesmanb. accident damages due to its delivery van driver’s midday sleepinessc. the chief baker’s incorrect statements regarding contents of the baked goodsd. accident damages due to its drunken janitor’s late-night theft of the delivery van

25. A rental apartment firm (responsible for renting and managing others’ buildings) can:a. commit to sell the property if the offer is very highb. withhold information about building dangers from the building ownersc. contract another party to do weekly lawn mowingd. contract another party to screen all new renters

26. All of the following require a written contract, except:a. an agreement to paint another person’s homeb. an agreement to purchase another person’s homec. an agreement to assume the debt for another person’s home

27. Which is not compensatory damages for a breach of a restaurant’s roofing contract?a. a restaurant’s cost for repairs and cleaning of their building and furnitureb. the lost business due to a restaurant’s inability to cook under a leaky roofc. the cost to replace a very rare aquarium fish killed by unusually toxic rainwater

28. All of the following circumstances will typically support voiding a contract, except:a. a party’s duress caused by the other party’s overbearing threatsb. a party’s failure to read the contractc. a party’s fraudulent description of an item being exchanged

29. Which one of the following is a legal purpose for a contract:a. a person who had been assaulted agrees to refrain from suing the other partyb. a person agrees to rent the use of his address to an immigrant for INS papersc. a person agrees to pay three times the regular bank rate for a loan

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30. All of these are bilateral promises, except:a. “I will mow your lawn if you will trim my trees.” b. “I will pay $20 to whoever finds my dog.”c. “I will pay you $100 if you promise to send me your autographed baseball.”

31. A novation is when one contract party:a. gets someone to purchase his right to payments due from the other contract partyb. gets someone to take over his rights / responsibilities and the other party agreesc. makes a the contract to provide benefits for a third party

32. Which of the following is true about offers:a. The offer is rejected if the offeree receives any other offers from anyone else. b. The offer is valid for months, years—indefinitely.c. The offer, once revoked by the offeror, cannot then be accepted by the offeree.

33. Which of these is not a defective promise:a. One party promises to do something he is already bound to do.b. One party promises to exchange a very valuable item for a less valuable item.c. One party promises to refrain from suing someone who has never wronged him.

34. Which of the following is not available to a corporation filing for bankruptcy:a. Chapter 7b. Chapter 11c. Chapter 13

35. A person filing for bankruptcy can expect to retain all of these items except:a. his clothesb. his motorboatc. his work equipment

36. A person filing for bankruptcy cannot expect to be relieved of:a. his credit card debts b. his overdue cable billsc. his child support obligations

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37. Creditors can try to force a person into:a. Chapter 9 bankruptcyb. Chapter 7 bankruptcyc. Chapter 13 bankruptcy

38. A trustee does all the following acts except:a. identify the reason the debtor was insolventb. examine the debtor’s recent transfers of propertyc. review all claims submitted by creditors

39. The trustee reviews the debtor’s past financial dealings for all of the following reasons except:a. to see if the debtor has hidden property with a friend or family b. to see if the debtor has paid off one creditor in preference to the othersc. to see if the debtor is a mentally incompetent

40. Regarding repayment after a debtor’s bankruptcy, Creditors cannot usually expect:a. to eventually get all the amount due themb. to be placed in a hierarchy with the other creditorsc. to be paid at least some portion of the amount due to them

41. A debtor may be denied discharge on the following grounds except:a. keeping poor records of his financial condition in the pastb. past poor decision making in managing his financial affairsc. a fraudulent transfer of property

42. Once someone files Chapter 7 bankruptcy:a. he is expected to provide a repayment plan and work with creditors to follow itb. he maintains control over which creditors get paid and whenc. he loses much control over the resolution of his financial problems

43. Which is not likely to be a violation of the Sherman and/or Clayton Act?a. A large gas station franchise agrees with a similar franchise to keep prices high.b. A corporation requires that its suppliers not deal with any of its competitors.c. All downtown retailers agree to stay open late for Midnight Madness sales.

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44. A violation of the Clayton Act could result in the following except:a. finesb. jail timec. court orders

45. Which act protects consumers who are injured by unfair competitive practices?a. the Sherman Actb. the Federal Trade Commission Actc. the Clayton Act

46. The Robinson-Patman Act prohibits:a. unjustified pricing discounts given to one buyer but not anotherb. mergers between competitorsc. competitors conspiring to hold prices high

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Practice Challenge Question Answers

Chapter 1 Answers1. Answer: T 2. Answer: F—The provisions of the Code may be changed by agreement among the

parties except as forbidden in the Code. Good faith, diligence, reasonableness and care may not be disclaimed.

3. Answer: T 4. Answer: F—In certain instances, the purchaser may actually take more than the seller.

For example, where: 1) the transferor is deceived as to the identity of the purchaser; 2) the delivery is in exchange for a bad check; 3) it was agreed to be a cash sale; or 4) the delivery was procured through fraud, the buyer receives a voidable title. This means that the seller may void the buyer’s title to the items he has received. If, however, the buyer with voidable title sells to a good faith purchaser for value of the items, the good faith purchaser receives full title and it ceases to be voidable by the original transferor.

5. Answer True6. Answer: F—Commercial paper consists of two basic types of instruments: drafts and

notes. 7. Answer: T8. Answer: T9. Answer: T10. Answer: F—The beginning of the collection process is the deposit of a check in a

customer’s account. The check is then provisionally credited by the bank.11. Answer: T 12. Answer: F—An issuer must honor a draft or demand for payment which complies with

the terms of the applicable letter of credit.13. Answer: True14. Answer: True15. Answer: F—Perfection by attachment requires only the attachment of the security

interest without any further action being required. This is often referred to as automatic perfection.

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16. Answer: T17. Answer: T

Multiple Choice Answers1. D

2. B

3. A

4. A

5. B6. A7. B8. C9. B10. A11. D

12. B

Essay Answers1. Commercial paper is a term used to describe certain types of negotiable instruments. A

negotiable instrument has the capacity to pass like money from person to person and is used as a medium of exchange. A negotiable instrument is a special type of written contract that represents credit and functions as a money substitute.

2. 1. must be in writing and signed by the drawer or maker 2. must contain an unconditional promise or order to pay a sum certain in money 3. must be payable on demand or at a definite time 4. must be payable to order or bearer

3. Warranty of title: The seller warrants good title, rightful transfer, and freedom from any security interest or lien of which the buyer has no knowledge. This warranty can only be disclaimed by specific language or circumstances which make it clear that the seller is not vouching for the title. A seller who is a merchant warrants the goods to be free of any rightful claim of infringement.

An infringement may occur when the buyer furnishes specifications to the seller for the manufacturer of the goods. In this case the seller does not warrant against infringement, and the buyer must protect the seller from any claims arising from such an infringement.

Express warranties: Express warranties include any affirmation of fact or promise which is not just sales talk or an opinion and which becomes part of the bargain. The buyer does not have to prove reliance on this affirmation, and the seller does not have to intend to create a warranty. A seller warrants the goods to be of the same general quality of the sample, model or his description.

Implied warranties: Implied warranties arise as a matter of law and are legally present unless clearly disclaimed or negated. Liability for the breach of an implied warranty is based on the public policy of protecting the buyer of goods. There are two kinds of implied warranties.

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If the seller is a merchant who deals in goods of the kind involved in the contract, an implied warranty of merchantability is created. This warranty means that the goods are fit for the ordinary purpose for which goods of this type are used and will pass without objection in the trade. This warranty applies to new and used goods in most states unless the warranty is modified or excluded.

An implied warranty of fitness for a particular purpose is created when the seller knows of the particular use of the good and knows the buyer is relying on the seller’s skill or judgment to select or furnish suitable goods. The implied warranty of fitness is applicable to both merchants and non-merchants. The warranty does not arise if the buyer’s knowledge is equal or superior to the seller’s. The good is warranted for the particular expressed purpose, and the seller may be liable if the good fails to so perform.

4. The express elements required for a sales contract are: 1. Parties: All parties involved or affected must be described. 2. Price: If a price is omitted, the contract will be enforced at a reasonable price. 3. Time for performance: If time is omitted, then reasonable time is implied. If the contract states that time is of the essence, then delay in performance is a material breach, which means the non-breaching party can terminate performance and sue for damages. 4.Subject matter: Typically, before an agreement is considered enforceable, the quantity must be included. If parties estimate the quantity involved, a quantity unreasonably disproportionate to the estimate will not be enforced. For the most part, if no mention of quantity is found, the contract is unenforceable. If, however, an estimate is not agreed on, a quantity in keeping with normal or other comparable prior output or requirements may be implied.

5. Protest is a formal method of fulfilling the conditions precedent. Protest is required only for drafts that are drawn or payable outside the U.S. The protest is a certificate which states that an instrument was presented for payment or acceptance and was dishonored. The protest explains why the instrument was not accepted or paid.

7. Holder in Due Course A third party who rightfully and legally possesses an instrument may be an assignee, a

transferor, a holder or a holder in due course. If the instrument is a simple contract, the third party is an assignee. If the third party possesses a negotiable instrument that has been improperly negotiated, the party is a transferee with the status of an assignee.

According to the UCC, a holder is a party in possession of a negotiable instrument issued, drawn or endorsed to his order, to him or bearer, or in blank. A holder in due course has a special status and a preferred position in the event there is a claim or a defense to the instrument.

The distinct benefit of negotiability is the ability to transfer the instrument to a holder in due course, that is a holder who takes free of personal defenses drawer/maker. There are three requirements that must be met before a holder becomes a holder in the due course. The holder must have acquired the instrument: 1. for value; 2. in good faith; 3. without notice that it is overdue, has been dishonored or any other person has a claim to or defense against it.

8. Depository bank: The first bank to take an item even though it is also the payor bank, unless the item is presented for immediate payment over the counter.

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9. An engagement by a bank or other person at the request of a customer that the issuer (bank or other person) will honor drafts or other demands for payment upon compliance with the conditions specified in the credit. A credit may either be revocable or irrevocable.

10. 1. a credit issued by a bank if it requires a documentary draft or documentary demand for payment 2. a credit issued by a person other than a bank if it requires that the draft or demand for payment be accompanied by a document of title 3. a credit issued by a bank or other person that conspicuously states that it is a letter of credit or is conspicuously so entitled

There are two types of letters of credit: revocable and irrevocable. Once an irrevocable letter of credit is established with the customer, it can only be modified or revoked with the customer’s consent. Once it is established with the beneficiary, a letter of credit can be modified or revoked only with the beneficiary’s consent.

Once a revocable letter of credit is established, it can be modified or revoked by the issuer without notice to, or consent by, the customer or the beneficiary.

11. 1. Each signature on a certificated security, in a necessary endorsement, on an initial transaction statement or on an instruction is admitted. 2. If the effectiveness of a signature is at issue, the burden of establishing effectiveness is on the party claiming under the signature. The signature is presumed to be genuine or authorized 3. If signatures on a certificated security are admitted or established, presentation of the security entitles the holder to recover on it, unless the defendant establishes a defense or a defect related to the validity of the security. 4. If signatures on an initial transaction statement are admitted or established, any facts presented in the statement are presumed to be true at the time it was issued. The issuer is free to show that later events changed the stated facts. 5. After it is shown that a defense or defect exists, the plaintiff must establish the fact that the defense or defect is ineffective against him

12. The seller may recover the price of: 1. certificated securities accepted by the buyer 2. uncertificated securities that have been transferred to the buyer or a person designated by the buyer 3. other securities, if efforts at their resale would be unduly burdensome or there is no readily available market for their resale

13. A secured transaction is a transaction in which a borrower or a buyer provides security that an obligation will be fulfilled in the form of personal property to a lender or a seller.

14. A secured party is a lender, seller or other person in whose favor there is a security interest.

15. 1. The debtor possesses rights in the collateral. 2. The debtor has authenticated a security agreement or the secured party has possession of the collateral. 3. There must be an obligation for value to be performed or given by the creditor.

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Matching Answers1. 1. c; 2. a; 3. e; 4. b; 5. d

2. a. S; b. B; c. B; d. S; e. S; f. S; g. B; h. B

3. a. C; b. B; c. C; d. B

Chapter 2 Answers1. True2. False—Community property states allow the Widow’s Right of Election in which the

surviving spouse gets a larger share of the property than the will reflected.3. False—Joint tenants includes the right of survivorship—tenants in common does not.4. True 5. False—Partial revocation must be a duly signed and attested instrument.6. False—Children cannot make a will.7. False—In joint tenancy, both parties have the right to be on the entire property.8. False—Proof of fraud or mistake sometimes permits an irrevocable trust to be changed.9. True10. True11. True—In a living trust, the settlor can also be the trustee and beneficiary.12. False—The trustee cannot act for his own interests.13. True14. True15. True16. True17. True18. True19. False—An agent can release simpler, nondiscretionary tasks to a subagent.20. False—The agent (salesman) isn’t responsible for the bad acts of his principal.21. False – Often, independent contractors work without the principal’s direction and

therefore the principal isn’t liable for the independent contractor’s torts.22. False—Most powers of attorney have a specified scope which the agent cannot

overstep. 23. True—If the principal ratifies the agent’s acts, then the principal is liable.24. True25. True26. True27. False—A constructive condition which is substantially performed does not amount to

breach.

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28. False—Promissory estoppel sometimes permits enforcement of a one-sided promise.29. False—Assignment, novation and third-party beneficiaries allow suit on a contract.30. True

31. False—Except for those listed in the statute of frauds section, unwritten contracts can be enforced. However, it’s always better to write any contract.

32. True

33. False – One-year term is the cut off for the writing requirement under the statute of frauds.

34. True

35. False—The proceeds can be assigned, but not the policy itself.

36. True—This is an example of the right of subrogation.

37. False—Property can be insured by mortgagors or leaseholders.

38. True

39. False—There is no legal right of subrogation in life insurance, only accident and property insurance.

40. False—In bankruptcy, the policy’s cash value can often be part of the policy owner’s assets.

41. True

42. False—If the insured dies by suicide within a certain time period, the policy is not required to pay.

43. True

44. True

45. True

46. False—Some state laws and some policies allow a grace period for late payments to still be applied to the policy.

47. False—General partners are personally liable for any partnership obligations which cannot be met by the partnership.

48. False—General partners have more control over the business than limited partners.

49. True

50. True

51. True

52. True

53. False—Usually limited partners have minimal control of the partnership, thus an additional limited partner doesn’t significantly change the control structure of the partnership.

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Answers to Multiple Choice Questions1. b

2. a3. c4. b

5. C

6. b7. b 8. d9. a10. b11. c12. b13. c14.b15.a16. c17.b18. a19.c20. d21. b22. b23.a24. d25. c26.a27. c28. b29. a30. b31.b32. c33. b34. c35. b36. c

37. b38.a39. c40. a41. b42. c43. c44. b45. b46. a

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Certified Bank Auditor

Glossary Section 7 • Chapters 1–2

absolute guaranty—An absolute guaranty agreement comes into effect upon the default of the principal. At that point the creditor may go directly to the guarantor to collect. In fact, a creditor can initiate action against the guarantor at the same time it is initiated against the principal.

accident insurance—Provides coverage against expense, suffer¬ing and loss of earnings resulting from personal injury or property damage.

accommodation party—An individual who lends his name and credit to another party by signing an instrument.

accord and satisfaction—An acceptable substitute to the original promised performances An accord is an agreement whereby one party undertakes to perform (and the other to accept) something different than what the original contract stated. Satisfaction means that the substituted performance is completed.

actions— In judicial proceedings: recoupment, counterclaim, set off, suit in equity, and any other proceedings in which rights are determined.

adequate assurance—A wri�en, convincing proof that a party will perform as promised.

administrator—An individual or a trust institution appointed by a court to se�le the estate of a person who has died without leaving a valid will. If the individual is a woman, she is an administratrix.

advising bank—Bank that gives notification of the issuance of a credit by another bank.

a�er-acquired property—Property acquired by a debtor at a later time and which can become collateral.

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agency coupled with an interest—This relationship exists when the agent has an actual beneficial interest in the property that is the subject ma�er of the agency (i.e., a mortgage or security agreement).

agency coupled with an obligation—A source of reimbursement to the agent.

agency—A trustee may act for an individual in many capacities, such as depository agent, escrow agent, advisory agent, custodian, managing agent, and a�orney in fact.

agent—The party who acts for the principal.

aggrieved party—A party entitled to pursue a remedy.

agreement—The bargain of the parties in fact as found in their language or inferred from other circumstances, including course of dealing, usage of trade, or course of performance.

anticipatory repudiation—A refusal to perform which occurs before performance is due and may be express or implied.

apparent authority—Acts that seem to have or are represented to have authority and may therefore be legally binding.

apparent partner—A person (by words spoken or wri�en, or by conduct) who represents himself as a partner in an existing partnership.

assignee—A person receiving the assets or transfers.

assignment— It involves transfer of assets (e.g., A/R) to a lending institution, or when a party to a contract (assignor) transfers to a third party (assignee) his rights under the contract.

assignor—A person giving the assets or transfers.

a�achment—The creation of a security interest in property occurring when the debtor agrees to the security, receives value from the secured party, and obtains rights in the collateral.

automatic perfection—The a�achment of the security interest without any further action being required, also called perfection by a�achment.

automobile insurance—Indemnifies against loss or damage to an automobile from collision, the�, windstorm and fire, plus damage and personal injury caused to others.

bank—Any person engaged in the business of banking including a savings bank, savings and loan association, credit union, and trust company.

bankruptcy schedule—Lists the debtor’s secured and unsecured creditors, all of his property, any property he claims is exempt and is a statement of the debtor’s affairs.

bankruptcy—Legal process by which a debtor’s property and debts are resolved.

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bargained-for consideration—Legally validates that there was some sort of exchange at the basis of the mutual assent.

bearer paper—Negotiable instrument where payment will be made to anyone who pos¬sesses or bears the instrument.

bearer—The person in possession of a negotiable instrument, document of title, or security payable to the bearer or the endorsed in blank.

beneficiary— Person for whose benefit a trust is created or the person to whom the amount of an insurance policy or annuity is payable.

bequest—A gi� by will of personal property. Devises and bequests are further subdivided into specific, general, and residuary.

bilateral contract—A bilateral contract is a promise exchanged for another promise, in other words, mutual promises.

bill of lading—A document evidencing the receipt of goods for shipment issued by a person engaged in the business of transporting or forwarding goods.

blank endorsement—The endorser’s (customer’s) signa¬ture and converts order paper to bearer paper.

blanket fire insurance policy—A fire insurance policy which covers a class of property that may be changing, such as inventory, rather than a specific piece of property.

blanket fire insurance—Covers a class of property which may be changing, such as inventory, rather than a specific piece of property.

branch—Includes a separately incorporated foreign branch of a bank.

broker—An agent with spe¬cial, limited authority to obtain a customer for an owner who wants to sell or exchange property.

burden of establishing a fact—The task of convincing the triers of the fact that the existence of the fact is more probable than its nonexistence.

buyer in ordinary course of business—A person, who in good faith and without knowledge that the sale to him is in violation of the ownership rights or security interest of a third party in the goods, buys in ordinary course from a person in the business of selling goods of that kind.

buy sell agreements—A method whereby the surviving partner(s) can buyback (i.e. purchase) the interest of the deceased partner, or the remaining partner or partners can purchase the interest of the withdrawing partner.

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captive insurance company—An insurance company that has been set up to provide coverage at a lower cost than available by going through the general insurance market. The company’s stock is controlled by one interest or a group of related interests so as to provide coverage for their business operations. A captive insurance company may be a nonadmi�ed, nonresident or foreign insurer. Sometimes it may provide reinsurance to a self-insure or a domestic company. Source: coverageglossary.com

certificated security—A share, participation or other interest in the property of an enterprise of the issuer; or an obligation of the issuer represented by an instrument issued in bearer or registered form of a type commonly traded on securities exchanges or markets; or typically recognized in the areas in which it is issued or dealt as a medium for investment; or by its terms divisible into a class or series of shares, participation, interests or obligations.

certification—The usual method of accepting a check., where the bank becomes the principal debtor because the bank appropriates from the depositor’s account the necessary funds to pay the instrument.

charitable trust—A trust that can benefit an indefinite group and can have perpetual existence.

cha�el paper—Writing or writings that provide evidence of both an obligation to pay money and a security interest in or a lease of specific goods, also called a security agreement.

claim—A debt or right to payment from the debtor that is held and asserted by the creditor.

clearing corporation—A person that is registered as a clearing agency under the federal securities laws, a federal reserve bank, or any other person that provides clearance of se�lement services with respect to financial assets that would require it to register as a clearing agency under the federal securities laws but for an exclusion or exemption from the registration requirement.

clearinghouse—An association of banks or other payors who regularly clear items.

coguarantors—People who are jointly and severally liable to a creditor.

coinsurance clause—A clause that requires the owner/insured to bear a certain percentage of the loss when he fails to carry complete coverage.

collateral—Pledged by a borrower to secure payment on a loan. Whether negotiable or nonnegotiable, it should have sufficient value to secure loan payment and be in a form that can be converted to cash, or specific property that a borrower pledges as security for the repayment of a loan. The borrower agrees that the lender will have the right to sell the collateral for the purpose of liquidating the debt if the borrower fails to repay the loan at maturity or otherwise defaults under the terms of the loan agreement. There are two types of collateral: tangible and intangible.

collecting bank—Any bank handling an item for collection except the payor bank.

commercial paper—Unsecured promissory note with a fixed maturity.

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community property—Property held jointly by a husband and wife. Source: Merriam-Webster, 10th ed.

compensated guarantors—Guarantors who receive some pay or other consideration in direct exchange for his contract with the creditor (e.g., bonding companies).

compensatory damages—Damages designed to compensate the aggrieved party for his loss, also called general damages.

conditional guaranty—A conditional guaranty agreement requires that the other acts (additional to the default of the principal) occur before the guarantor can be held liable.

conditional liability—The secondary liability of parties, such as drawers and endorsers.

confirming bank—Bank that engages either that it will itself honor a credit already issued by another bank, or that such a credit will be honored by the issuer or a third bank.

conglomerate merger—Parties who were neither former competitors nor in the same supply chain.

consequential damages—Damages that arise from special circumstances surrounding a contract and are not normally foreseeable, also called special damages.

conservator—The personal representative of a living but mentally incompetent person.

consideration—The inducement to a contract or other legal transaction; specifically : an act or forbearance or the promise thereof done or given by one party in return for the act or promise of another. Source: Merriam-Webster, 10th ed.

conspicuous—A term or clause wri�en, displayed or presented in such a manner that a reasonable person against whom it is to operate ought to have noticed it.

constructive condition—Part of the detailed interaction between two parties who have contracted. One party’s performance of a constructive condition triggers the other party’s duty to start performing his side of the bargain.

constructive trust—A trust created by a court of equity for the purpose of preventing unjust enrichment as in the case where a transfer of property is obtained by fraud or violation of some fiduciary duty.

consumer goods—Those goods bought primarily for personal, family or household purposes.

consumer—An individual who enters into a transaction primarily for personal, family or household purposes.

continuing guaranty—A continuing guaranty agreement covers a contemplated series of ongoing transactions over a period of time.

contract—A commitment concerning the future conduct of the parties.

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course of dealing—A course of dealing in a previous transaction between parties which establishes a common basis of understanding for interpreting their expressions and other conduct.

cover—In revocation of goods: to purchase the needed goods from another source to substitute for those due from the seller.

credible witness—One who is competent to testify to support a will.

creditor—A creditor includes a general creditor, a secured creditor, a lien creditor, and any representative of credi¬tors, including an assignee for the benefit of creditors, a trustee in bankruptcy, a receiver in equity, and an executor or administrator of an insolvent debtor’s or assignor’s estate.

creditor—An entity to whom a debtor owes money.

creditor beneficiary—A third party for whom a promisee has contracted for a promise to pay a debt.

creditor—The party entitled to receive payment or performance from the principal or obligor, also called an obligee.

cure—As a result of the rejection of goods: a right which allows the seller to correct the defective performance.

custodian bank—A bank or trust company that is supervised and examined by the state or federal authority having supervision over banks and is acting as custodian for a clearing corporation.

customer—A buyer or other person who causes an issuer to issue a credit.

debtor—An entity who owes money or to which the bankruptcy case pertains.

defendant—A person in the position of defendant in a counterclaim, cross-claim or third-party claim.

delivery—The voluntary transfer of possession of instruments, documents of title, cha�el paper or securities.

demand paper—A negotiable instrument that does not specify a due date. An example of demand paper is a check.

deposit accounts—Time deposits, demand deposits, savings deposits, passbooks, and share dra�s (a Certificate of Deposit is not a deposit account).

depository bank—The first bank to take an item even though it is also the payor bank, unless the item is presented for immediate payment over the counter.

devise—A gi� of real property by will of real estate.

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disclosed principal—An agent for a disclosed principal reveals the principal’s identity.

dissolution—The legal destruction of the existing partnership relation.

doctrine of cy pres (as nearly as)—A rule that provides that if a particular charitable purpose cannot be fulfilled in the manner directed by the se�lor, the court can carry out the general charitable intention by prescribing the application of the trust property to another charitable purpose consistent with the original.

document of title—Any document which in the regular course of business or financing is treated as adequately evidencing that the person in possession of it is entitled to receive, hold and dispose of the document and the goods it covers, including a bill of lading, dock warrant, dock receipt, warehouse receipt or order for the delivery of goods.

documentary demand for payment—An honor conditioned upon presentation of a document (i.e., a paper such as a document of title, security, invoice, certificate, etc.), also called a documentary dra�.

documentary dra�—An honor conditioned upon presentation of a document (i.e., a paper such as a document of title, security, invoice, certificate, etc.), also called a documentary demand for payment.

donee beneficiary—A third party for whom the promisee purchased the promise as a gi�.

dormant partner—A partner who is both silent and secret.

dra�—A signed wri�en order addressed by one person (the drawer) to another person (the drawee) directing the la�er to pay a specified sum of money to the order of a third person (the payee). Dra� is also called a bill of exchange.

due diligence—The care that a reasonable person exercises under the circumstances to avoid harm to other persons or their property. Source: Merriam-Webster, 10th ed.

economic expectancy—A verification of a pecuniary link between the parties when insuring the life of a more remote family member.

endorsers—Legal signatory on the bank of an instrument. An endorsement is required on a negotiable instrument to transfer and pass title to another party, who becomes a holder in due course.

endowment policy—A policy where the insured is required to pay premiums for a certain number of years.

equipment—Those goods that are used or purchased primarily for use in a business, in farming, in a profession, or by a nonprofit organization or government agency, (also serves as a catchall for all other goods which defy classification).

estate— The property a person owns and protects.

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estoppel—A legal bar to alleging or denying a fact because of one’s own previous actions or words to the contrary. Source: Merriam-Webster, 10th ed.

exclusive contract—A contract in which the seller agrees to sell a product to a buyer on the condition that the buyer will not purchase products from the seller’s competitors, also called a tying contract.

executed performance contract—A contract that has been fully performed by the contracting parties.

executor—An individual or a trust institution nominated in a will and appointed by a court to se�le the estate of the testator is said to be the executor. If a woman is appointed, she is referred to as an executrix.

executory performance contract—A contract that has yet to be performed by the contracting parties.

exemplary damages—Damages awarded to one party in order to punish the other’s conduct and to deter others from the same conduct in the future. Most o�en awarded when the breach is fraudulent, oppressive or malicious, also called punitive damages.

express contract—When the parties state their agreement orally or in writing.

express private trust—A fiduciary relationship with respect to property.

express repudiation—A clear, positive unequivocal refusal to perform.

express warranty—Any affirma¬tion of fact or promise which is not just sales talk or an opinion and which becomes part of the bargain. The buyer does not have to prove reliance on this affirmation and the seller does not have to intend to create a warranty.

factor—An agent who has possession and control of another’s personal proper¬ty and is authorized to sell that property.

failure to perform—In contracts: doing a poor quality job, a breach of contract.

farm product—includes crops and livestock, supplies used or produced in farming operations, and the products of crops or livestock in their unmanufactured state (co�on, milk, wool, etc.)

fault—A default, breach, wrongful act or omission.

fidelity bond—Provides coverage for losses resulting from the dishonest acts of people.

fidelity insurance—Insures against loss from dishonesty of employees or people in positions of trust, also called guaranty insurance.

financing statement—A document containing the addresses of both the debtor and the secured party. The financing statement also contains a description of the collateral.

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fire insurance—Covers direct fire damage plus any indirect fire damage such as damage from smoke, water or chemicals.

friendly fire—Damage caused by smoke from a fire in a fireplace.

frolics—When a servant neglects his master’s business and pursues his personal interests.

fungible—Being of such a nature that one part or quantity may be replaced by another equal part or quantity in the satisfaction of an obligation. Source: Merriam-Webster, 10th ed.

general agent—An agent who is authorized to conduct a series of transactions in the continuous service of the principal.

general damages—Damages designed to compensate the aggrieved party for his loss, also called compensatory damages.

general guarantor—A guarantor who is not limited to a single, specific creditor.

general intangible—goodwill, patents and copyrights.

general legacy—A legacy that can be satisfied by the delivery of any property of the general type.

general partner—A partner who is liable for all partnership liabilities plus any unpaid contributions.

general power of a�orney—A power of a�orney which gives the agent the authority to act in most respects for the principal and has a broad scope of authority.

genuine—Free of forgery or counterfeiting.

good faith—Honesty in fact and the observance of reasonable commercial standards of fair dealing.

good faith purchaser—One who buys the collateral and is unaware of the existence of any security interest in the property.

goods—All items which are moveable and personal property of a tangible, physical nature. They also include the unborn young of animals, growing crops, and standing timber to be cut.

grace period—A period of time a�er payment is due within which payment can be made without the policy lapsing.

guarantor—any party that promises the creditor to be liable in case of the principal’s failure to pay or perform, also called a surety.

guardian—The personal representative of a living person who is a ward (generally a child).

holder in due course—The person who obtains title to a transferred negotiable instrument.

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holder—Person in possession of a negotiable instrument that is payable either to the bearer or to an identified person that is the person in possession.

horizontal merger—A merger between former competitors.

horizontal restraint—An agreement among competitors such as manufacturers, retailers and wholesalers.

hostile fires—Unintentional fires or fires that have le� the intended burning spot.

Identified (identification)—In the UCC: designated as the specific goods that will be utilized in the transaction.

illusory promise—A statement that purports to be a promise but is not because the promisor need not perform it.

impaired claim—A debt that the bankruptcy proceedings either decrease or delay.

implied repudiation—When the promisor makes it impossible for himself to perform.

implied warranties—A warranty that arises as a ma�er of law and is legally present unless clearly disclaimed or negated. Liability for the breach of an implied warranty is based on the public policy of protecting the buyer of goods.

implied warranty of fitness—A warranty created when the seller knows of the particular use of the good and knows the buyer is relying on the seller’s skill or judgment to select or furnish suitable goods. The implied warranty of fitness is applicable to both merchants and nonmerchants.

implied warranty of merchantability—Warranty that the goods being sold are fit for the ordinary purpose for which goods of this type are used and will pass without objection in the trade. This warranty applies to new and used goods in most states unless the warranty is modified or excluded.

implied in fact contract—When the agreement is manifested only by the two parties’ conduct, but not in any writing.

implied in law contract—This is similar to an implied-in-fact contract For example, when A’s conduct (mis)leads B to think they have a certain firm agreement and B relies upon that agreement B then gives some benefit to A, but A refuses to honor the unspoken agreement, see also quasi contract.

inability to perform—An excuse from liability for a contract breach, where the defending party answers that the reason for the breach was because of an inability to perform, not a failure or refusal to perform.

incontestability clause—A clause where a�er a certain period of time, typically two years, a policy cannot be contested because of concealment or misstatements.

independent contractor—A person whose services are contract¬ed for by another person.

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infringement—An act or claim that interferes with an exclusive right of an owner.

insider—A debtor’s relatives, partners, or (if debtor is a corporation) directors or executives.

insolvency proceedings—Any assignment for the benefit of creditors or other proceedings intended to liquidate or rehabilitate the estate of the individuals involved.

insolvent—A person who either has generally ceased to pay his debts in the ordinary course of business other than as a result of a bona fide dispute, or who cannot pay his debts as they become due, or who is insolvent within the meaning of the federal bankruptcy law.

instruments—Negotiable instruments, securities such as stocks and bonds, and any other writing that evidences a right to the payment of money and is not itself a lease or security agreement; may be negotiable dra�s, checks, certificates of deposit and promissory notes.

insurable interest—The relationship between the policy owner, the insured and the event.

insurance—Coverage by contract whereby one party undertakes to indemnify or guarantee another against loss by a specified contingency or peril. Source: Merriam-Webster, 10th ed.

intangible collateral—Collateral that is an account (any right to payment for goods sold or leased or for services rendered, whether or not earned by performance), or any general intangible.

intentional torts—A tort prompted by a feeling of ill will.

inter vivos—A trust created by a transfer of property during one’s lifetime, also called a living trust.

interlocking directorates—Having the same individual on two or more board of directors.

intermediary bank—Any bank to which an item is transferred in the course of collection except the depository or payor bank.

intestate— Without having made and le� a valid will.

inventory—Goods that a person holds for sale or lease and that are to be furnished under a contract of service, including raw materials, works in process, finished goods, and materials used or consumed in a business

involuntary bankruptcy—A bankruptcy that is started when one or more of a debtor’s creditors files a petition.

irrevoca¬ble le�er of credit—A le�er of credit which can only be modified or revoked with the customer’s or beneficiary’s consent.

issuer—A bank or other person issuing a credit.

joint and several liability—Where two people are responsible for an action and can share liability for the injury.

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joint tenancy—Holding of property by two or more persons in such a manner that, upon the death of one joint owner, the survivor(s) take(s) the entire property.

legal detriment—A promise to perform an act that one had no prior legal obligation to perform It can also be to refrain from doing something that one could legally do and had no prior legal obligation not to do.

legal relief—A private action for money damages.

legal theory of estoppel—If a person by words spoken or wri�en or by conduct represents himself as a partner in an existing partnership, that person is not a partner but is liable to any party to whom such representation has been made.

le�er of credit—A formal document in le�er form addressed to and authorizing the beneficiary (for example, an exporter) to draw a dra� to a stated amount of money against the accepting bank.

liability insurance—Protects the insured against liability for accidental damage to people or property and typically includes the duty to defend the insured in a lawsuit brought by third parties.

liability—Probable future sacrifice of economic benefits arising from the present obligations of a particular entity to transfer assets or provide services to other entities on the future as a result of past transactions or events.

life insurance—insurance providing for payment of a stipulated sum to a designated beneficiary upon death of the insured. Source: Merriam-Webster, 10th ed.

Limited Liability Companies (LLC)—A partnership where there is no distinction between general or limited partners, all partners are considered members.

Limited Liability Partnerships (LLP)—A partnership where there are both general partners and limited partners.

limited partner—A partner who is obligated to the partnership to make any contribution stated in the certificate.

limited payment life insurance—Requires the payment of premiums over a fixed number of years and the policyholder is insured for life.

liquidated damages—The money damages applicable in the case of a breach.

living trust—A trust created by a transfer of property during one’s lifetime, also called inter vivos.

locus poenitentiae—A person who repents before performing any illegal part of the contract, also called place for repentance.

maker—Regarding negotiable instruments: the primary party.

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malpractice insurance—A form of personal liability insurance used by doctors, lawyers and other professionals. Protects against liability for harm caused by errors or negligence in performing work.

marshalling of assets—A rule which comes into play when a firm is insolvent and a court of equity becomes responsible for distribution of the partnership’s assets.

master—In tort liability: one who employs another person.

merchant—A person who deals in the goods being sold or who holds himself out as having knowledge or skill peculiar to the goods involved in the transaction.

midnight dead¬line—The time by which a bank must provide notice of dishonor: before midnight of the next banking day following the day the bank received the item.

money damages—Nominal damages, compensatory damages, consequential damages, punitive damages or liquidated damages.

money—A medium of exchange currently authorized or adopted by a domestic or foreign government. This includes a monetary unit of account established by an intergovernmental organization or by agreement between two or more countries.

mutual agreement—In contracts: the parties may agree in their contract to terminate the relationship at a definite point in time or on completion of a task. The parties may also mutually agree to cancel their relationship.

mutuality of obligation—Each party is bounded or neither party is bound.

negotiable instruments—(1) It must be in writing and signed by the maker or drawer; (2) it must contain an unconditional promise or order to pay a certain sum in money; (3) it must be payable on demand; (4) it must be payable to order or to bearer; and (5) when the instrument is addressed to the drawee, he must be named or otherwise indicated therein with reasonable certainty.

nominal damages—Symbolize the wrong done by the mere breach of con¬tract and are typically one dollar.

nontrading partnership—Engages in the production of merchan¬dise from raw materials or sells services.

note—A type of negotiable interest which is a wri�en promise to pay (other than a certificate of deposit) by a party—the maker—a sum certain in money to the order of another party—the payee or the bearer of the note. Hence this form of commercial paper includes promissory notes, bank certificates of deposit, and cashier’s checks.

notice of breach—Notice of any alleged breach of express and implied warranties.

notice of dishonor—Notice that a negotiable instrument has not been honored by the bank.

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novation—An agreement whereby a new party is substituted for an original party to a contract.

obligor—The party who borrows money or assumes direct responsibility to perform a contractual obligation, also called principal or principal debtor.

offeree—The party to a contract who responds to the final exchange of promises, (i.e., the one who receives the offer and accepts or rejects it), also called a promisee.

offeror—The party to a contract who initiates the final exchange of promises, (i.e., the one who makes the offer), also called a promisor.

option contract—An contract offer that cannot be revoked for a certain time period so that the offeree can decide whether or not to accept it.

option—Agreement that permits one to buy or sell something within a stipulated time according to the terms of the agreement.

order of relief—Court order from the bankruptcy judge (when he decides that the debtor is entitled to bankruptcy law protection) authorizing the bankruptcy, the trustee’s actions, the selling of assets and the payment of creditors.

order paper—A negotiable instrument which states that payment will be made to the order of a designated payee or to anyone that such a payee may order or direct. Order paper can be negotiated only by both endorsement and delivery.

ordinary life insurance—Insurance that requires the insured to pay premiums over his life. A fixed sum is then paid to the beneficiary on the insured’s death, also called whole life insurance.

organization—In the code, an organization is defined as a person other than an individual.

overdra�—The amount by which the sum of checks paid against an account exceeds the balance in the account.

Parol Evidence Rule—Prohibits the introduction of subsequent evidence that would alter a wri�en contract.

partial integration rule—The parties intend the writing to be final on the terms as wri�en but not necessarily complete on all terms of the agreement.

partially disclosed principal—The third party knows that a principal exists but does not know the principal’s identity.

partnership at will—When a definite term of duration of a partnership is not specified in the agreement.

partnership—An association of two or more people to carry on as co owners of a business for profit.

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party—In the UCC: a person or business that has engaged in a transaction or made an agreement.

payee—One to whom money is or is to be paid. Source: Merriam-Webster, 10th ed.

payor bank—The drawee of a dra�.

perfection by a�achment—A type pf perfection which requires only the a�achment of the security interest without any further action being required, also called automatic perfection.

perfection—Pu�ing the world on notice that a secured party has a security interest in a property.

performance bonds—Bonds that provide coverage against losses resulting from the failure of a contracting party to perform the contract as agreed.

performance—What the promisee/offeree and promisor/offeror agree to do for one another.

personal defense—An ordinary defense in a contract action—such as failure of consideration or nonperformance of a condition—which argues that the maker or drawer of a negotiable instrument is precluded from raising against a person who has the rights of a holder in due course.

person—In the UCC: an individual; corporation; trust; business trust; estate; partnership; limited liability company; association; joint venture; government; governmental subdivision, agency or instrumentality; public corporation; or any legal or commercial entity.

pledge (or pledge transaction)—The simplest type of secured transaction where a borrower gives the physical possession of his property (i.e., diamond ring) to a lender as security for a loan. If the loan is not repaid, the lender can sell the property to satisfy the obligation or debt.

power of a�orney—A formal document for conferring authority on an agent. Typically, signed by the principal in the presence of a notary public.

present value—The amount as of a date certain of one or more sums payable in the future, discounted to the date certain by use of either an interest rate specified by the parties if that rate is not manifestly unreasonable at the time the transaction is entered into or, if an interest rate is not so specified, a commercially reasonable rate that takes into account the facts and circumstances at the time the transaction was entered into.

presenting bank—Any bank presenting an item to a payor bank.

presentment—The act of presenting to an authority a formal statement of a ma�er to be dealt with; specifically : the notice taken or statement made by a grand jury of an offense from their own knowledge without a bill of indictment laid before them, or the act of offering at the proper time and place a document (as a bill of exchange) that calls for acceptance or payment by another. Source: Merriam-Webster, 10th ed.

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primary parties—Makers of notes and the acceptors of dra�s and are the parties who will actually pay the instruments.

principal debtor—The party who borrows money or assumes direct responsibility to perform a contractual obligation, also called principal, or obligor.

principal—The party who borrows money or assumes direct responsibility to perform a contractual obligation, also called principal debtor, or obligor. Or, the party who controls the agent and for whom the agent acts.

promisee—The party to a contract who responds to the final exchange of promises, (i.e., the one who receives the offer and accepts or rejects it), also called an offeree.

promisor—The party to a contract who initiates the final exchange of promises, (i.e., the one who makes the offer), also called a offeror.

promissory estoppel—The legal means used to enforce such promises almost as though they were contracts.

protest—A formal method of fulfilling the conditions precedent. Protest is required only for dra�s that are drawn or payable outside the U.S. The protest is a certificate which states that an instrument was presented for payment or acceptance and was dishonored, and explains why the instrument was not accepted or paid.

punitive damages—Punitive damages are awarded to one party in order to punish the other’s conduct. They are also awarded to deter others from the same conduct in the future. Punitive damages are most o�en awarded when the breach is fraudulent, oppressive or malicious, also called exemplary damages.

purchaser—A person that takes by purchase.

purchase—To take by sale, lease, discount, negotiation, mortgage, pledge, lien, security interest, issue or re issue, gi�, or any other voluntary transaction which creates an interest in property.

qualified endorsement—The transferor disclaims any liability on the instrument.

quasi contract—This is similar to an implied-in-fact contract. For example, when A’s conduct (mis)leads B to think they have a certain firm agreement and B relies upon that agreement B then gives some benefit to A, but A refuses to honor the unspoken agreement, see also implied in law contract.

ratification—The principal—with knowledge of all material ma�ers—has expressed or implied adoption or confirmation of a contract entered into on his behalf by a person with no authority to do so. The principal’s conduct, inconsistent with the intent to reject the contract, implies ratification.

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real defense—A type of defense that is good against any possible claimant, so the maker or drawer of a negotiable instrument can raise it even against a holder in due course. Examples are: fraud in fact, forgery of a necessary signature, etc.

reasonable time—Any time which is not manifestly unreasonable may be fixed by agreement. A reasonable time depends on the nature, purpose and circumstances of an action. If no time is agreed upon, it is within a reasonable time.

record—Information that is inscribed on a tangible medium or that is stored in an electronic or other medium and is retrievable in perceivable form.

refusal to deal—Selling to one firm while refusing to deal with another.

refusal to perform—A type of breach of contract.

registered form—Re: certificated securities: Specifies a person entitled to the security or the rights it represents, its transfer is registered on books maintained for that purpose by or on behalf of the issuer, or if the security so states.

remedy—Any remedial right to which an aggrieved party is entitled with or without resort to a tribunal.

replevin—The recovery by a person of goods or cha�els claimed to be wrongfully taken or detained upon the person’s giving security to try the ma�er in court and return the goods if defeated in the action, or the writ or the common-law action whereby goods and cha�els are replieved. Source: Merriam-Webster, 10th ed.

representative—A person empowered to act for another including an agent; an officer of a corporation or association; and a trustee, executor or administrator of an estate.

rescission—When the court disaffirms the contract and restores the parties to the position they occupied before making the contract.

residuary gi�—A gi� that includes all the personal property not included in the specific or general bequests or devises.

respondent superior—A concept which states that a master is liable to third persons for torts commi�ed by his servants within the scope of their employment and in pursuance of the master’s business.

restitution—When the court requires a party who has been unjustly enriched to return an unfairly-gained item or its value.

restricted guaranty—A restricted guaranty agreement is for a specified single transaction or specified group of transactions.

restrictive endorsement—Restricts the endorsee’s use of the instrument and does not prevent further transfer or negotiation of the instrument. A restrictive endorse¬ment is o�en used when a check is deposited in a bank for collection.

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resulting trust—A trust created by a court of equity when a party with legal title to property is not intended to have it.

revocable le�er of credit—A le�er of credit that can be modified or revoked by the issuer without notice to, or consent by, the customer or the beneficiary.

right—The same as a remedy.

sale on approval—In a consumer purchase: a transaction where the goods are delivered for use.

sale on return—When goods are delivered for resale.

sale—In a sales transaction: title to goods exchanged for a price.

scienter—Intention to mislead.

secondary parties—Drawers of dra�s and checks and endorsers of any instrument.

secret partner—A partner who may advise management and participate in decisions, but his interest is not known to third parties.

secured debt—A debt which is accompanied by giving the creditor an interest in property.

secured party—A lender, seller or other person in whose favor there is a security inter¬est.

secured transaction—A transaction in which a borrower or a buyer provides security in the form of personal property to a lender or a seller that an obligation will be fulfilled.

security agreement—Writing or writings that provide evidence of both an obligation to pay money and a security interest in or a lease of specific goods, also called cha�el paper.

security interest—An interest in personal property or fixtures which secures the payment or the performance of an obliga¬tion.

self-insurance—The advance financial preparation for possible losses and not a distribution of risk, not true insurance.

semi intangible collateral—Collateral that has physical existence but is simply representative of a contractual obligation (i.e., negotiable instruments).

send—A properly addressed writing, record or notice which is deposited in the mail or delivered for transmission by any of the usual means of communication and with postage or cost of transmission provided.

servant— In tort liability: a person who is employed with or without pay to perform personal services for a master and is subject to the master’s right or power of control.

se�lor—An individual who makes a trust, also called a trustor.

sight dra�—A dra� that is payable on presentation to the drawee.

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signed—Any symbol executed or adopted by a party with present intention to authenticate a writing.

silent partner—A partner who does not participate in management.

special agent—An agent who is not in the continuous service of the principal.

special damages—Damages that arise from special circumstances surrounding a contract and are not normally foreseeable, also called consequential damages.

special endorsement—An endorsement that specifies the party (endorsee) to whom or to whose order the endorsement makes the instrument payable. Further negotiation requires the endorsee’s signature.

special guarantor—A guarantor who limits his promise to a single transaction and/or a specific creditor. A special guarantor’s promise can¬not be assigned to a new creditor.

special property interest—An interest where the buyer has (1) an insurable interest in the goods, (2) the right to inspect the goods at a reasonable time and at the buyer’s expense, (3) the right to sue for damages caused by any third party who wrongfully destroys or damages the goods, and (4) the right to demand the goods upon offering the full contract price, if the seller becomes insolvent within ten days of the buyer’s first payment.

specific devise—A gi� of particular property so identified as to distinguish it from other property, also called a specific legacy.

specific legacy—A gi� of particular property so identified as to distinguish it from other property, also called a specific devise.

specific performance—When the court requires the breaching party to do exactly what he agreed to do under the contract.

stale check—A check that is over six months old.

state—A state means a state of the United States, the District of Columbia, Puerto Rico, the United States Virgin Islands, or any territory or insular possession subject to the jurisdiction of the United States.

subagent—A third party who has been delegated the duties of an agent by that agent.

subguarantors—A guarantor’s guarantor.

Subrogation—The right of an insurance company to assume an injured party’s legal claims against third parties.

subsequent purchaser—A person who takes other than by original issue.

suicide clause—A clause in an insurance policy that states the policy will not cover the insured’s suicide for a certain period of time. Typically this time period coincides with the one used in the incontestability clause. A�er the time period expires, suicide is covered.

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surety—A surety is a guarantor or other secondary obligor.

suretyship—The relationship where one person agrees to be answerable for the debt or default of another person.

tangible collateral—Physical property or goods.

tenancy by the entirety—Tenancy by a husband and wife in such a manner that, except in concert with the other, neither husband nor wife has a disposable interest in the property during the lifetime of the other.

tenancy in common—Holding of property by two or more people in such a manner that each has an undivided interest which, upon his death, passes as such to his heirs or devisees and not to the survivor(s).

tender—In contract law: the presentation of performance.

term life insurance—Covers the insured for a fixed number of years. If the insured dies within that term, then the life insurance policy pays.

termination at will—When the agency agreement does not state a definite time period, either the principal or the agent may terminate the relationship.

termination—The winding up process is completed.

term—The portion of an agreement which relates to a particular ma�er.

testamentary trust—A trust established by the terms of the will.

testator—Person who has made and le� a valid will at his death. If the individual is a woman, she is a testatrix.

third party beneficiary—When one party contracts with a second party for the purpose of conferring a benefit upon a third party.

title—All the elements constituting legal ownership, a legally just cause of exclusive possession, the instrument (as a deed) that is evidence of a right, something that justifies or substantiates a claim. Source: Merriam-Webster, 10th ed.

tort—A wrongful act other than a breach of contract for which relief may be obtained in the form of damages or an injunction. Source: Merriam-Webster, 10th ed.

trading partnership—Engages in the business of buying and reselling merchandise.

transferor—One that conveys a title, right, or property. Source: Merriam-Webster, 10th ed.

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trust— Fiduciary relationship in which one person (the trustee) is the holder of the legal title to property (the trust property) subject to an equitable obligation (an obligation enforceable in a court of equity) to keep or use the property for the benefit of another person (the beneficiary). An agreement by which an individual or a corporation as trustee holds title to property for the benefit of one or more persons, usually under the terms of a will and other wri�en agreement.

trustee— Individual or a trust institution that holds the legal title to property for the benefit of someone else. Or, in bankruptcy law, a person responsible for managing the debtor’s assets.

trustor—An individual who makes a trust, also called a se�lor.

tying contract—A contracts in which the seller agrees to sell a product to a buyer on the condition that the buyer will not purchase products from the seller’s competitors, also called an exclusive contract.

unauthorized signature—A signature made without actual, implied, or apparent authori¬ty. This includes a forged signature.

uncertificated security—A share, participation or other interest in property; an enterprise of the issuer; or an obligation of the issuer which is not represented by an instrument and whose transfer is registered on books maintained for that purpose by or on behalf of the issuer; of a type commonly traded on securities exchanges or markets; either one of a class or series; or by its terms divisible into a class or series of shares, participation, interests or obligations.

uncompensated guarantors—A guarantor who doesn’t receive pay or anything else in direct exchange for his contract with the creditor, (e.g., a cosigner on a loan).

undisclosed principal—The principal’s existence is a secret from the third party.

unilateral action—Either party to an agency agreement acting independently to terminating an agency even though he has no right.

unilateral contract—A promise exchanged for an act of performance, (i.e., the offeror promises the offeree a benefit if the offeree performs some act).

unimpaired claim—A debt that is essentially unchanged by the bankruptcy proceedings.

unity of interest—Each owner having equal shares of the property.

unity of possession—Each owner having the right to possess all of the real estate subject to the owner’s rights of possession.

unity of time—The joint tenants’ ownership must be created at the same time.

unity of title—The joint tenants must have the same estate created in the same manner.

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