October 2013

‘Good Faith’ in Commercial Transactions — Toward a Uniform Standard

Varying definitions under different UCC Articles can conceivably cause a party to be governed by a different “good faith” standard in the same relationship. As Paul Shur explains, an awareness of these issues and the benefits of a uniform standard should be goals of practitioners and legislators.



Paul Shur Partner Windels, Marx, Lane & Mittendorf

Paul Shur
Partner
Windels, Marx, Lane & Mittendorf

Amidst the effort by the States to adopt the 2010 amendments to Article 9 of the UCC1 is a simultaneous effort to adopt amendments to UCC Article 1 (General Provisions), which harmonizes, makes consistent and applies general definitions and principles to other Articles of the UCC.2

Uniformity as an Objective

The purpose of Article 1 is to promote the overall policy of the UCC “to make uniform the law among the various jurisdictions.”3 In so doing, the Article 1 amendments revise the definition of “good faith” to apply to each of the Articles of the UCC except if another Article has a particular definition of its own.4 Except for Article 5 (letters of credit) the intent of the amendments is to create a single uniform definition of “good faith” to apply to all UCC transactions because UCC Article 1 provides that “every contract or duty within [the UCC] imposes an obligation of good faith in its performance and enforcement.”5

The pre-revision definition of “good faith” was “. . . honesty in fact in the conduct or transaction concerned.”6 The definition contained no element or requirement of commercial reasonableness. If the performance of a party under the UCC was under scrutiny, the analysis of that performance or conduct was whether the actor was subjectively truthful and behaved honestly.7 The revised definition intended by the Official Text to apply to all Articles (except Article 5) adds an additional requirement such that “good faith” upon amendment means “. . . honesty in fact and the observance of reasonable commercial standards of fair dealing.” 8
The amendments that revise UCC Article 1 also revise other Articles of the UCC so that there will be a simultaneous and consistent definition of “good faith” upon enactment.9 For example, Article 2A (personal property leases) is intended to be amended so that the duty of good faith and its commercially reasonable component applies to all parties to a transaction and not just to merchants as is the current definition.

The effect of the “good faith” amendments in UCC Article 1 is to apply a higher standard of care to both merchants and non-merchants in a commercial transaction. As applied to parties (such as a borrower or debtor) in a complex commercial transaction, having a uniform standard of care appears to promote the UCC goal of “uniformity.” It also adds an “objective” standard of review which measures conduct and performance consistently against a benchmark of commercial reasonableness in the marketplace.10

A Consistent Standard has Practical Benefit

For lenders and their counsel, the incorporation of a higher standard of “good faith” to the conduct of borrowers and debtors in multi-task and multi-state transactions, is desirable. Lenders will thusly advocate in a workout or dispute, that the interposition of defenses or tactics by debtors should be measured and adjudicated by the same standards of commercial reasonableness which govern lenders as secured parties. Thus, if there are several elements of a commercial relationship involved, all aspects of that relationship should have a consistent standard to avoid confusion caused by different definitions. A lack of consistency in the application among the states of a standard will force lenders to consider choice of law rules to determine the applicable duty of care.

Not every state has adopted the amendments to Article 1 and some that have (or have bills pending to do so) have non-uniform versions. These circumstances pose interpretive questions for practitioners who must scrutinize transactions where the conduct of the parties to a commercial relationship bears analysis. In a commercial lending transaction, for example, the parties may have several related transactional relationships that may be analyzed and where “good faith” may be an issue. For example, if a borrower has a secured lending relationship with a lender, each party’s good faith will be measured by UCC Article 9; and if there are equipment lease finance components (Article 2A), deposit and checking account components (Articles 3 and 4), warehouse or storage components (Article 7) or stock pledge components (Article 8), those Articles must be reviewed for their “good faith” definitions. If the State whose law applies11 has not adopted either or both of the Article 1 and 9 amendments (or has enacted a non-uniform version), the analysis of “good faith” may become more complex. Using, as an example, three states whose participation in the amendment adoption process varies,12 the reader can better understand that the choice of state law rules can have a material effect upon the determination of “good faith” in particular transactions.

How My Three States Have Adopted Good Faith Definitions

Florida

Florida last amended its UCC in 2010. Its definition of “good faith” for all Articles of the UCC (except where otherwise noted) is the uniform two-pronged and higher standard of “honesty in fact and the observance of reasonable commercial standards of fair dealing.” However, for leasing transactions under Article 2A, Florida has retained the pre-amendment definition which limits the applicability of “reasonable commercial standards” to merchants and effectively creates a non-uniform standard of review.13 The higher standard applies to all parties to a negotiable instrument (Article 3), bank deposit (Article 4), warehouse agreement (Article 7), investment security (Article 8) or secured transaction (Article 9).

New Jersey

New Jersey adopted Senate Bill No. 2144 into law on June 13, 2013. It adopts amendments to several Articles of the UCC, including Articles 1, 7 and 9.14 The uniform 1-201(20) two-pronged definition of “good faith” was adopted as part of the bill and applies to Article 7 (warehouse receipts) by virtue of the conforming amendments that accompany the Official Text. New Jersey retains (as does Florida) the non-uniform pre-amendment definition of “good faith” in Article 2A which limits the higher standard of care to “merchants” because the uniform definition was not adopted. New Jersey had previously adopted amendments to Articles 3, 4, 8 and 9 and these Articles were already consistent with the uniform “good faith” definition.

New York

New York Bill 5901 proposes to amend several Articles of the UCC, including Articles 1 and 9. To date, the bill has not been adopted. Proposed New York UCC 1-201(20) has a non-uniform definition for “good faith” meaning “honesty in fact.” In Article 2A (leasing) the New York bill would retain the pre-amendment definition of “good faith” which limits the higher standard to merchants (as does Florida and New Jersey). Amendments to Articles 3, 4 and 7 are included in the bill, which adopts the uniform two-pronged “good faith” standard to these Articles.15 Articles 8 and 9 already have the uniform two-pronged “good faith” definition under New York law.

Existing New York law applies the subjective “honesty in fact” definition for transactions in Articles 1, 2A, 3, 4, 7 and the higher two-pronged “good faith” definition in Articles 8 and 9. If Bill 5901 (or something like it) is enacted in New York, the subjective standard will apply to Article 1 and Article 2A (non-merchants only) and the two-pronged definition based upon an application of commercial reasonableness will apply to Articles 3, 4, 7, 8 and 9.
The lack of uniformity caused both by the failure of the states to adopt the Article 1 amendments and by non-uniform enactments is demonstrated by the chart below and the actions of the three highlighted states.

How the Issue Arose in a Recent Case
A recent case from the Southern District of New York is illustrative. In Arthur Glick Truck Sales, Inc. v. Stuphen East Corp.,16 the court reconciled various claims to equipment under the UCC in the context of the bankruptcy of a merchant engaged in the assembly and sale of fire trucks. In its analysis, the court considered choice of law issues as applied to the various “good faith” definitions of Articles 1 and 9 of the UCC.

Plaintiff (New York corporation) sold various truck chassis to debtor(s) (a Michigan corporation and a Wisconsin corporation). Debtor(s) engaged in the construction of fire trucks for purchasers and agreed to pay plaintiff for the chassis upon sale. After delivery of the chassis to debtor(s), plaintiff requested an executed consignment agreement with debtor(s), and plaintiff’s secured inventory lender (General Electric Capital Corp.) filed UCC financing statement(s) against the debtors. Thereafter, the debtor(s) filed Chapter 11 petitions in bankruptcy.

As New York, Michigan and Wisconsin law each conceivably applied to the matter, the court considered each state’s law. The purchasers claimed a superior right to the fire trucks as buyers in the ordinary course who purchased the goods in “good faith” under UCC 1-201(b)(9) in the “ordinary course of business” from a merchant without knowledge that the purchase violated the rights of another person.17 The court reviewed the definition of “good faith” in each state, finding that each state definition was the same.18

Plaintiff argued that its consignment interest and its lender’s perfected security interest was superior because the debtor(s) did not purchase the chassis in “good faith” and did not qualify as a buyer in the ordinary course. Moreover, the plaintiff argued that the debtor(s) should be held to a higher duty of “good faith” by investigating the chain of title to the chassis and other commercially appropriate due diligence.19 Neither of the three states’ law imposed such a higher statutory requirement.

It is conceivable that the application of another state’s law (such as Florida or New Jersey) would have resulted in the purchasers being obligated to observe “. . . reasonable commercial standards of fair dealing” required by UCC 1-201(20). Had that “good faith” definition been applicable, the plaintiff might have been able to successfully argue that due diligence would have been commercially reasonable to apply, such as an investigation of title or an investigation of the debtor(s)’ business relationship with the plaintiff; which evidence might have provided the “knowledge” that the rights of plaintiff were to be violated by the purchase without payment to the plaintiff and disqualified the purchasers as a buyer in the ordinary course under Article 1 of the UCC.

The decision of Arthur Glick Truck Sales highlights the issue created by two different definitions of “good faith” in the same controversy. The priority claims of the parties were governed by Article 9, and the issue was whether the purchasers as a buyer in the ordinary course of business under UCC 9-320 would take free of the plaintiff’s consignment and secured party claims. The definition of “buyer in the ordinary course of business” was located by the court in Article 1, particularly UCC 1-201(b)(9). Since the premise of the definition is that such a “buyer” must exercise “good faith,” the court stayed in Article 1 and applied the Article 1 definition of “good faith” found in pre- amendment UCC 1-201(19). However, since the case involved an Article 9 priority dispute, could not the Court have used the Article 9 definition of “good faith” found in UCC 9-102(43) to impose upon the purchasers (irrespective of whether the plaintiff made such an argument) a duty to observe “reasonable commercial standards of fair dealing” in order to prove their entitlement to buyer in the ordinary course status? Is a dual definitional standard consistent with UCC policy of uniformity? Can legislators in New York avoid this problem before enacting Bill 5901?

Conclusion

A uniform definition of “good faith” does not exist. Several states have adopted different definitions of the duty applicable to several Articles of the UCC. Therefore, it is necessary for the parties to commercial transactions to be cognizant of choice of law principles in order to determine whether a party’s performance and enforcement of its rights in that transaction has satisfied the applicable standard of care. Differing definitions under different UCC Articles can conceivably cause a party to be governed by a different “good faith” standard in the same relationship.20 An awareness of these issues and the benefits of a uniform standard should be goals of practitioners and legislators.

Paul H. Shur is a partner with Windels, Marx, Lane & Mittendorf. He has more than 30 years of experience in commercial transactions, financial transactions, loan workouts and restructures.

Steven L. Shur provided research assistance for this article. He is a third-year law student at Rutgers University School of Law-Camden and a member of the Rutgers Journal of Law and Public Policy.

  1. Uniform Commercial Code (UCC), as drafted by the Uniform Law Commissioners (ULC) in conjunction with the American Law Institute. In this article, all references to the UCC will be to the Official Text, and not to a particular state adopted version unless otherwise noted.
  2. As of this writing (August 30, 2013), the ULC Website indicates that 45 states, the District of Columbia and the U.S. Virgin Islands have adopted the amendments to Article 1. Two states, including New York, have bills pending to enact them.
  3. UCC 1-103(a)(3).
  4. UCC 1-201(a).
  5. UCC 1-304.
  6. Pre-amendment UCC 1-201(19).
  7. See, Rowley, “The Often Imitated, but (Still) Not Yet Duplicated, Revised Article 1,” 38 UCC Law Journal 195 (2006).
  8. UCC 1-201(20).
  9. Articles 5 has a somewhat different definition of ‘“good faith.” See, Official Comment #20 to UCC 1-201. “Thus, the definition of ‘good faith’ in this section merely confirms what has been the case for a number of years as Articles of the UCC have been amended or revised-the obligation of ‘good faith,’ applicable in each Article, is to be interpreted in the context of all Articles except for Article 5 as including both the subjective element of honesty in fact and the objective element of the observance of reasonable commercial standards of fair dealing.” Hawkland, Uniform Commercial Code Series §1-201 (Thomson Reuters 2013).
  10. “The obligation of good faith imposed by §1-304 [Rev] with respect to performance or enforcement relates not only to contracts but also to duties governed by the UCC. . . Important social policy is served, however, by requiring all of the actors in a commercial transaction to employ good faith in its performance and enforcement. . . .” Hawkland, Uniform Commercial Code Series §1-304:1 (Thomson Reuters 2013).
  11. UCC 1-301(c) provides that the parties to transactions governed by the UCC may agree to select the state law that should apply so long as there is a “reasonable relation” unless another Article provides otherwise. In the case of Article 9, for example, the “location” of the debtor determines which state law applies to perfection, the effect of perfection or nonperfection and the priority of a security interest in collateral. UCC 9-301.
  12. The three states chosen are Florida (which has adopted both Article 1 and all Article 9 amendments but some non-uniform), New Jersey (which recently adopted substantially uniform amendments to Article 1 and Article 9) and New York (which has adopted neither Article 1 nor 2010 Article 9 amendments, but which has Bill No. 5901 pending, which would adopt non-uniform amendments to these Articles as well as uniform amendments to Articles 3 and 4 of the UCC simultaneously). Coincidentally, these are three states where the author is licensed to practice law.
  13. Fla Stat. §672.103(1)(b); §680.1031(3)(i). Thus in reviewing the “good faith” of a non-merchant borrower or debtor in an equipment lease transaction under Florida law, the actor would not be governed by an objective commercial reasonableness standard.
  14. The New Jersey amendments to Article 1 omit the text of §1-301 et. seq., which appears to be an oversight.
  15. Existing NY UCC text in these Articles refers to Article 1 for definitions such that until enactment of the bill, New York does not have a two-pronged definition for “good faith” for transactions in negotiable instruments, bank deposits or warehouse receipts. NY UCC 1-201 (McKinney). New York also chose a non-uniform format in the Bill for the amendments which has no substantive consequence.
  16. A case decided December 18, 2012. 914 F.Supp. 2d 529 (S.D.N.Y. 2012); U.S. District Judge Kenneth M. Karas stated that for those “who find great joy in reading” about the UCC, reading the decision “will make your day.”
  17. Such a buyer would take free of a security interest created by the debtor seller (as a merchant) even if the security interest is perfected. UCC 9-320(a); UCC 1-201(b) (9); 914 F. Supp. 2d, at 544.
  18. The subjective “honesty in fact” definition maintained and proposed in New York; none of the three states in the case were held to have the two-pronged definition found in Florida or New Jersey.
  19. The court acknowledged that if a “merchant,” there was authority for holding the purchasers to such a higher commercial standard of care but that plaintiff never asserted the argument and never presented any evidence that the purchasers could or should have known that a purchaser would violate plaintiff’s rights or would be contrary to “good faith.” 914 F.Supp.2d at 547-549.
  20. For example, in Florida, New Jersey or New York a debtor as a lessee in a lease financing transaction governed by Article 2A will not have to act and perform under a commercial reasonableness standard in that transaction (unless a merchant), but will be governed by that standard as a debtor in a secured transaction governed by Article 9. That same debtor in a depository relationship with that same lessor/secured party acting as a bank will be governed by the lesser standard in New York — but that could change if New York adopts Bill 5901.
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