Liberty, trade, and the Uniform Commercial Code: when should default rules be based on business practices?

• Jurisdiction: United States
• Date: 01 May 1997
• Author: Macintosh, Kerry Lynn

The last several years have been a time of revision and renewal for the Uniform Commercial Code (the "Code," UCC) and its drafters. The American Law Institute (ALI) and the National Conference of Commissioners on Uniform State Laws (NCCUSL) have added two entirely new articles,(1) extensively revised four others,(2) and presently are redrafting two more.(3)

These new and revised articles reflect a strong trend toward choosing default rules(4) that codify existing business practices.(5) This is particularly true of the recent revisions to Articles 3 (Negotiable Instruments), 4 (Bank Deposits and Collections) and 5 (Letters of Credit).

At first glance, this trend may seem unremarkable; after all, scholars have long suggested that Karl Llewellyn, the principal draftsman of Article 2, intended the Code as a codification of business practices--a simple reaffirmation of the "morals of the marketplace."(6) However, consumer advocates have protested loudly the recent revisions and their probusiness orientation(7) sometimes to the point of jeopardizing legislative enactment.(8) This controversy invites reexamination of the relationship between business practices and the default rules of the UCC.

Economists long have argued that contract and commercial law should establish default rules reflecting what the parties would have chosen if bargaining were costless.(9) As Professor Mitchell Polinsky has explained, "[s]ilence the parties would have included contract terms that maximize their joint benefits net of their joint costs--both parties can thereby be made better off--this approach is equivalent to designing contract law according to the efficiency criterion."(10) Building on this tradition, the drafters have argued that revised Articles 3, 4, and 5 reduce transaction costs and make payment systems more efficient.(11) Consumer advocates have argued their case using similar economic terms, but have concluded that the same revisions are not efficient.(12)

Although this economic debate has been informative in many ways, it also has proven inconclusive.(13) More importantly, the economic debate has focused on the merit of specific rules that are based on business practices, and not on the more general question of whether business practices are an appropriate source of commercial default rules, and if so, why.

This Article provides a normative account of the relationship between business practices and the default rules of the UCC. The thesis is that business practices are a legitimate source of default rules, to the extent that those practices are the product of free choice by market participants. In other words, default rules should be based on business practices as a means of respecting individual liberty.

In developing this theory of commercial law, this Article reasons by analogy to works of political philosophy. Part I explains Robert Nozick's theory of the evolution of the minimal state. Nozick has theorized that individuals in a state of nature will exercise their liberty to develop voluntary protective associations capable of protecting members against others who would threaten their lives, health, liberty, or property.(14) Emerging over time, a dominant protective association may exercise a de facto monopoly over the use of force, and have a moral obligation to extend its services to individuals within its boundaries.(15) Thus, a minimal state can arise through an "invisible hand" process.(16)

Part II employs similar reasoning to develop a theoretical model of commercial law. Individuals who enjoy freedom and who own property will trade goods and services with each other, and, across countless transactions, business practices will begin to emerge. Individuals may choose to band together in voluntary trade associations, enforcing contractual promises and relevant business practices through a system of arbitration and private sanctions. As a voluntary association comes to dominate a certain trade or geographical area, it will have the de facto power to enforce arbitration decisions--and underlying business practices--against members and nonmembers alike. Through this "invisible hand" process, business practices may come to approach the status of law.

Part III of this Article explores the policy implications of my theoretical model of commercial law for the UCC. Drawing upon Articles 1 and 2 of the Code, this Article documents several ways in which the UCC codifies business practices. Then, reasoning by analogy to the theoretical model, I explain that existing business practices are generated when individuals use their freedom of contract over the course of many commercial transactions. Thus, when the Code adopts such business practices, it respects the liberty of the individuals who helped to create those practices. The Code further safeguards liberty by allowing individuals to agree to vary the effect of its default provisions.

Part IV furthers my theoretical model by applying it to specific developments that have occurred in letter of credit law. Both the original and the revised Article 5 are based on letter of credit practices that ensure operational efficiency. Such practices, however, have more than economic benefits. They also embody the free choices made by individual issuers, beneficiaries, and applicants over many years and transactions. By incorporating default rules based on letter of credit practices, revised Article 5 respects the liberty of issuers, beneficiaries, and applicants.

Finally, Part V examines controversial rules within revised Articles 3 and 4 that affect the rights and obligations of banks and their customers. In theory, checking account practices reflect the free choices of both banks and customers. Problems arise, however, in applying this theory to consumer checking accounts. Consumers lack the knowledge and power to bargain effectively with banks, and have few alternative payment mechanisms available to them. Unfortunately, this lack of meaningful choice within a significant segment of the market makes it hard to justify the codification of checking account practices on liberty grounds.

This Article concludes that liberty has important normative implications for the content of commercial law. Often, business practices embody principles of freedom. As a general rule, the drafters should adopt business practices as law in order to respect commercial judgment and protect free choice. Nevertheless, I recognize that this reasoning has limits. Practice-based default rules are justifiable on liberty grounds only when affected individuals have a reasonable opportunity to participate in the development of underlying practices. Too often, consumers lack the knowledge and bargaining power necessary to participate in the evolution of consumer-friendly practices. Thus, the drafters should be cautious in extending practice-based rules beyond their commercial roots. The drafters should continue to adopt business practices as the general framework for the Code, but also should stand ready to carve out specific rules as necessary to accommodate consumer interests.

1. ANARCHY, STATE AND UTOPIA

   Some twenty years ago, Robert Nozick published his masterwork of political theory, Anarchy, State and Utopia.(17) Arguing that state of nature theory packs "explanatory punch and illumination,"(18) Nozick expounded a theory of the state that owed much to John Locke's Second Treatise of Government.(19)

   Nozick began his analysis by repeating several of Locke's fundamental observations.(20) The cornerstone of the Lockean state of nature is the liberty of the individual. Individuals are in "a state of perfect freedom to order their actions and dispose of their possessions and persons as they think fit, within the bounds of the law of nature, without asking leave, or depending upon the will of any other man."(21) The bounds of nature impose minimal restraints upon this liberty: "[N]o one ought to harm another in his life, health, liberty, or possessions."(22)

   Within the Lockean state of nature, each individual has the right to enforce the law of nature: [E]very one has a right to punish the transgressors of that law to such a degree, as may hinder its violation."(23) When an individual enforces his own rights, however, self-interest can lead to biased judgment and disproportionate punishment.(24) Moreover, execution of judgment may be impossible for the weak, and difficult and dangerous even for the strong.(25) Because of such drawbacks, men will abandon the absolute freedom found in a state of nature, preferring instead to unite in society to protect their lives, liberties, and estates.(26)

   1. The Rise of Protective Associations

      Working from these basic premises, Nozick theorized that individuals in a state of nature will form protective associations.(27) These associations will provide services (including detection of misdeeds and apprehension, adjudication, punishment, and recovery of compensation from wrongdoers) that protect members from each other and from outsiders.(28) To discourage private retaliation, associations will refuse protection against counterretaliation launched by outsiders or other members.(29)

      Over time, several different protective associations may arise in the same geographical area.(30) What happens when different agencies reach different decisions? Nozick identified three possibilities. First, when competing agencies engage in battle, one is always stronger, and therefore, always wins.(31) Eventually the losing agency falls apart, as clients leave to do business with the winner.(32) Second, different agencies do exist, but are located within entirely separate geographical areas, so that little conflict results.(33) Third, competing agencies that fight evenly and often create mechanisms to help resolve conflicting judgments, such as separate jurisdictions, choice of law rules, or perhaps a unified judicial system with appellate courts.(34) "Out of anarchy, pressed by spontaneous...