Ucc Update: Revised Articles 3 and 4 - Michael D. Sabbath

• Publication year: 1996

UCC Update: Revised Articles 3 and 4by Michael D. Sabbath^*

I. Introduction

The National Conference of Commissioners on Uniform State Laws and the American Law Institute, cosponsors of the Uniform Commercial Code ("UCC"), have approved comprehensive changes to Articles 3 and 4. The Revised Articles were initially presented to the various states for approval in early 1991. As of September 1996, forty-four jurisdictions have adopted the Revised Articles, most with few, if any, variations to the official text.¹ Revised Articles 3 and 4 became law in Georgia effective July 1, 1996.²

Few debate that Prior Articles 3 and 4, which were drafted more than forty years ago, were in need of revision. Article 3 was the most dated article of the UCC. It was merely a revision of the previous uniform act, the Uniform Negotiable Instruments Law, which was drafted in 1896, and was based primarily on eighteenth and nineteenth century British case law. Some of the concepts and language of Prior Article 3 were quite archaic. It should be noted that Revised Article 3 does not radically depart from previous law. Revised Article 3 carries forward the basic doctrines of negotiable instruments law embodied in Prior Article 3. Moreover, the organization of the new statute generally follows that of the old statute. But the revision does update Article 3 to modernize language and take into account technological developments and changes in business practice. In addition, the revision resolves conflicting lines of case authority.

Similarly, Prior Article 4 was seriously outdated, having emerged as part of the "1958 Official Text" of the UCC. However, Magnetic Ink Character Recognition ("MICR")—the encoding of identifying numbers on checks that made automated check processing possible—did not become operable until 1959. Thus, Prior Article 4, drafted in a time of manual processing of checks, was inadequate to deal with the automated processing of checks based on MICR technology. Prior Article 4 was saved to some extent by section 4-103, which allows the parties to vary the terms of that article by agreement, and provides that Federal Reserve regulations and letters, clearinghouse rules, and the like, have the effect of agreements.³ But the movement from a paper-based payments system to an electronic-based payments system made it apparent that Prior Article 4 needed to be reformed. Revised Article 4 accommodates technical developments in automated check processing and check truncation. Although some changes have been made to accommodate Federal Regulation CC⁴ (which relates to mandated funds availability), those provisions most heavily impacted by Regulation CC remain intact and are retained for nonpreempted provisions and for items other than checks. Although the drafting committee initially intended to extensively coordinate Article 4 with Regulation CC, it ultimately abandoned this effort due to the extensive preemption that exists, and also because of the different character of the provisions in Article 4 and Regulation CC. In addition, the Federal Reserve Board has revised, and will continue to revise, Regulation CC administratively. State legislative processes move much more slowly than these administrative processes, making it very difficult to keep Article 4 and Regulation CC closely coordinated.

II. Discussion

No effort will be made here to cover every aspect of the revisions to Articles 3 and 4. Instead, this Article will discuss some of the major new provisions to illustrate improvements made by the revisions.

A. Revised Article 3

1. Scope of Article 3. Revised Article 3 clarifies the types of contracts within Article 3. For example, the confusion over whether traveler's checks are covered has been eliminated. Traveler's checks are governed under Revised Article 3.⁵ Although the requirement of a countersignature is a condition to the obligation to pay, it is recognized that traveler's checks are treated in the commercial world as money substitutes and therefore should be governed by Article 3.⁶ The revision also expressly recognizes the negotiability of, and clarifies much of the law with respect to, teller's checks, cashier's checks, and checks that may omit "words of negotiability."⁷

In an important provision, variable rate instruments are included as negotiable instruments under Revised Article 3.⁸ Prior Article 3 required that a negotiable instrument state a "sum certain."⁹ The holder must be "able to determine the amount then payable from the instrument itself."¹⁰ Most courts considering the issue under Prior Section 3-106 found that instruments with variable interest rates could not be negotiable instruments because of this "sum certain" requirement.¹¹ However, instruments providing for variable interest rates pegged to some sort of fluctuating standard rate of interest are much more common now than they were when Article 3 was originally promulgated. The requirement of a sum certain has been completely eliminated in Revised Article 3. Rather than a sum certain, an instrument must show a "fixed amount of money, with or without interest or other charges described in the promise or order."¹² Rates of interest may be stated as "fixed or variable."¹³ Thus, the revision clearly recognizes the negotiability of variable rate instruments.

The revision also clarifies the impact of the Federal Trade Commission "holder" rule.¹⁴ This federal regulation requires a conspicuous legend in consumer notes that makes any holder subject to the claims and defenses which the issuer could assert against the original payee.¹⁵ Revised Article 3 makes clear that complying with the federal regulation does not render the instrument "conditional" so as to exclude it from Article 3.¹⁶ The revision treats such notes bearing the legend as negotiable instruments for all purposes except that no one may be a holder in due course of such instruments.¹⁷

Under Prior Article 3, a promise to pay was not made conditional (thereby destroying negotiability) if the promise was limited to payment out of a particular fund or source, so long as the instrument was issued by a government or governmental agency or unit.¹⁸ But a corporation's or individual's promise to pay that was limited to a particular fund was conditional, destroying negotiability.¹⁹ Revised Article 3 rejects this approach, stating that a promise to pay is not made conditional "because payment is limited to resort to a particular fund or source."²⁰

Finally, the revision has some special rules governing checks. Under Revised Article 3, there is no way to destroy the negotiability of a check. A check need not be payable to order or to bearer.²¹ Further, even if a drawer prints or types the words "not negotiable" or adds a statement that the check is not governed by Article 3, it nevertheless is negotiable.²² This change is in recognition of automated processing and avoids prejudicing a party who takes the instrument without the ability to notice the exclusionary language. On the other hand, a promissory note containing similar language prevents the writing from being a negotiable instrument for any purpose.²³ Of course, a court could nevertheless apply Article 3 principles to such a writing by analogy.²⁴

2. "Good Faith" and "Ordinary Care." The most significant benefit offered to consumers by Revised Articles 3 and 4 may be the new definition of "good faith."²⁵ Under the prior articles, good faith was defined as "honesty in fact."²⁶ The new definition, found in Revised Section 3-103(a)(4), requires both honesty in fact and "observance of reasonable commercial standards of fair dealing."²⁷ This new definition is consistent with the definitions of good faith applicable to Articles 2, 2A, 4, and 4A.²⁸

"Ordinary care" was not defined generally in Prior Articles 3 and 4. The official comments to Prior Article 4 stated that "[n]o attempt is made in this Article to define in toto what constitutes ordinary care or lack thereof."²⁹ Revised Section 3-103(a)(7) contains a detailed definition of ordinary care. "Ordinary care" means, for a person engaged in business, the "observance of reasonable commercial standards, prevailing in the area in which the person is located, with respect to the business in which the person is engaged."³⁰ Reasonable commercial standards do not require banks that process instruments for collection or payment by automated means to examine every instrument if the failure to examine does not violate the bank's procedures, and if those procedures do not vary from general banking usage.³¹ This revision resolves a conflict between cases holding that the use of automated procedures which did not require the examination of every item constituted a lack of ordinary care as a matter of law, and cases holding that the issue of whether the use of such procedures constituted ordinary care was one of fact.³² The revision is also consistent with the policy of encouraging the rapid processing of checks and establishing a statutory framework for accommodating a regime of truncation in which payor banks will have to pay checks with no opportunity to see them. It should be noted, however, that the "prevailing standards" test is not intended to shield unreasonable bank procedures.³³ Comment 5 to Revised Section 3-103 states: "Nothing in Section 3-103(a)(7) is intended to prevent a customer from proving that the procedures followed by a bank are unreasonable, arbitrary, or unfair."³⁴

3. Holder in Due Course Status. A holder in due course must take an instrument "in good faith."³⁵ As discussed above, Revised Article 3 has redefined good faith. Therefore, satisfying the good faith element for qualifying as a holder in due course will require observance of reasonable commercial standards in addition to honesty in fact.³⁶

Under Prior Article 3, an incomplete or irregular instrument would prevent a purchaser from having the lack of notice of a claim or defense required of a holder in due course.³⁷ It was...