Long-Term Solutions, Deleveraging, and Mortgage Modification

Photo by Jonny Thirkill

So the Dow has bounced back over 400 points in the latest roller-coaster move. It's hard in these trampoline-like days to tell at any given moment whether we're still falling or bouncing back. Apparently, investors were heartened by rumors that the Feds are considering longer-term solutions to the credit crisis, including a "new government entity to help Wall Street unwind its disastrous credit bets" (a "bad bank" or latter-day Resolution Trust Corporation to take on the worst toxic mortgage-related securities and other investments). The basic idea seems to be that banks need to jettison once and for all the disastrous investments they have made, put the losses behind them, and go and sin no more.

Or banks could just get a reality check! That this crisis is of their creation is now clear. That they continue to foster the illusion that they need not act rationally to cooperate in its resolution is maddening. One of the most informed and engaging experts on the mess in the home mortgage market, Alan White at Valparaiso, has a fantastic new post today over at the Consumer Law & Policy Blog reminding us of just how irrational and stubbornly unwilling to accept reality the major mortgage banks are being. Though they claim to be on board with the notion of acknowledging reality and writing down mortgages to the (vastly lower) value of the collateral-homes, they are backing up these words with action in only a small fraction of cases. Sure, they'll cut people a break on interest and maybe fees, but modify mortgages to reduce principle--Heaven forbid! White presented to Congress evidence that banks are taking the necessary bottom line action and writing down mortgage principle in only 2% of cases. As White explains, the half-hearted Hope for Homeowners program is a cruel joke, offering relief to those facing foreclosure only if their banks were willing to accept the reality of property values and forego some of the principle on their mortgage loans (which has, not suprisingly, not happened in most cases). The FDIC is doing the right thing and setting an example by aggressively modifying IndyMac mortgages (FDIC is now the conservator of IndyMac), so why can't this reality check be extended to the broader market?

When asked about their willingness to take decisive action along the lines of the FDIC-IndyMac program, major commercial bank representatives explained, according to White, "take 10% off the loan balance, rather than foreclose at a 40% loss? This was described as the least-preferred option, and none were willing to answer what percentage of their loan mods involved any principal write-down." Ridiculous, even reckless in this era when the bottom line--the point at which the financial crisis will hit bottom and truly bounce back--depends on establishing that mortgage collateral is fairly valued at levels that allow folks to stay in their homes or allow the banks to recoup real value in foreclosure sales (rather than evicting people, taking huge losses, externalizing even further losses onto communities and the entire housing market, and then asking for redemption from the Feds in the form of a new RTC . . . revolting!). Entertaining the fantasy that the housing market will bring back the losses that are causing this spiraling financial crisis (the root of all the ills from sub-prime bond investments and credit-default swaps, etc.) is, in a word, irresponsible.

So what's the Fed to do? Well, the Fed can't do much, judging by yesterday's stock dive (Dow up 140 points on Tuesday on rumors that the Fed wills save AIG; Dow down 450 points on Wednesday because the Fed saved AIG!!??). A higher authority should step in and do at least one simple thing: amend § 1322(b)(2) of the Bankruptcy Code to treat claims secured by home mortgages just like most other secured claims; that is, allow the claim to be written down to the value of the collateral (the home), rather than forcing the law to continue to entertain the fantasy that the claim and the home are worth the inflated price originally paid. Better yet, allow mortgages to be forcibly written down to the value of the home without bankruptcy, but in any event, the special-interest gift to mortgage lenders and MBS investors in § 1322(b)(2) seems increasingly unwarranted. The notion that subjecting mortgages to "lien stripping" in this way would drive up rates was refuted, in my view quite convincingly, by a clever analysis presented in a recent paper (versions one and two) by Adam Levitin and Joshua Goodman, in which they explain that allowing forcible modification of mortgages in bankruptcy would likely result in an interest rate increase of at most 15 basis points (0.15%)!

Rather than waiting for Treasury and the Fed to turn the financial system upside-down based on questionable regulatory authority, the real regulatory power center of our political system, Congress, should introduce law(s) based on a new policy for mortgage bankers and investors in mortgage-backed securities: GET REAL!

Retailer Warranty/Replacement Plans: more than a matter of reading the fine print

Typically, I purchase many of my consumer electronics at Circuit City because I have had mostly success in getting them to honor their product replacement plans (when I purchase them). Point in case, I purchased an in-car dvd system through Circuit City not that long ago and did buy the replacement plan. Having young children, I depend on the dvd system. So, when the system blue-screened after about six months of use, I hurried into Circuit City and they replaced the unit and had me back on the road in less than thirty minutes. Whew! Dodged that bullet with my three year old. Consumer happy.

Last Friday I stopped in Best Buy to look at IPods. I settled on an IPod Nano and was set to go. The sales clerk recommended that I purchase for $20 the Best Buy replacement program. Having heard my student's complaints about Best Buy replacement programs for years now, I was wary, but asked for an explanation about the program. The clerk told me that the program for IPods was "different" and that if my IPod broke, I would bring it to them and they would just give me a new one, no hassle. I said great, sounds like you are now matching your competitor, Circuit City. So, I purchased the program and went home (they did conveniently put the details into my bag only after the purchase).

Upon arriving home, of course, I read the details and discovered that the program is simply one where if my Ipod breaks, I must bring it to them and they will mail it for me to the manufacturer under the warranty. After one year, they will mail it away to a repair center for me, so long as a "covered defect" is found. This is not what I was sold, so I went back to the store, asked for and was given a refund. The manager at Best Buy informed me that no one sells replacement plans on IPods, not even Circuit City. So, of course, I called Circuit City while I was standing there at Best Buy. Of course, the Circuit City replacement plans are available for the IPod. Consumer not-happy with Best Buy.

Surely, the outright deception is disturbing (see Rant #13: Retail Warranty at Best Buy, but be cautioned about the language). Of course, product warranties are uniform across retailers (see Apple's IPod warranty). Yet, there can be a marked difference not only amongst companies honoring their own warranties, but also amongst retailers who sell these "replacement" or "warranty extension" plans. The heart of the matter is that while companies may offer warranties, the track record of the company either making good products or performing warranty service if it fails is what matters.

While I am a big believer in reading the fine print, this goes to remind me that the business practices of sellers should matter to consumers. Deception in the sale of warranty extension plans is obviously unacceptable. While the plans themselves often differ (perhaps for market reasons), how and whether companies honor their plans ultimately determines the value of the plan. As for me, you know who I will be getting service from if my IPod needs it.

— JSM

Lehman/Merrill/AIG the Day After--What Crisis?!

Photo by bucklava

Not to say "I told you so," but notice that stocks are up the day after all of that hoopla broke on Wall Street (granted, not as much as they were down yesterday, but give it some time). If the biggest impact of this imbroglio on the "little guy (or gal)" will be a hit to the value of 401(k) and other retirement savings, the fact that stocks are already headed back up should come as a relief. And again, with crude futures headed toward the $90 mark, the economic future for Mr. and Ms. Average U.S. Consumer seems notably brighter.

In other good news, it looks like Barclay's is back at the Lehman bargaining table after all (as a surprise to no one who knows the Chapter 11 process). This breaking story from the W$J has it exactly right when it notes that shepherding the sale of Lehman's investment-management and capital-markets businesses through Chapter 11 allowed the parties to get what they wanted (walling off the toxic assets from the good ones) with less complication (and therefore probably a higher price). Would it be putting too sharp a point on it to call this "laundering"? By the way, if Barclay's is buying these crown jewels for $2 billion, one wonders how Lehman arrived at its $639 billion valuation of its assets, as mentioned in its bankruptcy petition (hat tip to CreditSlips and Steven Lubben). Indeed, could it be that Lehman was actually $20 billion in the black (in light of the reported $613 billion debt) when it filed yesterday (or at least as of May 31, 2008, the date of the valuation statement)? Doubtful. These valuation figures must be the sort of fairytale numbers that GAAP allows companies to get away with. For shareholders pouring over the Lehman petition hoping to find some ray of hope for a distribution, don't get your hopes up. The asset figure must be wildly on the high side, and though the Chapter 11 process will likely enhance the value that buyers like Barclay's are willing to pay for Lehman's "good" assets, the total kitty at the end of the day is likely to be nowhere in the region of $600 billion. The lawyers and other professionals who will have to manage this humongous case (ten times larger than Enron; six times larger than WorldCom) and sort out the millions of swaps, repos, and other complex contractual arrangements certainly will make out like bandits, though.

Lehman et al.'s Limited Impact on Main Street

Lots of ordinary folks seem to be in an uproar about the fallout on Wall Street, and they deserve some reassurance NOW! In last night's text poll on WGN News, nearly 90% of the respondents said they were worried about the state of the economy.

What we all have to bear in mind, it seems to me, is that this is a financial crisis, not an economic crisis. Yes, Lehman and many others made bad bets on mortgages and related securities, as I mentioned yesterday, and yes, the consequences of that bad bet will be visited on investors far and wide (and on the people who got themselves into unaffordable mortgages), especially as the stock market continues to plunge (note that I am intentionally not linking to the hysterical stories about world markets plummeting!). But this doesn't mean the medium- to long-term view is dim for the broader economy. The markets are fickle and have short memories--they will bounce back. Notice, by the way, that crude oil futures are also in free-fall (nearing $90 a barrel!), which seems more likely to impact us commoners far more than the goings-on in lower Manhattan.

For a reality check, see this discussion on the all-things-banking BankRate.com and this post on the business-oriented Conglomerate blog. Don't take rash action on investments or deposits. Don't go crazy. It's too late to run from this storm, but it will not be nearly as bad as the doomsday soothsayers are suggesting.

Lehman Chapter 11 = Reorganization?

Photo by jurvetson

The 158-year-old Lehman Brothers investment bank has gone up in smoke in the biggest bankruptcy filing in U.S. history . . . or has it? One of my students today observed that Lehman had filed for protection under Chapter 11 rather than Chapter 7 of the Bankruptcy Code. Does that mean the firm intends not to liquidate and go out of business, but rather to remain in operation, reorganize its business, and emerge as a leaner, meaner firm still operating under the august Lehman name? This topic lies at least on the periphery of the commercial law, and besides, how can any self-respecting business and financial blog avoid discussing today the events of this past weekend?!

The Lehman case offers us a nice opportunity to make an often forgotten observation about the fluid division between reorganization (Chapter 11) and liquidation (Chapter 7) in U.S. business bankruptcy. Yes, the holding company at the top of what must be a mind-bogglingly complex Lehman org charge has filed under Chapter 11, but this does not mean that the firm intends to rehabilitate itself and reemerge as so many other companies have done. If Lehman intends to have an orderly sell-off of its assets and units, why not just file for chapter 7 and be honest about it, one might ask. So-called "liquidating Chapter 11s" and other strategies involving the use of Chapter 11 to administer asset sales are not at all uncommon. Chapter 11 offers at least two substantial and related advantages over Chapter 7 under Lehman's circumstances (and there are doubtless others): First, while a Chapter 7 filing would most likely mean a turnover of the company's assets to an appointed trustee with little or no connection to or knowledge of Lehman's complex activities, the "debtor-in-possession" model of Chapter 11 will allow the firm's managment, who are intimately familiar with the firm and its business, to wind down operations and negotiate asset sales from a position of maximum strength and knowledge. They can carefully and deliberately choose to sell assets in productive, related units (e.g., the broker-dealer and investment management units), maximizing their value in part by ring-fencing them off from the "bad" assets that have laid low Lehman and so many other investors recently. Chapter 11 will provide time (at least several months, if not longer) for emotions to cool, assets to be surveyed, and values to stabilize. Announcing a turnover to a trustee and a piecemeal firesale might well spook the markets even further into believing that a wholesale loss of value is at hand, depressing the value of Lehman's assets (and similar assets held by others) and disrupting Lehman's other operations. Second, Chapter 11 allows Lehman to remain in largely uninterrupted operation. Its talented employees can continue to administer the firm's operations (to a limited extent) and maintain their value to squeeze as much return as possible from the firm's assets and minimize a piling-on of further debt and loss. At the end of the day, a filing under Chapter 11 here in all likelihood will lead to something of the same result as Chapter 7 (sell-off), but in a much more orderly, flexible, potentially creative and value-maximizing way, still under the chaos-minimizing effects of the automatic stay and court supervision.

Does it make sense here to leave the same scoundrels whose poor judgment created this mess in charge? Shouldn't a disinterested trustee step in and take charge? More so than in many other cases, it seems to me, this mess wasn't all the fault of Lehman management. Yes, they made a bad bet in choosing to go all-in on mortgage-backed bonds, but investment banking is all about taking on stomach-wrenching risk. I have neither seen nor heard of any indication that Lehman's woes are in any way tied to accounting scandal or fraud of any kind--which is a breath of fresh air after the sad events of recent years. Lehman became the leading underwriter of mortgage-backed bonds, which as we all know now turned out to be toxic investments when scads of ordinary borrowers started defaulting on their mortgage loans, which given the unexpected (and unheard of) downward trend in home values led to a serious and spiraling crisis. Oops! A bad call, yes; mismanagement, not so much, it seems to me. Worse yet, Lehman and other banks had ratcheted up their risk by increasing their leverage (the ratio of outstanding debt to assets) to by some accounts as much as 100-to-1. The leverage scissors basically shredded Lehman. On the debt side, losses on credit-default and interest-rate swaps and other complex investments it had made with borrowed money translated into huge losses through the magic of leverage (each dollar of loss was effectively amplified by 100 at a leverage ratio of 100:1), and on the asset side, mortgage-backed securities that it carried on its books turned out to be worth even less than it had thought (reducing the "1" in the leverage ratio to a fraction, severely exacerbating the problem).

So even with the value-maximizing effects of Chapter 11 rather than Chapter 7, the last-in-line shareholders seem almost sure to receive no distribution in a Lehman bankruptcy, and even the holders of Lehman debt (perhaps even preferred unsecured debt) might get very little if the leverage ratio is as high as I have heard. A penny on the dollar is not an overly pessimistic expectation for unsecured debt holders, it seems to me. I guess even a penny is better than nothing, and the choice to file under Chapter 11 may produce that penny that a Chapter 7 might well have left on the table.

An experiment: Cruxlux F675

Greetings to all readers of Commercial Law. I've decided to implement a widget referring readers to Commercial Law's Cruxlux.com page, known within Cruxlux.com as F675. We welcome feedback on this little experiment.

Two Great Escapes Into Commercial Law History

Photo by Kivanç

I guess I'm just an escapist at heart. If I'm not escaping to some foreign locale to compare its commercial law with ours, I'm escaping into history to compare yesterday's commercial law with today's. This weekend, I am escaping with two marvelously interesting papers on the history of commercial law.

The first is now one of my very favorite history papers, by a new professor at Texas Law School, Emily Kadens, who is quickly becoming one of my favorite historians. I can't do the paper justice here, but briefly, in Merchants, Kings, and the Codification of Commercial Law, Kadens challenges the conventional story of collision and opposition between the law merchant and the beginnings of state regulation of commerce. In fact, Kadens reveals in her lucid and incisive way, merchants might well have been all-too-happy to see state regulation impose a bit of certainty and stability on a system of customs that, even if they had worked for trading within confined networks earlier, they were ill-suited to governing the burgeoning inter-network (proto international) trade. Kadens's wonderfully clear description of the operation of bills of exchange shows that she is not only a talented and entertaining historian, but a gifted commercial law professor. This paper is a strong buy! Besides, the audience of this blog must contain that small subset of people who might have a special interest in a paper about bills of exchange in the 17th century.

The second is one I just discovered, thanks to Mary Dudziak's fabulous Legal History Blog. Earlier this week, Daniel Klerman uploaded his paper to SSRN, entitled "The Emergence of English Commercial Law: Analysis Inspired by the Ottoman Experience" (hence the picture I chose to accompany this post). With a title like that, you can't go wrong! Klerman contrasts the development of English and Ottoman commercial law to suggest that the former's approach is a better model for modern reformers interested in stimulating domestic engagement with global trade (my extrapolation from the intro--not explicit in the paper). English law supported the implementation of special institutions (esp. mixed foreign-domestic juries and streamlined debt collection) that offered equal benefits to foreign and domestic traders alike, jump-starting the economy on a level playing field and integrating strong foreign trading practices domestically. Ottoman law, on the other hand, created special institutions (especially dispute resolution mechanisms) exclusively for foreign merchants, ring-fencing the foreigners off from the locals and putting domestic traders at a competitive disadavantage. Klerman's consideration of why English and Ottoman law headed in different directions is fascinating.

Happy reading!

How Commercial Law Can Save the Law School Curriculum

Photo by furryscaly

Over at Prawfsblawg earlier this week, a Con Law professor (Marc Blitz) discussed a teaching "experiment" that he calls The Case-Free Class Day. I felt almost smug reading his post, as we commercial law professors have been successfully conducting this "experiment" for years now. We call it The Problem Method, or something similar. In Payment Systems, Secured Transactions, and Bankruptcy (and to a lesser extent, Corporations), I tell my students on the first day of class that we will not be reading and discussing cases; rather, we will do every day what most main-street lawyers do: solve problems. Unlike Blitz's approach (which sounds like a good one for public law, jurisprudential courses), every day in most of my classes is "case-free." Leveraging the pedagogical truism that the best learning is active learning, students are thrust into actual situations (well, at least conceivably realistic scenarios) and challenged not only to understand some concept or doctrine of statutory law, but to apply that doctrine/statute and their appreciation of the motivations of the actors involved to understand the real-world problem, explain how the law affects it (or not), and come down with a piece of advice (which may well be, often to the students' chagrin, "there's nothing the law can do for you, so can we find a business or social solution?"). This makes class totally fun for me, even the umpteenth time that I've taught the perfection requirements and the funds availability rules, and it accomplishes what everyone seems to want from us in the legal academy--making students not just think like lawyers, but to actually be lawyers, in the sense of making decisions and formulating advice not limited to the particular narrow legal issue at hand.

As a simple example, one day this week in Payment Systems, we covered the "accord and satisfaction" rules (for using a check with a "full satisfaction" legend as a simple settlement device) and a problem that challenged students to think broadly about their client advice. A small business person (lessor) had deposited a check from a disgruntled renter for half of the rent owed. The check contained the "full payment" legend, and the question was whether the landlord's depositing the check was a problem. The obvious answer, of course, was that this might well be a problem, as the check seemingly satisfied the requirements for "accord and satisfaction," so the landlord might have (inadvertently) agreed to accept half payment. The harder questions came next, much to the surprise of students trained to focus on one legal provision at a time. The client doesn't want to hear "you probably have a problem"; it wants to know "what do I do now?" This question always sets the students back on their heels. Well, someone generally says, you might refund the money if 90 days have not yet elapsed (another part of the A&S statute). Good! Problem potentially identified and solved. Assuming we're beyond 90 days, then we get to delve into the stickier questions--did the renter act in good faith in issuing the full payment check (yet another sub-requirement of A&S); i.e., was there a bona fide dispute as to the amount owed? On what basis? You mean we have to remember something about contracts and landlord-tenant law to think about whether constructive eviction is a bona fide claim here?? Yes! And the client doesn't want to hear "we could litigate that issue"! Small business people hate lawyers, our waffling, and especially our fees, and (consequently?) some 98% of all civil litigation settles today, so we need to think concretely about what we would actually say to opposing counsel (or the renter) about solving the problem efficiently. Can we convince opposing counsel that our case is strong and/or the renter's case is weak? Can we squeeze out a compromise? On what terms? Extended discussions of law, business, ethics/professionalism, and actual lawyering arise daily in my problem-based classes. What a joy! Lest we forget that commercial law affects folks from all walks of life, our exploration later this week of the negotiation rules in the context of a check-cashing outlet allowed us to discuss the business model of such an establishment and some of the characteristics and motivations of its often "unbanked" customers.

All of which brings back to mind a post by Jim Chen in the early days of this blog: Teaching (commercial) law. With this post, Jim earned himself the undying adoration of all commercial law professors by observing that our courses involve "real-world problem-solving techniques" for which "clients are most likely to be willing to pay," and they expose students to statutory law and analysis in a very real, down-to-earth way. My classroom is a no-abstraction zone. What a judge or someone else might do is relevant, but the real question for my students is "what do you actually do in light of the messy uncertainties and exigencies of real business/consumer clients in real life?" When students begin to feel like, view themselves as, and act like lawyers, formulating strategy and action based on law and the realities of life, that's a fantastically satisfying experience for a teacher.

By the way, for those at schools like mine where the Bar Exam looms large in every curricular discussion, I have made lemonade out of lemons by using actual bar exam questions (often edited to make them more challenging, realistic, or fun) as problems to be solved in class (see also here and here and here). Many states (and to a limited extent, the NCBEx) make their bar exams available online, sometimes with invaluable examiner commentary (and lecturing and writing model answers for BarBri is a wonderful way to stay current on what the bar examiners are doing). Nothing grabs your students' attention more than saying that a particular classroom exercise is a verbatim reproduction of a question from the bar exam--wanna know "the answer"? O.K., but you'll have to walk through how the problem might be solved in real life, too. Welcome to the bar!

Payment Card Hokey Pokey

Photo by The Consumerist

Two seemingly unrelated stories in this morning's news demonstrate the lengths to which credit and debit card issuers are now going to market their wares and squeeze out income.

First, the Wall Street Journal's "Personal Journal" today explains that card issuers, responding to a campus clamp-down on marketing credit cards, have begun hawking prepaid debit cards to college students (D1, D6, "The New Card On Campus: Prepaid Debit"). The W$J report contains a very sophisticated discussion of the EFTA and Reg E fraud protection rules (fail to report the loss within 48 hours, liable for up to $500, unlimited liability after 60 days), contrasting them with the much more protective TILA and Reg Y protections for credit cards (max $50, period). Perhaps giving up some fraud protection is a small price to pay for avoiding the horrors of college-student debt chronicled in, e.g., James Scurlock's fabulous and disturbing documentary, Maxed Out.

But perhaps not. The subtitle of the story tells it all: "Issuers Push High-Fee Alternatives." It turns out that these limited-fund, pre-paid debit cards don't allow users to incur interest or most overdraft charges, but these cards are "often laden with transaction fees," such as enrollment/activation fees, monthly account fees (that are waived if the card balance exceeds $1000!!), ATM fees (in addition to fees charged by the ATM's bank-owner), and my favorite--monthly inactive-account fees; that is, if the card isn't used within a 90-day period, the overly-miserly user is charged $5 per month of inactivity! Interest income is just too straightforward and oh so 20th century, while fee-based income runs under the radar and kills silently, bit by bit. My sense is that these kinds of cards will become very common, as parents try to limit their college kids' spending, but this array of fees will eat away at balances in a hurry. Caveat emptor, indeed!

So what are issuers doing with all of those extra credit cards? Sending them to small business people, of course! The American Bankruptcy Institute's daily headline service alerted me to this story in today's New York Times. It explains that more and more small businesses are turning to credit cards for liquidity because credit lines and other "prime" sources of financing have dried up. Isn't one source of credit the same as any other in this context--surely businesses can negotiate for favorable treatment. Nope! Small business credit cards are like sub-prime predatory lending in the consumer context, "offering" higher interest rates and unpredictable terms for changing (read: increasing) those rates at the drop of a hat (or the drop of Fannie & Freddie's stock price). One small business owner explained that her rate had jumped from 3.9% to 27.9% after her payment allegedly arrived one day late, and another's jumped from 16.99% to 34.99% (where do they come up with these numbers?!) when the financial aftermath of a home fire increased his debt-to-income ratio and decreased his credit score. Banks are worried about their bottom lines these days, too (capital requirements and the like), so if they can't squeeze college kids, they've moved on to a segment of the market that is even more desperate for large amounts of liquidity--and a segment that can and will pay big interest charges to carry them through to the next "in the black" period.

So what's a parent or small entrepreneur to do? The best and only advice seems to be, "Shop around."

The Joy of Comparative Commercial Law

Photo by thebusybrain
Thanks so much to the Commercial Law blog folks for inviting me to be their guest for a while! I am thrilled to have a chance to discuss topics outside my primary area of scholarship, though I am delighted to have been granted license to talk about bankruptcy and comparative insolvency law, as well. In my first post, then, I thought I'd mention something at the intersection of commercial law stricto sensu, bankruptcy, and my love for all things comparative law.

In the course of researching for the book I'm co-authoring on international bankruptcy, I got to explore the different approaches to the treatment of secured creditors in bankruptcy around the world. I have to admit that I was surprised to find that in many countries, when the rubber really meets the road (i.e., in the borrower's bankruptcy), secured creditors are not the king of the hill, as in U.S. law. Quite a few bankruptcy laws subordinate secured claims to (1) administrative claims arising in the reorganization/liquidation process (e.g., fees for trustees, lawyers, appraisers, auctioneers, etc.), (2) taxes and other public debts, (3) employee wage and benefit claims, and even certain kinds of other unsecured claims (in the Czech Republic before January of this year, secured creditors enjoyed priority in insolvency cases in only 70% of the value of their collateral, with the remaining 30% reserved for unsecured creditors!). One of my favorite curious subordination laws is section 134(4) of the new Russian Bankruptcy Law, which subordinates secured claims to two kinds of unsecured claims if they arose before conclusion of the security agreement: (1) compensatory tort claims for personal injury and associated "moral harm" (emotional damages) and (2) claims for compensation for the use of intellectual property. One wonders whether the unique IP exception was designed to buttress Russia's bid to join WIPO or some other international IP or trade pact.

Along similar lines, I sheepishly admit that after teaching Secured Transactions for years, I was unaware of the substantial differences between "fixed" and "floating" charges (consensual liens) in English law. As a gross over-generalization, a "floating" charge is a blanket lien, generally on all of an enterprise's property, which "crystallizes" into a "fixed" charge and divests the debtor of unfettered control over the property upon default--for a more detailed exploration of the not-altogether-clear distinction between fixed and floating charges, see here. Floating charges are often subordinated to a variety of different unsecured claims in places like England, Australia, Bermuda, and the Cayman Islands, and in England, floating charges created after 15 September 2003 are subordinated to general unsecured claims as to a percentage of the collateral proceeds, capped at £600,000 [this clause has been edited--see comments]. Indeed, in Sweden, the equivalent of floating charges (företagshypotek on immovables and företagsinteckning on movables) created after 1 January 2004 are limited to 55% of the value of the debtor-company’s unencumbered assets (with the remaining value reserved for unsecured claims).

These kinds of significant limitations on secured creditors' rights are anathema in the United States, and given my U.S. training, I had been a strident "secured creditors über alles"-type guy. Having been exposed to these very different approaches from countries that I regard as populated by reasonable-minded, intelligent, generally commerce-friendly people, however, really opened my mind and made me think twice. For more of this kind of mind-opening study, take a look at the proceedings from a recent World Bank conference on secured transactions and insolvency law reform here.

We have a lot to learn from our friends around the world, and it's so darned FUN to travel (at least mentally) to exotic places with unfamiliar commercial and insolvency law systems. I hope to share some of my joy in the travel-and-learning process during my visit. Thanks again for having me!

Commercial Law Welcomes Jason Kilborn as Guest Blogger

Commercial Law is pleased to welcome Jason Kilborn as a guest blogger. Kilborn is an associate professor of law at the John Marshall Law School and a leading expert on comparative bankruptcy -- with a book in the works on cooperative cross-border bankruptcy. His two most recent articles are Comparative Cause and Effect: Consumer Insolvency and the Eroding Social Safety Net and Out with the New, In with the Old: As Sweden Aggressively Streamlines Its Consumer Bankruptcy System, Have U.S. Reformers Fallen Off the Learning Curve?

We look forward to Kilborn's insights on comparative and domestic topics!

UCC Legislative Update

Nearly three months after both houses of the Illinois legislature passed SB 2080, Governor Rod Blagojevich signed it into law on August 22, making Illinois the 34th state to enact Revised UCC Article 1 and the 31st state to enact Revised UCC Article 7.

As have all thirty-three prior state enactments, and consistent with the ALI's and NCCUSL's promulgation earlier this year of a substitute for the original version of uniform R1-301, Illinois Public Act 95-0895 (neé SB 2080) rejects the 2001 uniform version of R1-301 in favor of language generally tracking its version of pre-revised 1-105. Act 95-0895 also rejects the uniform good faith definition in R1-201(b)(20), joining Alabama, Arizona, Hawaii, Idaho, Indiana, Nebraska, Rhode Island, Tennessee, Utah, and Virginia in opting to retain the bifurcated good faith standard of pre-revised 1-201(19) and 2-103(1)(b).

Act 95-0895 will take effect January 1, 2009.

In Memoriam: Richard E. Speidel (1933-2008)

The fields of contracts and commercial law (as well as ADR) lost an important scholar and a wonderful gentleman Saturday. At the time of his death, Dick Speidel was the Beatrice Kuhn Professor Emeritus at Northwestern University School of Law and a half-time professor at the University of San Diego School of Law. A longtime collaborator of James J. White and Robert Summers, with whose UCC hornbook and treatise I assume all our readers are familiar, Dick served from 1991-1999 as reporter for Revised UCC Article 2 — an experience he recounted in Revising UCC Article 2: A View from the Trenches, 52 Hastings L.J. 607 (2001). Among his many other books and articles are Studies in Contract Law (7th ed. 2008), which he co-authored with Ian Ayres (and previously with the late Edward J. Murphy), Commercial Transactions: Sales, Leases, and Licenses (2d ed. 2004), which he co-authored with Linda J. Rusch (who served from 1996-1999 as associate reporter for Revised Article 2).

USD Law Dean Kevin Cole posted this brief tribute.

Destined to be a "Heartless" Barracuda?

The Republican National Convention rocked last week to Heart's 70's hit Baracuda when Sarah Palin took center stage. Apparently, the Wilson Sisters who make up the band are none to happy with the use of their song by the Republicans. "I think it's completely unfair to be so misrepresented," singer Nancy Wilson told Entertainment Weekly. "I feel completely f****ed over." The McCain campaign responded that all license fees were covered under U.S. copyright law by the blanket fee paid by the St. Paul venue.


The barracuda, of course, is a large fearsome fish known for its strong jaws! Wilson commented "[Barracuda] was written in the late 70s as a scathing rant against the soulless, corporate nature of the music business, particularly for women ... There's irony in Republican strategists' choice to make use of it there." Harsh! Unfortunately for Heart, the tune does seem to be covered by the BMI/ASCAP blanket license. Under the blanket licensing, the artists do not retain any moral or political rights to object to the use of licensed music. Of course, the U.S. Supreme Court long ago blessed the blanket license practices in Broadcast Music, Inc. v. Columbia Broadcasting System, Inc.
As a matter of commercial law: no breach of contract, no damages. Simple as that.

Even if Heart can persuade the McCain campaign to cease and desist, another problem for Heart is that fans have adopted the "Barracuda" image (complete with song) for Sarah Palin as well.



So, at least for now Palin can have her barracuda tune and campaign to it, so long as the blanket license applies. Perhaps ABBA is next in line to raise a complaint?

— JSM

Citizens Bank: Maybe not your typical bank, but typical overdraft fees apply

Following up on my earlier post on Consumer Overdraft Protection (and always curious about how commercial matters are working in practice), I made a call to one of the banks I use, Citizens Bank, to ask. I was surprised to find out that they charge a whopping $39 per item on overdrafts, whether by debit or by paper check (of course, not tied in any respect to the size of the transaction). This is higher than the average of average $34.65 per item reported in the Consumer Federation of America study. It makes sense since overdraft fees are a big money maker for banks. If consumers write fewer paper checks, then banks was to recoup the income with debit card overdraft fees.

According to a USA Today article earlier this year, banks used to just deny debit card purchases (in the same way many credit cards do) in the event a consumer had too little money in their account. So, the banks charged overdraft fees primarily on bounced checks. In the USA Today article, a representative of Wachovia explained that debit card overdrafts are for customer “convenience” and that banks don’t really know if a particular transaction will overdraw the account. Underscoring the small size of many transactions, Greg McBride of Bankrate.com commented “"I don't know a consumer on the street who's willing to pay a $35 overdraft fee to have a $3 Slurpee." McBride has a point here. Moreover, many colleges now have partnered with banks to allow student id cards to operate as debit cards. This includes the overdraft fees on debit charges.

I asked the Citizens Bank representative about opting-out of overdraft protection. The rep acted like they had never heard of such a thing. Why would you want that I was asked? Then I explained to her the practices of PNC and some other banks beginning to offer opting out to customers (and I mentioned the proposals before the Federal Reserve). So, I asked again if I could opt out and what programs the bank had. She then told me that in fact, I could either entirely opt-out or just opt-out for the debit card simply by asking over the phone (no forms to fill out). She did advise me that they don’t always know if a debit card transaction will in fact overdraw an account. I chose to opt-out for the debit card just in case.

The Federal Reserve’s proposed regulations on overdraft protection appear more needed than ever. This is true, even if they only address the notice to consumers and some basic opting-out options. I understand that some customers may want full overdraft protection (even against the smaller debit card purchases). It is concerning, though, that even a consumer who knows they want to opt-out may have difficulty in getting the bank to accept the opting-out. Those who don’t know about how to opt-out or who cannot master the bank bureaucracy are out of luck.

— JSM

Consumer Overdraft Protection

My first class in Negotiable Instruments tomorrow covers the issue of checking overdrafts, including the problem of excessive fees. Of course, under UCC 4-401 a check is properly payable even if it creates an overdraft. Hence, the overdraft protection (for a fee of course) both loved and hated by consumers. The students will surely ask about these fees, which according to the Consumer Federation of America average $34.65 and total about $1.7 billion in fees paid by consumers. The Center for Responsible Lending (CRL) complains that overdraft fees maximize the profit for the banks by: “automatically putting customers into overdraft systems by default, routinely reordering daily transactions to subtract highest-dollar amounts first, and holding deposits longer than necessary.”

One of the big complaints about the overdraft fees is that banks use a system whereby most consumers automatically have some overdraft protection whether they want it or not. In response, the Federal Reserve Federal Board proposed rules in May 2008 that allow customers to opt-out of bank overdraft loans to avoid future fees and impose other disclosure requirements regarding fees. At least PNC Bank has adopted the opt-out procedure. The CRL complains that the proposed rules don’t go far enough because they put the burden on the consumer to opt-out of the bank overdraft programs. Rather, overdraft protection should be opt-in in nature. Banks, like Wachovia, have objected to the rulemaking by commenting that the proposed required disclosures are too onerous and should only apply to banks that market their overdraft services in any event.

I tend to agree with CRL’s comments that the proposed rules don’t really go far enough. Since many overdrafts these days occur on small debit card transactions, consumers might genuinely prefer to be denied on the spot for these transactions, rather than get the $34 overdraft charge. It might be advantageous for consumers to have a choice that would allow them to have overdraft protection on paper checks, yet not on debit card transactions. A broad-based opt-out doesn’t address the overdraft charges on these smaller debit transactions. An issue that is likely to increase as consumers use their debit cards more and more. The CRL’s complaints about the disproportionate impact the overdraft programs have on the poor and senior citizens on social security is also concerning.

It seems that one of the underlying issues here is the way that the banks charge overdraft fees and the types of protections they offer consumers. Without an opt-in system, it is hard to imagine that the more aggressive banks will change their programs as there is no market incentive to do so. Further, the big gorilla lurking in the corner here is also the size of the fee charged per transaction in the first place. Until the Federal Reserve reconsiders its interpretation that these overdraft fees are not regulated as loans per se, banks will seem to have broad discretion in the amount charged. We'll see what the students say about this in class tomorrow . . .

— JSM

Credit Card Fair Fee Act

Update: The final amended language of the Credit Card Fair Fee Act, as reported by the House Judiciary Committee, is now available. It employs a rather clever two-step device in an attempt to stimulate negotiated merchant fees. First, as blogged below, the bill extends antitrust immunity to groups of merchants and banks negotiating card acceptance fees. But then, it pulls the immunity back whenever a card issuer, or acquirer, or a merchant “is engaged in any unlawful boycott.”

Could this language mean that neither the merchant group, nor the banks, can walk away from the negotiations if the other side does not agree to acceptable terms? The take-it-or-leave-it approach has long been the banks’ modus operandi. Taking this threat from their arsenal could meaningfully change the market dynamic. Still, one has to wonder how a negotiation is supposed to proceed if the parties can’t threaten to walk away.

The bill would require the largest merchants, card issuers, and acquirers to produce cost information to the DOJ Antitrust Division, and Division representatives would take part in the negotiations. All this seems to stack the deck in favor of some sort of cost-based, negotiated merchant fee, which would be fine if costs served as a basis for setting an efficient fee. Unfortunately, they don’t; as the economist Michael Katz has explained.

A competitive means to set merchant fees would likely be superior to a cost-based system. There are at least three proposals in the literature to set fees competitively: (1) placing the costs of payment mechanisms on consumers by, for example, allowing merchants to surcharge card transactions; (2) empowering merchants to select the network over which a payment will be processed; and (3) forcing large card issuers to negotiate their own interchange fees. I have advocated for the latter, but all three seem to hold more promise that the Judiciary Committee’s current approach.

Original Blog: On July 16, the House Judiciary Committee reported out Congressman Conyers’ Credit Card Fair Fee Act over a sharply divided, yet surprisingly non-partisan, 19-16 vote. The amended text is not yet available, but you can piece it together from the hearing transcript at http://judiciary.house.gov/hearings/transcripts/transcript080716.pdf.

The bill as reported differed significantly from the bill originally introduced in March. Both bills are intended to combat the problem that merchants need to accept Visa and MasterCard so desperately that they have little ability to resist fee increases. At the heart of both the original March bill and the amended bill is essentially a bargaining order, requiring the banks issuing cards on large systems to negotiate with merchant groups on interchange fees and exempting from antitrust scrutiny the agreements reached in these negotiations. A key provision of the original bill would have created a panel of interchange fee judges, who would have set the fees if the parties could not agree. The Department of Justice and Federal Trade Commission both opposed the bill and were particularly critical of the panel of judges. At the July 16 hearing, Congressman Conyers removed the panel proposal from the bill. In addition, he added provisions (1) permitting small banks and credit unions to exempt themselves from these negotiations and (2) requiring that merchants do not simply retain fee reductions as profit.

This bill fails to engage the real problem with interchange fees, because a bargaining order is unlikely to reduce the card systems’ market power. Removing the judicial panel means that there is no real threat if the card companies fail to engage in meaningful bargaining. Still, eliminating the panel was a wise decision. Efficient interchange fee setting cannot track costs or any other factor accessible to a panel of experts. Appropriate fee setting must take account of demand conditions that are simply inaccessible to a regulator and probably the market participants as well. Given that, there seems to be little reason to provide an antitrust exemption. Who knows what mischief these bargaining groups might get themselves into?

The remedy to the interchange problem will ultimately be competitive, not regulatory. Congress could bring this about by simply requiring the large card-issuing banks to set their own interchange fees. If Discover can set an independent merchant fee with a market share of 5-6% of transaction volume, Citibank, Chase, Bank of America, CapitalOne, and perhaps a handful of others should be able to do so as well. Merchants would have substantially more leverage if they could refuse one issuer’s cards as opposed to the entire Visa or MasterCard association. Congress could achieve this result by simply prohibiting the card systems from enforcing the aspect of their honor-all-cards rule that requires merchants to accept the cards of every issuer on the network. Traditionally, this sort of remedy has been opposed as unworkable. After all, there are thousands of issuing banks. Requiring all of them to set their own fees, many have claimed, would be a mess. One positive aspect of Fair Fee bill is that it apparently recognizes that the rules that apply to the big issuers should not necessarily apply to smaller players. The bill applies only to systems with more than 20% of card volume and permits small banks and credit unions to exempt themselves from the negotiations. A competitive bill might require only those issuers with more than 5% of card volume to set their own fees. Without the large issuers in the mix, Visa and MasterCard could continue to set interchange fees for their thousands of smaller issuers without the power to compel merchant acceptance that has led to excessively high fees.

Waiting for SB 2080

Both chambers of the Illinois legislature passed SB 2080 on May 31, 2008. Taking advantage of most of the 30 days the Illinois Constitution affords the legislature to present a passed bill to the governor, see Ill. Const. art. IV, § 9(a), SB 2080 was sent to Governor Rod Blagojevich on June 27, 2008. As of July 30, 2008, Governor Blagojevich has neither signed nor vetoed SB 2080. If this were legislation Congress forwarded to President Bush or that most state legislatures forwarded to their respective governors, SB 2080 would by now be deemed enacted by passage of time. However, the Illinois Constitution affords the governor 60 days to sign or veto a bill before it is deemed enacted without the governor's action. See Ill. Const. art. IV, § 9(b). So, while the bills enacting Revised Article 1 in Pennsylvania (also enacting Revised Article 7), South Dakota, Tennessee, and Vermont this year have all taken effect since the Illinois General Assembly passed SB 2080, Illinois's incipient enactment of Revised Articles 1 and 7 continues to idle. (Hopefully, unlike Godot, SB 2080 will eventually arrive.)

If enacted, SB 2080 will make Illinois the thirty-fourth state to have enacted Revised Article 1 and the thirty-first state to have enacted Revised Article 7.

Losing Limited Liability with the Stroke of a Pen: Serge Doré Selections Ltd. v. Universal Wines and Spirits LLC, 23509/2007.

My Payment Systems students sometimes struggle with the notion that a check constitutes its own, separate contract and can be an independent means of liability, wholly apart from the contract pursuant to which the check was written. A recent Westchester County, New York Supreme Court case provides a good example.

The case arose from Serge Doré Selections, Ltd.’s sale of about 900 cases of wine to Universal Wine and Spirits LLC for $112,372.92. There is no dispute that Universal received the wine, has resold at least some of the wine, and never paid for the wine. The interesting portion of the case, for the purposes of this posting, concerns the personal liability of two individuals, Jesse Kessler and Carla Lewin, for Universal’s debt to Serge Doré. The court’s opinion does not indicate who Kessler and Lewin are, but a public-records search reveals that Jesse Kessler is one of two manager-members of the LLC and Carla Lewin is apparently his wife.

Universal’s contract with Serge Doré was memorialized by an invoice and a purchase order, neither of which Kessler and Lewin signed. Instead, Leah B. Dedmon, whose name does not appear in any of the public records for Universal that I found, signed on behalf of Universal.

After the wine was delivered, Universal issued a check in the amount of the invoice, then instructed Serge Doré not to deposit the check. Serge Doré complied, and then a lengthy correspondence ensued between Kessler and Mr. Doré, the President of Serge Doré Selections Ltd. In the course of this correspondence, Kessler provided – and then withdrew – a personal check drawn on his joint account with Lewin for the full price of the wine. Universal also later supplied a second corporate check, which bounced twice and was never paid, precipitating the lawsuit.

Ultimately, the court found that Kessler’s correspondence with Serge Doré, coupled with his issuance of a personal check, showed that he had undertaken personal responsibility for Universal’s debt. (The court found that Lewin, however, had no liability to Serge Doré, since she had not signed the check and apparently knew nothing of its issuance.)

Universal was organized under the laws of Florida, which, like most states, has adopted its own version of the Uniform Limited Liability Company Act. Kessler would normally have been shielded from liability for Universal’s debt pursuant to Florida’s version of Uniform Limited Liability Company Act §303 (a) (1995), which states that generally “the debts, obligations, and liabilities of a limited liability company . . . arising in contract . . . are solely the debts, obligations, and liabilities of the company, [and] [a] member or manager is not personally responsible for a debt, obligation, or liability of the company solely by reason of being . . . a member or manager.” Thus, he was not personally liable to Serge Doré under the contract. The personal check he wrote, however, constituted a separate contract under which he undertook personal responsibility as a drawer.

The court’s analysis does contain an error with regard to UCC §3-402 (b) (1), in that it tends to suggest that Kessler could have avoided personal responsibility if the check had expressly indicated (1) the identity of the principal (Universal) and (2) the fact that Kessler was signing only in a representative capacity. While this would have been true in the case of a promissory note, for example, this would not have shielded Kessler from liability in this instance, since he wrote a personal check drawn on his own account and would therefore necessarily face liability as the drawer of that check under UCC §3-414.

The lesson of this case is an important one for businesspeople as well as lawyers and law students, in that it tends to suggest that limited liability can be quite literally wiped out with the stroke of a pen, at least if that pen is used to write a personal check.

Of Settlements and Sales: Hanson Staple Co. v. Ole Mexican Foods, Inc., A08A0658.

In one of the better-reasoned cases on this topic I have read, the Georgia Court of Appeals has explained why settlement agreements that arise from disputes regarding sales of goods should not normally be considered sales contracts, even when those settlements require one of the settling parties to purchase additional goods.

The parties’ dispute centered on Ole Mexican Foods’ decision to stop buying packaging materials from Hanson, and instead to purchase the necessary materials from one of Hanson’s former employees. In its suit for breach of contract, Hanson contended it was left holding more than $300,000 worth of packaging materials that it had customized for Ole Mexican Foods and could not resell. In its counterclaim, Ole Mexican Foods claimed it should be relieved from its contractual obligations due to the fact that Hanson had tendered defective materials. Hanson, of course, vigorously defended against this contention, claiming the goods were merchantable.

The parties negotiated a settlement whereby Ole Mexican Foods agreed (1) to purchase at least $130,000 worth of inventory from Hanson, (2) to test Hanson’s remaining inventory and, if it proved satisfactory, to purchase additional inventory, and (3) to begin to do business once again with Hanson.

Unfortunately, the settlement agreement did not end the parties’ dispute. Instead, Ole Mexican Foods refused to perform, and Hanson moved the trial court to enforce the settlement agreement. In response, Ole Mexican Foods claimed, among other things, that Hanson had violated the parties’ agreement by insisting that Ole Mexican Foods purchase inventory without regard to its merchantability. In support of its claim, Ole Mexican Foods contended that the Uniform Commercial Code’s implied warranty of merchantability found in 2-314 should apply to the settlement agreement.

The trial court accepted this argument, and Hanson appealed. In properly reversing, the Court of Appeals applied the predominant purpose test and held that the predominant purpose of the settlement agreement was to resolve the parties’ dispute regarding an earlier sales agreement, not to create an additional agreement of the kind to which implied warranties of quality would normally apply. Instead of turning on the merchantability of Hanson’s goods, Ole Mexican Foods’ duties under the settlement agreement would be governed by principles of good faith and “honest judgment.”

Although the court did not expressly say so, one reason why the court’s holding is so clearly correct is that a contrary holding would essentially eviscerate the purpose of this particular settlement: since one of the central disputes in the underlying litigation was whether Hanson’s goods were merchantable within the meaning of the Uniform Commercial Code, and since the case was settled rather than having this issue decided by the court, applying the implied warranty of merchantability to the settlement agreement would almost certainly require the parties to relitigate the question of merchantability.