By Keith P. Bishop in Daily Journal
The Uniform Commercial Code has become the "forgotten code" when it comes to agreements to acquire a business in an asset purchase transaction. It may be forgotten, but it is still relevant. Lawyers who fail to consider the UCC may encounter some unexpected and undesired consequences.
When drafting or negotiating an asset purchase agreement, the first question should be does the UCC apply at all? Section 2102 of the UCC provides that Division 2 of the UCC, covering sales, applies to "transactions in goods." (Other states refer to "Article 2" rather than "Division 2.") Section 2105(1) defines "goods" as all things (including specially manufactured goods) which are movable at the time of identification to the contract for sale, other than money in which the price is to be paid, investment securities and things in action. Thus, existing inventory, equipment and machinery are goods for purposes of the UCC.
Section 2107 establishes special rules for things that are attached to real property. For example, a contract to sell a structure or its materials to be removed from the realty is a contract for the sale of goods if the seller is to "sever" the structure or materials. In addition, Division 2 governs a contract for the sale of other things attached to real property that are capable of being removed without material harm regardless of who does the severing and even though they form part of the realty at the time of contracting.
A common misunderstanding is that the UCC applies only to merchants. The UCC defines a "merchant" in Section 2104 as "a person who deals in goods of the kind or otherwise by his occupation holds himself out as having knowledge or skill peculiar to the practices or goods involved in the transaction or to whom such knowledge or skill may be attributed." While the UCC includes certain rules that apply to only to merchants, most of the UCC applies to merchants as well as nonmerchants.
When dealing with parties located in different countries, the United Nations Convention on Contracts for the International Sale of Goods (CISG) may govern the agreement. Although the CISG is similar to the UCC, its provisions are different. If parties don't want to be governed by the CISG, the contract should explicitly disclaim its application. However, simply providing that California law governs may be ineffective since the CISG may be considered part of California law. In Asante Technologies Inc. v. PMCSierra Inc., 164 F. Supp. 2d 1142 (2001), the court found "Although selection of a particular choice of law, such as 'the California Commercial Code' or the 'Uniform Commercial Code' could amount to implied exclusion of the CISG, the choice of law clauses at issue here do not evince a clear intent to opt out of the CISG."
When the UCC applies, there is much to consider. For example, lawyers often spend a great deal of time negotiating representations and warranties, seemingly with no understanding that the UCC implies or applies specific warranties that may only be excluded in specific ways. If the seller is a merchant with respect to the goods being sold, Section 2314 implies a warranty of merchantability. Exclusion or modification of this implied warranty only occurs if done in compliance with Section 2316.
Although every other state has followed the Uniform Law Commission's recommendation and repealed their Bulk Sales Law, California has resisted calls for its repeal. California's Bulk Sale Law, Division 6 of the UCC, generally applies to sales out of the ordinary course of more than half of the seller's inventory and equipment as measured by value on the date of the agreement. The purpose of the law is to protect the seller's creditors by requiring the buyer to give notice and in some cases deposit the purchase price into an escrow. Failure to comply can result in the buyer becoming liable to the seller's creditors.
The UCC continues to be important even after the closing. Many buyers may be surprised to learn that Section 2607(3) provides that once they have accepted tender, they must within a reasonable time after discovery of any breach, notify the seller of the breach or be barred from any remedy. For example, in Cardinal Health 301 Inc. v. Tyco Electronics Corp., 169 Cal. App. 4th 116 (2008), the Court of Appeal reversed a jury verdict in favor of a buyer on a breach of warranty claim because there was insufficient evidence that the buyer had provided the notice required by Section 2607.
Often parties will negotiate provisions limiting the time period within which claims must be made. Section 2725, however, provides that claims must be brought within four years after the cause of action accrues. This period may be reduced by agreement to one year, but may not be extended beyond the four years. Under the statute, a cause of action accrues when the breach occurs. A breach of warranty occurs when the seller makes tender of delivery of the goods. Thus, the clock will normally start ticking at closing. A special rule applies to warranties that explicitly extend to future performance and discovery of the breach must wait until performance. In that case, a cause of action accrues when the breach is or should have been discovered.
The UCC is an important, but often neglected, body of law. The consequences of overlooking it, however, can be significant. Therefore, lawyers negotiating an asset purchase agreement should ask themselves a series of questions. Does the UCC apply? If so, does the agreement properly exclude or modify warranties? Is the transaction subject to the Bulk Sales Law? What steps must a party take in the case of a breach?
Posted with permission.
Keith P. Bishop
Corporate & Finance
Investment Management Group
Residential & Multifamily
Securities Offerings & Other Financings
Corporate Governance & Compliance
(949) 553-8354 (fax)