author: Simons, J.

text:
    Henry L. Fox Co., Inc., Respondent, v William Kaufman Organization, Ltd., et al., Appellants.
    Argued May 31, 1989;
    decided July 11, 1989

      POINTS OF COUNSEL

      Milton S. Gould, Robert J. Ward and Jonathan M. Landsman for appellants.
    I. This court should reverse the judgment of the Supreme Court because Insurance Law § 2119 requires a writing signed by the Kaufmans "specifying or clearly defining the amount or extent of [Fox’s] compensation,” and no such writing exists. (New Amsterdam Cas. Co. v Stecker, 3 NY2d 1; Sega v State of New York, 60 NY2d 183; Matter of Erie County Water Auth. v Kramer, 4 AD2d 545, 5 NY2d 954; Matter of Country-Wide Brokerage v Hartnett, 58 AD2d 517; Kahn v Levenson, 10 Misc 2d 1058; Garfunkel v Moloff, 103 Misc 2d 769; Metz v National Adjustment Co., 89 Misc 2d 1067; Sheridan Suzuki v Caruso Auto Sales, 110 Misc 2d 823; Thompson v Blanchard, 3 NY 335; Fairmount Film Corp. v New Amsterdam Cas. Co., 189 App Div 246.) II. This court should reverse the judgment of the Supreme Court because the documents adduced by Fox cannot be "pieced together” in a satisfactory manner under traditional Statute of Frauds principles. (Marks v Cowdin, 226 NY 138; Scheck v Francis, 26 NY2d 466; Crabtree v Elizabeth Arden Sales Corp., 305 NY 48; Intercontinental Planning v Daystrom, Inc., 24 NY2d 372; Cohon & Co. v Russell, 23 NY2d 569; Dorman v Cohen, 66 AD2d 411; Solin Lee Chu v Ling Sun Chu, 9 AD2d 888; Karlin v Avis, 457 F2d 57, 409 US 849; Kobre v Instrument Sys. Corp., 54 AD2d 625; Shapiro v Dictaphone Corp., 66 AD2d 882.)

      Andrew B. Schultz for respondent.
    I. Well-established "Statute of Frauds” principles apply to Insurance Law § 2119 (a) (1), and the statute may be satisfied by "piecing together” a series of writings. (Marks v Cowdin, 226 NY 138; Crabtree v Elizabeth Arden Sales Corp., 305 NY 48; East Europe Domestic

      Intl. Sales Corp. v Island Cr. Coal Sales Co., 572 F Supp 702; APS Food Sys. v Ward Foods, 70 AD2d 483; Condo v Mulcahy, 88 AD2d 497; Shapiro v Dictaphone Corp., 66 AD2d 882.) II. On the record presented, there was a triable issue of fact on plaintiffs first cause of action for breach of contract, and summary judgment was properly denied. (Sillman v Twentieth Century-Fox Film Corp., 3 NY2d 395; Gilinsky v Sarbro Realty Corp., 138 AD2d 823; Cohon & Co. v Russell, 23 NY2d 569.)
   OPINION OF THE COURT

Simons, J.

The issue presented by this appeal is whether plaintiffs action for breach of contract is barred by Insurance Law §2119 (a) (1) — a specialized Statute of Frauds applicable to contracts for insurance consulting services. Applying that statute, Supreme Court denied defendants’ motion for summary judgment dismissing plaintiffs causes of action sounding both in breach of contract and quantum meruit. The Appellate Division modified by dismissing the quantum meruit claim, but permitted the breach of contract cause of action to proceed to trial, holding that plaintiff could "piece together” certain signed and unsigned writings prepared by defendants to satisfy the writing requirements of section 2119 (a) (1). After trial, plaintiff obtained judgment on a jury verdict in the principal amount of $81,796. Defendants are here by our leave. Their appeal from the final judgment brings up for review the prior nonfinal order of the Appellate Division (CPLR 5602 [a] [1] [ii]).

I

Plaintiff, Henry L. Fox Co., Inc., is a licensed New York State insurance agent, broker and consultant. On September 14, 1981, it sent a letter to defendant, William Kaufman Organization, Ltd., a corporation with substantial New York City real estate holdings, and its principals, proposing to perform consulting work by reviewing its existing insurance portfolio in an effort to reduce “insurance costs. The letter concluded:

"Our total remuneration places you [defendants] in a 'can’t lose’ situation as follows:

"1. A first year fee being 50% of the net premium savings based upon your current property/casualty coverages only.; reducing to 25% for all subsequent years.

"2. The above fee is paid for only the period of time in which the bidding sources are used; giving management the continuous option of terminating this fee arrangement, by simply cancelling or not renewing these market sources.”

Defendant did not respond to this letter in writing, although the proposal was circulated internally among defendant’s principals, in September and October 1982, as an attachment to two unsigned interoffice memoranda indicating that it should be "discussed.” In February 1982, plaintiff sent defendant another letter setting forth a schedule of its current insurance coverage and a list of building superintendents to be contacted for inspection purposes. In March, plaintiff requested that defendant prepare a letter authorizing plaintiff to obtain inspection reports from certain insurance companies.

Defendant responded by letter, dated March 5, 1982, and provided a copy of an authorization letter permitting plaintiff to obtain inspection reports. The authorization letter and accompanying cover letter are the only two writings signed by defendant relating to plaintiff’s request to perform insurance consulting work. Neither refers to plaintiff’s September 14th proposal. Subsequently, in March and April 1982 plaintiff sent defendant various insurance policies, reflecting bids it had obtained, allegedly in response to defendant’s request, but defendant subsequently purchased its insurance through another broker.

In 1983, after defendant refused to compensate plaintiff for the services rendered, plaintiff commenced this action seeking recovery for breach of contract and quantum meruit. After joinder of issue, defendants moved for summary judgment contending that the action was barred by Insurance Law § 2119 (a) (1) which requires that one seeking to recover for insurance consulting work must provide a memorandum signed by the party to be charged "specifying or clearly defining the amount or extent of * * * compensation.” Supreme Court and the Appellate Division both rejected defendants’ argument, holding that general Statute of Frauds principles were applicable and that the signed and unsigned writings prepared by defendant could be pieced together to satisfy the writing requirement of the statute. We reverse and dismiss the complaint.

II

In the absence of agreement, an insurance broker’s compensation traditionally has been limited to the commissions deductible from premiums paid by the insured upon the purchase of insurance. To protect insureds from unsubstantiated demands for compensation, the Legislature has for the past 50 years required that agreements for additional compensation from a client for consulting services be in writing (L 1939, ch 882, § 129). In 1972, the statutory requirements were extended to licensees other than brokers, specificálly agents and consultants, as part of a comprehensive consumer protection measure to license and regulate insurance consulting practices (Insurance Law former § 112-a [7], L 1972, ch 498, § 1). The statute was subsequently recodified and presently provides: "No person licensed as an insurance agent, broker or consultant may receive any fee, commission or thing of value for examining, appraising, reviewing or evaluating any insurance policy, bond, annuity or pension or profit-sharing contract, plan or program or for making recommendations or giving advice with regard to any of the above, unless such compensation is based upon a written memorandum signed by the party to be charged and specifying or clearly defining the amount or extent of such compensation” (Insurance Law § 2119 [a] [1]).

Plaintiff maintains that this provision is to be construed like other "more familiar” Statutes of Frauds and that it has satisfied the statute’s requirements by "piecing together” the contents of several writings of the parties (see, Crabtree v Elizabeth Arden Sales Corp., 305 NY 48).

The purpose of Statutes of Frauds is to avoid fraud by preventing the enforcement of contracts that were never in fact made. Generally the statute is satisfied by some note or memorandum signed by the party to be charged that is adequate to establish an agreement when considered in light of the admitted facts and surrounding circumstances. Given proof of agreement by such evidence, its particular terms may be furnished by piecing together other, related writings (Crab-tree v Elizabeth Arden Sales Corp., 305 NY 48, supra). The writings are not the agreement, of course, only evidence of the agreement. They are required so that there is no serious possibility that the assertion of the contract is false.

New York has enacted several Statutes of Frauds, each with its own particular language and requirements (plaintiff cites as examples General Obligations Law § 5-701 [formerly Personal Property Law § 31], § 15-501 [2]; Uniform Commercial Code §§ 2-201, 8-319). General Obligations Law § 5-701, for example, provides in general terms that certain enumerated agreements are void unless "some note or memorandum thereof be in writing, and subscribed by the party to be charged therewith”. Under this provision, the writings must contain all the essential terms of the purported agreement. To contrast, the Statute of Frauds applicable to the sale of goods provides that the agreement is binding even if the writing omits or incorrectly states a term of the agreement. Even the price need not be specified (Uniform Commercial Code § 2-201). It is sufficient that the writing affords a basis for believing the offered oral evidence rests on a real transaction (Uniform Commercial Code § 2-201, comment 1). If it does, the finder of fact may set a reasonable price (id.; cf., Uniform Commercial Code § 8-319 [price and quantity of securities sold must be specified]). Thus, the statutes may require more or less particularity in the writings depending upon the Legislature’s perception regarding the risks of false claims inherent in the contractual setting.

Plaintiff contends that Insurance Law § 2119 (a) (1), like General Obligations Law § 5-701, requires that it prove a written document signed by the party to be charged establishing the existence of a contractual relationship and if it does then both signed and unsigned writings referrable to the signed writing may be considered to establish the complete terms of the contract (see, Crabtree v Elizabeth Arden Sales Corp., supra).

The Insurance Law sets forth a more exacting standard, however. It focuses on the amount of compensation, requiring the parties to agree on a clearly defined price, with their agreement being evidenced in a writing signed by the party to be charged.

As explained in the legislative history, insurance licensees often provide consulting services with the sole expectation that as a result of their successful efforts in achieving premium reductions, their clients will use them to purchase insurance coverage from the insurance carriers. Consequently, absent an express contract proving otherwise, it is reasonable for prospective insureds to contemplate that the insurance licensees are providing consulting services for no separate compensation beyond the commission they would receive on the sale (see, Mem of New York Ins Dept, re: An Act to Amend, the Insurance Law, in Relation to Written Contract for Compensation to an Insurance Broker by Insured, 1952 McKinney’s Session Laws of NY, at 1229). Where additional compensation is expected by licensees, they must secure a signed writing agreeing to the terms and conditions of this special arrangement from the insured, and retain a copy for three years (see, Insurance Law § 2119 [a] [2]). Thus, the various terms of the agreement may be found in separate writings but there must be one document, signed by the party to be charged, that specifies the compensation either explicitly or by reference to another identified document which sets forth the terms of compensation.

The legislative purpose underlying this requirement is exemplified in this case by the significant inconsistency between the compensation formula contained in plaintiffs verified complaint and the compensation arrangement plaintiff relied upon in response to the motion for summary judgment. In the verified complaint (and also in response to a separate motion made by defendants to dismiss for failure to state a cause of action), plaintiff asserted that the amount of compensation to be paid was "to be equal to the amount of the first year’s saving enjoyed by defendants”. When defendants moved for summary judgment, plaintiff changed its theory, attaching to its opposition affidavits a copy of its September 14th proposal and arguing that the letter established plaintiff’s compensation as 50% of the net premium savings for the first year and 25% for subsequent years. Manifestly, defendant was free to terminate the alleged agreement after one year, however, and the compensation claimed was not the same under both formulations. Section 2119 (a) (1) was enacted to avoid just such uncertainties.

The reliance of plaintiff and the Appellate Division on our decision in Crabtree v Elizabeth Arden Sales Corp. (305 NY 48, supra) is misplaced. In Crabtree, we reaffirmed the principle that the writing requirement of the Statute of Frauds " 'may be pieced together out of separate writings, connected with one another either expressly or by the internal evidence of subject matter and occasion’ ” (id., at 54, quoting Marks v Cowdin, 226 NY 138, 145). We held it necessary that one writing, the one establishing a contractual relationship between the parties, bear the signature of the party to be charged and that the signed and unsigned writings clearly refer to the same subject matter or transaction. Parol evidence is admissible only to connect the papers, not to establish missing terms of the agreement (Crabtree v Elizabeth Arden Sales Corp., supra, at 55-56). In Crabtree, there was no question that a writing signed by employees of the defendant corporation established the existence of a contractual employment relationship with the plaintiff; the only question was the duration of that relationship and this element was supplied by the unsigned memorandum prepared by Elizabeth Arden’s personal secretary which indicated that a two-year agreement had been reached.

In the present case, it is plain that plaintiff cannot satisfy the requirements of section 2119 by piecing together multiple writings because there is no writing signed by defendants "specifying or clearly defining” the amount to be paid or referring to a document doing so. Indeed, there is no writing or collection of writings establishing that defendants agreed to hire plaintiff for the consulting work. Of the four writings prepared by defendants, only two are signed and none refer to the amount or extent of compensation payable to plaintiff for the insurance consulting work. The only document relating to compensation is plaintiff’s letter of September 14, 1981. The two unsigned interoffice memoranda prepared by defendant make reference to the letter but state only that the proposal should be "discussed” by the corporate officers. The signed building inspection authorization letter and cover letter which defendant sent to plaintiff do not refer to the September 14th proposal or in any way mention that plaintiff was to be compensated by defendant for its efforts. The writings signed by defendant do no more than authorize plaintiff to make arrangements to have buildings inspected.

The gaps in these documents cannot be filled by parol evidence. The writings are insufficient on their face, and the conclusion follows, as a matter of law, that they do not satisfy the Statute of Frauds (see, Bazak Intl. Corp. v Mast Indus., 73 NY2d 113, 118; Scheck v Francis, 26 NY2d 466, 472).

Accordingly, the judgment appealed from and order of the Appellate Division brought up for review should be reversed, with costs, and the complaint dismissed.

Judges Kaye, Alexander, Titone, Hancock, Jr., and Bellacosa concur; Chief Judge Wachtler taking no part.

Judgment appealed from and order of the Appellate Division brought up for review reversed, etc.

       Both the corporation and Melvyn and Robert Kaufman, its principal stockholders, were named defendants. "Defendant” refers to the corporation.


source: Caselaw Access Project

author: Alexander, J.

license: Public Domain

text:
    Susan Berkowitz, Respondent, v Chavo International, Inc., Defendant. Congress Talcott Corp., Intervenor-Appellant.
    Argued June 7, 1989;
    decided July 11, 1989

      POINTS OF COUNSEL

      Richard Weinberger and Mitchell D. Kessler for intervenorappellant.
    I. The promissory note is not an "instrument” as defined in UCC 9-105 (1) (i). II. Actual possession of the promissory note was not required for Congress Talcott’s prior security interest to be perfected. (Lipkowitz & Plaut v Affrunti, 95 Misc 2d 849; Allegaert v Chemical Bank, 657 F2d 495.) III. Chavo has no interest in the promissory note and its proceeds to which Berkowitz’s judgment lien could attach. (Cibro Petroleum Prod. v Fowler Finishing Co., 92 Misc 2d 450; Matter of Valerio v College Point Sav. Bank, 48 Misc 2d 91; Matter of Gray, 28 Misc 2d 1051.)

      Gabriella Jordan and Robert A. Gaynor for respondent.
    I. Ms. Berkowitz’s judgment lien takes priority over Congress’ alleged security interest in the promissory note because Congress did not perfect its security interest as it did not take possession of the promissory note. (Aspen Indus. v Marine Midland Bank, 52 NY2d 575; Lipkowitz & Plaut v Affrunti, 95 Misc 2d 849; Landmark Land Co. v Sprague, 529 F Supp 971, 701 F2d 1065; In re Farley Corp., 612 F2d 1197; Smith v Mark Twain Natl. Bank, 805 F2d 278.) II. The factoring agreement was never intended to extend to the after-acquired promissory note. (Bostwick-Westbury Corp. v Commercial Trading Co., 94 Misc 2d 401; In re Laminated Veneers Co., 471 F2d 1124.)
   OPINION OF THE COURT

Alexander, J.

The issue presented on this appeal is whether a promissory note executed in favor of the judgment debtor is an instrument under UCC 9-105 (1) (i) such that intervenor Congress Talcott Corp. was required to take possession of the note in order to perfect its security interest therein prior to execution of a lien on the note’s proceeds obtained by the judgment creditor (see, UCC 9-304 [1]). We conclude that possession of the promissory note was required and that, consequently, the judgment creditor has a prior right to the proceeds due thereunder.

I

In August 1985, judgment creditor, Susan Berkowitz, entered into an agreement with judgment debtor, Chavo International, Inc. (Chavo), and Chavo’s then president, Christine Thomson, pursuant to which Berkowitz agreed to perform services as a salesperson and Chavo and Thomson agreed to pay her a commission on the resulting sales. When Chavo and Thomson later refused to make payment, Berkowitz commenced an arbitration proceeding in California resulting in an award in her favor in the amount of $125,494.67 plus interest. On October 5, 1987, this award was confirmed and reduced to judgment by the Superior Court of California, County of Los Angeles. Four days later, the California judgment, totaling $127,529.11, was duly filed in New York County pursuant to CPLR 5402.

Prior to execution of the Berkowitz service contract, Chavo entered into a factoring agreement with James Talcott, Inc., the predecessor-in-interest to intervenor Congress Talcott Corp. (Talcott). Pursuant to that agreement, Chavo assigned and sold to Talcott all of its present and future receivables: "We [Chavo] hereby assign to you [Talcott] and agree to sell to you as absolute owner all Receivables now and hereafter owned by us. The term 'Receivables’ includes all obligations of every kind at any time owing to us (whether classified under the Uniform Commercial Code as accounts, instruments, contract rights, chattel paper, general intangibles or otherwise) all proceeds thereof, all security therefor and all our rights to goods sold which may be represented thereby and all products and proceeds of such goods.” The agreement describes the assigned "Receivables” as "bona fide existing obligations created by the sale and actual delivery of goods or the rendition of services to customers in the ordinary course of business”. It is undisputed that Talcott filed the appropriate financing statements covering its security interests under the factoring agreement (see, UCC 9-402).

Subsequent to the effective date of the factoring agreement but prior to the execution of Berkowitz’s judgment lien, Chavo entered into a written purchase agreement with Forest Lake Ltd. (Forest Lake) covering the purchase by Forest Lake of certain of Chavo’s assets. Under this agreement, Forest Lake became the obligor under a promissory note in the principal amount of $137,948.42 given to Chavo as payment for the purchased assets. Although this note was executed in favor of Chavo, by its terms it was made subject to the provisions of the purchase agreement which direct that payment on the note be made to Talcott in order to reduce the substantial debt amassed by Chavo under the prior factoring agreement. Both Berkowitz and Talcott claim entitlement to the proceeds due under this promissory note, the former by virtue of her judgment lien and the latter by virtue of its factoring agreement with Chavo under which it was assigned all of Chavo’s future "receivables”.

In an attempt to enforce her judgment, Berkowitz served a restraining notice and execution on Forest Lake prohibiting payment by the latter of any moneys due under the promissory note except in satisfaction of the judgment. Forest Lake thereupon notified all parties that it would withhold payment on the note until the court determined who was entitled to the proceeds. Talcott subsequently moved for an order vacating the restraining notice and execution, contending that it had a prior and superior interest in the moneys owed to Chavo by Forest Lake. Berkowitz opposed the motion, contending that Talcott lacked standing, that it had not properly perfected its security interest in the note by taking possession thereof prior to execution of the judgment lien, and that its security interest does not cover the debt owed to Chavo under the note.

In granting the motion, Supreme Court first rejected Berkowitz’s procedural argument, concluding that, as an adverse claimant, Talcott had standing to intervene in the proceeding (CPLR 5239). The court further determined that by filing the proper financing statements relating to its factoring agreement with Chavo, Talcott perfected its security interest in the note and since this filing occurred prior to execution of the judgment lien, Talcott’s security interest was superior to that of Berkowitz. Finally, the court concluded that the security agreement between Chavo and Talcott properly applied to all after-acquired property of Chavo, including the promissory note at issue.

The Appellate Division reversed and reinstated the restraining notice and execution. That court determined the promissory note to be an "instrument” within the meaning of article 9 of the Uniform Commercial Code requiring that Talcott take possession of the note in order to perfect its security interest therein (UCC 9-105 [1] [i]; 9-304 [1]). Since Talcott had not taken possession, the judgment lien was held to be a prior and superior interest. In reaching this result, the court rejected Talcott’s contention that the note was not in fact an "instrument” because it was not "transferable by delivery in the ordinary course of business” (UCC 9-105 [1] [i]) concluding that, although the note was nonnegotiable because subject to the terms of the purchase agreement, nothing in the note or the agreement restricted the assignability of either (144 AD2d, at 264).

Leave to appeal was granted to Talcott by the Appellate Division which certified the following question of law for our review: "Was the order of this Court, which reversed the order of the Supreme Court, properly made?” For the reasons that follow, we now affirm and answer the certified question in the affirmative.

II

Berkowitz’s contention that the factoring agreement did not grant Talcott a security interest in the proceeds due under the promissory note because the note does not constitute a "receivable” generated in the ordinary course of Chavo’s business is without merit. The security agreement between Talcott and Chavo assigns to Talcott all of Chavo’s receivables, including "all obligations of every kind at any time owing to [Chavo]”. This contract provision is plainly broad enough to encompass the promissory note at issue. Though the agreement also provides that all "receivables” which are described in schedules prepared by Chavo "will be bona fide existing obligations created by the sale and actual delivery of goods or the rendition of services to customers in the ordinary course of business” (emphasis supplied), this provision does not narrow the scope of the term "receivable” as it pertains to those assets created in ways other than by the routine sale of goods and services. Notwithstanding that the promissory note was executed in connection with a purchase agreement pursuant to which Chavo transferred a substantial share of its business assets, it clearly is an "obligation * * * owing to [Chavo]” and thus is properly embraced within those receivables assigned to Talcott under the factoring agreement. Talcott, therefore, had a security interest in the note.

Although we conclude the factoring agreement created a security interest in the proceeds due under the promissory note, the question remains as to whether Talcott was required to take possession of the note in order to perfect that security interest. It is not open to doubt that if possession were not required, then Talcott’s security interest would prevail over the judgment lien of Berkowitz since the security agreement between Talcott and Chavo and the financing statements pertaining thereto were executed and filed long before the California judgment issued. Whether or not possession was required depends on whether the subject promissory note is the sort of instrument contemplated by UCC 9-304 (1) which provides that "[a] security interest in * * * instruments (other than * * * instruments which constitute part of chattel paper) can be perfected only by the secured party’s taking possession”.

UCC 9-105 (1) (i) defines "instrument” as "a negotiable instrument * * * or a certificated security * * * or any other writing which evidences a right to the payment of money and is not itself a security agreement or lease and is of a type which is in ordinary course of business transferred by delivery with any necessary indorsement or assignment”. The promissory note executed by Forest Lake clearly qualifies as an "instrument” under this definition (see, UCC 3-103; 2 White & Summers, Uniform Commercial Code § 24-12, at 349 [3d ed— Practioner’s 1988]). The note constitutes a writing evidencing a monetary obligation of Forest Lake running to Chavo, it is not itself a security agreement (see, 2 White & Summers, op. cit., § 24-3, at 297-305), and notwithstanding the payment restrictions attaching to the note rendering it nonnegotiable, both the note and the agreement to which it is made subject are freely assignable — indeed, they are expressly made so by the language in the agreement and the personal guarantee accompanying the note.

Our determination that the promissory note is an "instrument” under article 9 does not end the inquiry, however, since, as suggested by Talcott, although the note is an instrument, it may also constitute "chattel paper” which may be perfected either by possession or by filing (UCC 9-304 [1]). It has been observed that "[c]hattel paper and non-negotiable instruments lie somewhere on the spectrum between the negotiable instrument on the one hand and the account on the other; for the former possession is everything, for the latter it is nothing” (2 White & Summers, op. cit., § 26-18, at 548). Section 9-105 (1) (b) of the code defines chattel paper as "a writing or writings which evidence both a monetary obligation and a security interest in or a lease of specific goods” and provides further that "[w]hen a transaction is evidenced both by such a security agreement or a lease and by an instrument or a series of instruments, the group of writings taken together constitutes chattel paper” (UCC 9-105 [1] [b]). One example of a transaction involving chattel paper offered in the official commentary to UCC 9-105 is of a dealer who sells a tractor to a farmer pursuant to a conditional sales contract and then assigns the contract to a bank in order to secure a loan. In this scenario, the conditional sales contract is the type of collateral known as chattel paper because it is a security agreement relating to specific goods that has been transferred in order to secure a debt owed by the transferor to the transferee (see, Uniform Commercial Code § 9-105, comment 3; 53 NY Jur, Secured Transactions, §56, at 301-302; Federal Deposit Ins. Corp. v Herald Sq. Fabrics Corp., 81 AD2d 168, 178).

Talcott’s apparent argument that the promissory note is similar to the above-described conditional sales contract because it evidences both a monetary obligation and a security interest covered by its factoring agreement with Chavo must be rejected. Whether the note represents a security interest included in the prior factoring agreement is irrelevant to the issue of whether the note constitutes chattel paper. Under the proper analysis, the dispositive question is whether the note and purchase agreement together evidence a monetary obligation and a security interest in the assets purportedly sold under the agreement. Viewed in this context, the promissory note plainly does not constitute chattel paper because, although the note does evidence a monetary obligation running to Chavo, the purchase agreement creates no security interest in the goods sold thereunder. Rather, the note was offered in even exchange for the sale of Chavo’s business assets in which Chavo retained no residual interest. Inasmuch as the promissory note does not constitute chattel paper, Talcott was required to take possession thereof in order to perfect whatever security interest it may have had by virtue of its factoring agreement with Chavo. As Talcott failed to take this critical step, the Appellate Division correctly concluded that the interest of Berkowitz, as the judgment creditor, must take precedence (see, UCC 9-301).

Accordingly, the order of the Appellate Division should be affirmed, with costs, and the certified question answered in the affirmative.

Chief Judge Wachtler and Judges Simons, Kaye, Titone, Hancock, Jr., and Bellacosa concur.

Order affirmed, etc.

       Alternatively, the conditional sales contract might be sold to the bank, not as collateral to secure a debt, but simply as personal property for value received. In this circumstance, the sales contract is still "chattel paper” and the transaction remains one governed by article 9 of the Uniform Commercial Code (see, Federal Deposit Ins. Corp. v Herald Sq. Fabrics Corp., 81 AD2d 168,178; UCC 9-102 [1] [b]).


author: Kaye, J.

text:
    Hartford Accident & Indemnity Company, Appellant, v American Express Company et al., Respondents, et al., Defendants.
    Argued May 31, 1989;
    decided July 11, 1989

      POINTS OF COUNSEL

      David Gottfried and Jerome Murray for appellant.
    I. Defendants are liable in conversion as a matter of law. (Sims v United States Trust Co., 103 NY 472; Borrello v Perera Co., 381 F Supp 1226, 512 F2d 1380; Key Appliance v National Bank of N. Am., 75 AD2d 92; Federal Ins. Co. v Groveland State Bank, 37 NY2d 252; Munn v Boasberg, 292 NY 5; Matteawan Mfg. Co. v Chemical Bank & Trust Co., 244 App Div 404, 272 NY 411; Fidelity & Cas. Co. v Hellenic Bank Trust Co., 181 Misc 40, 44; Alpert v City Motor Sales, 194 Misc 909; Federal Sav. & Loan Ins. Corp. v Kearney Trust Co., 151 F2d 720; New Jersey Natl. Bank & Trust Co. v Sachs, 91 F2d 533.) II. Defendants were not holders in due course. (Banco Di Roma v Merchants Bank, 92 AD2d 42; Bank Leumi Trust Co.

      v Isramkor, Ltd,., 51 AD2d 940; Brinkmann v Carter, 65 AD2d 744; Sims v United States Trust Co., 103 NY 472; Key Appliance v National Bank of N. Am., 75 AD2d 92; Rochester & Charlotte Turnpike Rd. Co. v Paviour, 164 NY 281; Chemical Bank v Haskell, 51 NY2d 85; Underpinning & Found. Constructors v Chase Manhattan Bank, 46 NY2d 459; Jewett v Manufacturers Hanover Trust Co., 48 Misc 2d 1094; Travelers Indem. Co. v American Express Co., 559 F Supp 452.) III. Defendants were not holders. IV. Estoppel and negligence are not valid defenses to plaintiffs claims in conversion. (Bunge Corp. v Manufacturers Hanover Trust Co., 31 NY2d 223; Borrello v Perera Co., 381 F Supp 1226, 512 F2d 1380; Tonelli v Chase Manhattan Bank, 41 NY2d 667; Lund v Chemical Bank, 665 F Supp 218; Hartford Acc. & Indem. Co. v Walston & Co., 21 NY2d 219; Rosenthal v Manufacturers Hanover Trust Co., 30 AD2d 650; Matteawan Mfg. Co. v Chemical Bank & Trust Co., 244 App Div 404, 272 NY 411; Fidelity & Cas. Co. v Hellenic Bank Trust Co., 181 Misc 40, 44.)

      Susan J. Kohlmann and Eloise L. Morgan for American Express Company and another, respondents.
    I. Amex and Phillips are holders in due course. (Chemical Bank v Haskell, 51 NY2d 85; Manufacturers & Traders Trust Co. v Sapowitch, 296 NY 226; Indyk v Habib Bank, 694 F2d 54; Hall v Bank of Blasdell, 306 NY 336; Jenkins v Evans, 31 AD2d 597; Travelers Indem. Co. v American Express Co., 559 F Supp 452; Bunge Corp. v Manufacturers Hanover Trust Co., 31 NY2d 223; National Safe Deposit Co. v Hibbs, 229 US 391; Prudential-Bache Sec. v Citibank, 73 NY2d 263.) II. Hartford has no claim in conversion because the checks were paid to the intended payee. (Sims v United States Trust Co., 103 NY 472; Federal Ins. Co. v Groveland State Bank, 37 NY2d 252; Key Appliance v National Bank of N. Am., 75 AD2d 92; Matteawan Mfg. Co. v Chemical Bank & Trust Co., 244 App Div 404, 272 NY 411; Fidelity & Cas. Co. v Hellenic Bank & Trust Co., 181 Misc 40, 44; Tonelli v Chase Manhattan Bank, 41 NY2d 667; Firemen’s Ins. Co. v Chase Manhattan Bank, 102 Misc 2d 613; Alpert v City Motor Sales, 194 Misc 909; Munn. v Boasberg, 292 NY 5; Rochester & Charlotte Turnpike Rd. Co. v Paviour, 164 NY 281.) III. Amex and Phillips were holders of the checks in question. (Security State Bank v Baty, 439 F2d 910; Swanson v Fuline Corp., 248 F Supp 364; Cohen v Lincoln Sav. Bank, 275 NY 399; Northern Trust Co. v Chase Manhattan Bank, 582 F Supp 1380, 748 F2d 803.) IV. As holders in due course, Amex and Phillips are not liable to plaintiff. (RAM Indus. v Van De Maele, 20 AD2d 783, 14 NY2d 968; Clothier v Adriance, 51 NY 322; Merson v Sun Ins. Co., 44 Misc 2d 131; Hartford Acc. & Indem. Co. v Walston & Co., 21 NY2d 219; Hibbs v Brown, 190 NY 167; Turnbull v Bowyer, 40 NY 456; Geneva Natl. Bank v Fox, 117 Misc 129; Gruntal v United States Fid. & Guar. Co., 254 NY 468.) V. The courts below were correct in granting summary judgment. (First Intl. Bank v Blankstein & Son, 59 NY2d 436; Citibank v Deutsch, 99 AD2d 452; Manufacturers & Traders Trust Co. v Murphy, 369 F Supp 11; Jenkins v Evans, 31 AD2d 597; Saale v Interstate Steel Co., 27 AD2d 1, 19 NY2d 933; First Natl. Bank v Glen Enters., 101 AD2d 848; Bank of N. Y. v Welz, 118 Misc 2d 645.)

      Robert M. Makla for E.J., Audi, Inc., respondent, relies on the brief and argument of American Express Company and another.

      William T. Kennard for Metropolitan Opera Associates, Inc., respondent, relies on the brief and argument of American Express Company and another.

      Jeff L. Greenup for Zanders Auto Rental Service, Inc., respondent, relies on the brief and argument of American Express Company and another.
   OPINION OF THE COURT

Kaye, J.

Stratford Skalkos, formerly manager of the import/export transportation department of Avon Products, Inc., had authority to requisition checks up to $25,000 on his signature alone. For nearly three years, Skalkos used that authority to perpetrate a fraud on Avon, by requisitioning corporate checks totaling $162,538.65 to pay his own debts. This case represents an effort to recover a portion of those proceeds from defendant payees.

Skalkos followed a simple pattern: on check requisitions to Avon he altered the names of the payees just enough to obscure immediate recognition by his employer yet remain in the range of apparent clerical error; he meticulously but fictitiously explained each expenditure in the requisitions as relating to freight; and he had Avon route the checks to him instead of following the more usual procedure of having the corporation transmit the checks to the named payees. Fifteen Avon checks, for example, were paid to defendant American Express Company — the largest recipient of the purloined funds. On their face the checks were payable to "Amerex Corp., 770 Broadway, New York, NY 10003.” Each check requisition submitted by Skalkos to Avon explained those charges as relating to particularized shipping expenses. After Avon routed the checks to Skalkos, he transmitted them to American Express to pay his own credit card bills.

Similarly, defendant Metropolitan Opera Association, Inc. on three Avon checks became "Metropolitan Opng. Co.,” "Metropolitan Opptg. Inc.” and "Metropolitan Oprtg. Co.” By the movement of a letter of the alphabet, defendant E.J. Audi, Inc. became "E. Jaudi, Inc.” on two checks; it was accurately named on the third Avon check it received. While each of the 10 Avon checks to defendant Zanders Auto Rental Service used the name "Zanders,” that name variously became "R. Zanders Crtg. Inc.,” "R. Zanders Carting Inc.,” "Zanders Carting Inc.,” and "R. Zanders Crete, Inc.” Defendant Phillips Son & Neale, Inc. (an auction gallery) received one Avon check, containing the name Phillips but payable to "Phillips Auctgullert & Co.” As with American Express, the recipients’ addresses appeared beneath their names on the face of the checks. In each instance, defendants credited the proceeds against Skalkos’ existing personal indebtedness to them, for credit card charges, an opera subscription, apartment furnishings, car service and Oriental rugs purchased at auction. There is no assertion that any of the defendants was actually aware of Skalkos’ scheme.

Plaintiff insurer, as Avon’s subrogee, brought this action against defendants for conversion, money had and received, and negligence. On cross motions for summary judgment, Supreme Court granted defendants’ motions, concluding that defendants were holders in due course and thus took the checks free of any claims or defenses (136 Misc 2d 62). The Appellate Division affirmed, without opinion, and we granted plaintiff leave to appeal.

The dispositive issue is whether defendants were holders in due course. The holder in due course doctrine — which has particular importance in commercial transactions like those at issue here — has as its objective encouraging and facilitating the ready transaction of negotiable instruments, central to our credit economy; people can rely on the fact that negotiable instruments in the hands of good-faith purchasers will be paid according to their tenor and intent and not paid otherwise (see, Cohen v Lincoln Sav. Bank, 275 NY 399, 412). Holder in due course status advances that objective by providing that persons in that category take free of virtually all claims and defenses (UCC 3-305 [1], [2]). In the circumstances presented, we conclude that defendants were holders in due course, free of Avon’s claims, and we therefore affirm the Appellate Division order dismissing the complaint.

A payee may become a holder in due course if it meets the conditions set forth in the Uniform Commercial Code (UCC 3-302 [2]). The code defines a holder in due course as a (1) holder (2) of a negotiable instrument (3) who took it for value, (4) in good faith, and (5) without notice that it is overdue or has been dishonored or of any defense against or claim to it on the part of another (UCC 3-302 [1]). Satisfaction of these requirements is all that is necessary for a payee to obtain the special protections of a holder in due course (see, Saale v Interstate Steel Co., 19 NY2d 933; 1 White & Summers, Uniform Commercial Code § 14-7, at 718-719 [3d ed — Practitioner’s]).

Undisputedly, the checks in question are negotiable instruments that were taken by defendants for value and in good faith as those terms are defined in the code (see, UCC 1-201 [19]; 3-303). The points of contention are the first requirement —the “holder” provision — and the fifth — the “notice of claim or defense” provision. We conclude that both requirements were satisfied, and address each in turn.

The Holder Requirement Under the UCC

The threshold status of “holder” requires possession of an instrument “drawn, issued or indorsed to him or to his order or to bearer or in blank.” (UCC 1-201 [20]; see, Marine Midland Bank v Price, Miller, Evans & Flowers, 57 NY2d 220, 224-225; Whaley, Forged Indorsements and the UCC’s "Holder”, 6 Ind L Rev 45 [1972].)

Defendants of course had possession of checks payable to order, but mere possession of order paper does not transform a person into a holder. Unless checks have been drawn to their order, possessors cannot be holders (1 White & Summers, op. cit., § 13-21, at 680). Plaintiff urges that because the checks were made payable to fictitious entities, they were categorically not drawn or issued to defendants or to their order. This is especially so, according to plaintiff, because Avon did not intend for defendants to have the checks; Avon intended that those checks pay the freight charges fraudulently represented on the requisitions completed by Skalkos.

Supreme Court rejected plaintiff’s argument on the strength of UCC 3-203, which authorizes a payee to negotiate an instrument to a third party notwithstanding an erroneous or misspelled name. The court reasoned that the protection of the provision should be extended to the situation at hand. UCC 3-203, however, concerns the validity of endorsements and not the validity of the checks themselves. We reach the same result as Supreme Court — concluding that defendants are holders — but we do so by the application of UCC 3-110, which is addressed to the question when an instrument is payable to order.

A check is payable to order when the instrument specifies the payee with "reasonable certainty.” (UCC 3-110 [1] [c].) That standard is not dependent on the subjective intent of the maker or drawer of the instrument (see, 4 Hawkland & Lawrence, Uniform Commercial Code Series § 3-110:03, at 126). An instrument need not name the payee punctiliously to have been issued to the order of that person; minor errors in a name will not affect the status of holder so long as the person specified is identified with reasonable certainty (see, Northern Trust Co. v Chase Manhattan Bank, 582 F Supp 1380, 1385 [SD NY], affd 748 F2d 803 [2d Cir]; Security State Bank v Baty, 439 F2d 910, 912 [10th Cir]).

Applying this standard, we agree with the conclusion reached by Supreme Court and the Appellate Division: what is involved here is in the nature of minor error or misspelling. Skalkos’ slight alterations of the payees’ names so as to retain their essence yet appear to be clerical errors, coupled with the address of each defendant shown on the face of the checks, plainly identified defendants with reasonable certainty.

Thus, Supreme Court and the Appellate Division correctly concluded as a matter of law that defendants were "holders” under the code.

The Notice Requirement Under the UCC

To be a holder in due course a party must take the instrument "without notice that it is overdue or has been dishonored or of any defense against or claim to it on the part of any person.” (UCC 3-302 [1] [c]; see generally, Blum, Notice to Holders in Due Course and Other Bona Fide Purchasers Under the Uniform Commercial Code, 22 BC L Rev 203 [1981].) Plaintiff contends that defendants took the checks from Skalkos with notice of Avon’s claim — in particular, that they took with notice that Avon had not authorized defendants to apply its funds to Skalkos’ personal indebtedness. Essentially three grounds are advanced for this proposition.

First, plaintiff asserts that defendants were on notice of Avon’s claims by virtue of UCC 3-304 (1) (a): "The purchaser has notice of a claim or defense if * * * the instrument is so incomplete, bears such visible evidence of forgery or alteration, or is otherwise so irregular as to call into question its validity, terms or ownership or to create an ambiguity as to the party to pay”. Plaintiff argues that the misnomers were so irregular as to call the validity of the checks into question.

But "[i]t will be rare that an instrument will be so irregular as to call into question its validity, terms or ownership.” (4 Hawkland & Lawrence, op. cit., § 3-304:11, at 432.) Indeed, as explained in the Official Comment, the irregularity contemplated by section 3-304 (1) (a) is "notice to the purchaser of something wrong”. (UCC 3-304, comment 2.) By any measure, the misnomers — correctly portrayed by Supreme Court as minor errors or misspellings — were not irregularities of such magnitude as to put a holder on notice that something was "wrong.”

Second, plaintiff urges that defendants had notice of Avon’s claim against the checks by reason of UCC 3-304 (2), which provides: "The purchaser has notice of a claim against the instrument when he has knowledge that a fiduciary has negotiated the instrument in payment of or as security for his own debt or in any transaction for his own benefit or otherwise in breach of duty.” Plaintiff contends that defendants had actual knowledge that Skalkos was Avon’s fiduciary, and their acceptance of Avon’s checks in satisfaction of personal indebtedness constituted the very sort of notice that UCC 3-304 (2) contemplated, whether or not defendants had actual knowledge of Avon’s claim against the checks. This argument is also without merit.

Assuming for purposes of this summary judgment motion that Skalkos was Avon’s fiduciary, and that this fact was known to defendants, what is essential to plaintiff’s argument is that Skalkos "negotiated” the checks. UCC 3-304 (2) requires as much.

Negotiation is defined in the code as "the transfer of an instrument in such form that the transferee becomes a holder.” (UCC 3-202 [1].) That concept, however, does not include the first delivery or “issue” of a check, although the payee to whom the check is issued may become a holder (see, UCC 1-201 [20]; 3-102 [1] [a]; 3-302 [2]; Brady, Bank Checks ¶ 7.2 [Bailey 6th ed]). “Thus, in the case of order instruments, only the payee or one who signs on his behalf can make the first effective endorsement and negotiate the instrument.” (1 White & Summers, op. cit., § 13-9, at 641.) Accordingly, section 3-304 (2) by its terms is inapplicable where, as here, the alleged fiduciary "uses an instrument drawn by his principal in favor of the holder to pay not the principal’s indebtedness to the holder but his own.” (Blum, Notice to Holders in Due Course and Other Bona Fide Purchasers Under the Uniform Commercial Code, 22 BC L Rev 203, 242-243 [1981].)

We conclude, moreover, that on the undisputed facts Supreme Court and the Appellate Division correctly relied on UCC 3-304 (7), which reads: "In any event, to constitute notice of a claim or defense, the purchaser must have knowledge of the claim or defense or knowledge of such facts that his action in taking the instrument amounts to bad faith.”

The purpose of UCC 3-304 (7) — unique to New York and Virginia — was to require that questions of notice would be determined by a subjective test of actual knowledge rather than an objective test which might involve constructive knowledge (Chemical Bank v Haskell, 51 NY2d 85, 92-93; see also, Lawton v Walker, 231 Va 247, 343 SE2d 335 [construing Va Code Ann § 8.3-304 (7)]). The New York Legislature’s addition of a nonuniform subjective test to the code’s uniform notice provision signals a deliberate, unmistakable choice to give added protection to good-faith purchasers in this State.

Thus, UCC 3-304 (7) demands nothing less than actual knowledge of the claim against the instrument or of facts indicating bad faith in taking the instrument (Chemical Bank v Haskell, supra; First Intl. Bank v Blankstein & Son, 59 NY2d 436, 445; Federal Deposit Ins. Corp. v Russo, 58 NY2d 929, affg for reasons stated at 89 AD2d 575). Holders in due course are to be determined by the simple test of what they actually knew, not by speculation as to what they had reason to know, or what would have aroused the suspicion of a reasonable person in their circumstances (see, First Natl. Bank v Fazzari, 10 NY2d 394, 399).

That defendants knew Avon’s checks were being used to satisfy Skalkos’ personal debts does not constitute actual knowledge of Avon’s claim against the checks, or knowledge of such facts that defendants’ action in taking the checks amounted to bad faith. Skalkos’ transmission of company checks payable to the order of defendants was itself an innocuous act. It did not give defendants notice of any claim by Avon against those checks or betray an ongoing fraud; nor did the application of the checks to Skalkos’ personal indebtedness. As Supreme Court observed, the use of corporate checks to pay employees’ debts "is an every day occurrence in the business world. Employers often help an employee to maintain a residence as an inducement to continued employment in an area where living expenses are high. Employers often pay for the entertainment of customers by an employee. Employers often pay for travel and transportation expenses of an employee.” (136 Misc 2d, at 66.) Defendants themselves in their summary judgment submissions have indicated that they regularly receive payment through corporate accounts for goods or services furnished to individuals.

Checks of this kind may represent an employer’s compensation to its employee or the reimbursement of business expenses (see, 4 Hawkland & Lawrence, op. cit., § 3-304:06, at 425; Spaulding & Sherwood, The Wayward Corporate Check: Notice of Diversion Under the UCC, 18 Cath U L Rev 127, 134, 149 [1968-1969]). That being so, defendants were entitled to conclude that Skalkos had lawfully transmitted the checks to them to discharge the expenses he had incurred. They were not required to surmise that the checks, rather than representing reimbursement or payment for Skalkos’ services by his employer, were in effect stolen (see, Eldon’s Super Fresh Stores v Merrill Lynch, Pierce, Fenner & Smith, 296 Minn 130, 207 NW2d 282). Parties who take commercial paper for value " '[are] not bound at [their] peril to be upon the alert for circumstances which might possibly excite the suspicions of wary vigilance.’ ” (Hall v Bank of Blasdell, 306 NY 336, 341; Chemical Bank v Haskell, supra, at 93-94.)

Thus we conclude as a matter of law that defendants did not have notice of Avon’s claim under UCC 3-304.

Third, plaintiff urges that defendants should be charged with notice, or otherwise deemed to have breached a duty of care, by virtue of a line of cases typified by Sims v United States Trust Co. (103 NY 472). In the Sims line of cases, a bank’s customer (having no indebtedness to the bank) drew checks to the order of the bank, intending that the proceeds be deposited in its account, but a third party diverted the proceeds. It has long been the rule that a depositary bank cannot disburse its customer’s funds without inquiry of the customer (id., at 475-476; Federal Ins. Co. v Groveland State Bank, 37 NY2d 252, 258; Arrow Bldrs. Supply Corp. v Royal Natl. Bank, 21 NY2d 428, 431; Brady, op. cit., ¶ 13.3; 5A Michie, Banks and Banking § 183, at 563-564 [1983]). A bank that ignores this rule, choosing to treat a customer’s check payable to the bank as instead payable to the bearer, is negligent as a matter of law (see, Federal Ins. Co. v Groveland State Bank, supra; Whaley, Negligence and Negotiable Instruments, 53 NC L Rev 1, 15-16 [1974]; cf., Banking Law § 9; New York Metro Corp. v Chase Manhattan Bank, 52 NY2d 732).

But the bank deposit rule exemplified by Sims has no application in the present case, where the issue is payment of an obligation for goods and services, not deposit in a bank account. This distinction is important. A bank and its depositor have the contractual relationship of debtor and creditor, with an implicit understanding that the bank will pay out a customer’s funds only in accordance with its instructions (see, Merrill Lynch, Pierce, Fenner & Smith v Chemical Bank, 57 NY2d 439, 444; Tonelli v Chase Manhattan Bank, 41 NY2d 667, 670; see also, Underpinning & Found. Constructors v Chase Manhattan Bank, 46 NY2d 459). There was no such relationship between Avon and defendants (see, Firemen’s Ins. Co. v Chase Manhattan Bank, 102 Misc 2d 613). When defendants received Avon’s checks, issued to their order and regular on their face, they had no statutory or common-law duty to stop their business operations in order to ask Avon its purposes in issuing the checks to them before applying the proceeds against existing indebtedness.

While there are a few cases that have applied the Sims rationale outside the banking context (see especially, Munn v Boasberg, 292 NY 5, and Rochester & Charlotte Turnpike Rd. Co. v Paviour, 164 NY 281), those cases must be read in the light of the Uniform Commercial Code. Simply put, UCC 3-304 (7) precludes the possibility that nonbank creditors like defendants will be held to the strict duty of inquiry that may be required of bank payees (Brady, op. cit., ¶ 13.3). That defendants, in retrospect, might have made further inquiry or might even have been careless when they accepted Avon’s checks to pay Skalkos’ debts (as plaintiff urges), is insufficient to deny them the status of holder in due course; there is no proof either of their actual knowledge of Avon’s claim against those checks or of such facts that their action in taking the checks amounted to bad faith.

Finally, the result we reach is fully consistent with the letter and spirit of the check fraud rules contained in the Uniform Commercial Code. It promotes the policy favoring ready negotiability of commercial paper, assuring that good-faith purchasers need not stand as insurers of the honesty of a drawer corporation’s employees. And it assigns losses by the relative responsibility of the parties, allocating liability to the party best able to prevent them (see, Prudential-Bache Sec. v Citibank, 73 NY2d 263, 269; Comment, Allocation of Losses from Check Forgeries Under the Law of Negotiable Instruments and the Uniform Commercial Code, 62 Yale LJ 417 [1953]). As among the parties to this dispute Avon — whose misplaced trust or inattention enabled its employee to misappropriate funds, undetected, for several years — was plainly the party best able to prevent the losses and to protect itself by insurance. The losses were therefore properly allocated to Avon, not defendants.

Accordingly, the order of the Appellate Division dismissing the complaint should be affirmed, with costs.

Chief Judge Wachtler and Judges Titone, Hancock, Jr., and Bellacosa concur; Judges Simons and Alexander taking no part.

Order affirmed, with costs.

      . Zanders’ undisputed evidence indicates that its "proper corporate name” is "R. Zanders Rental Service, Inc.”

        . This nonuniform provision, recommended by the New York Law Revision Commission, was received with misgivings by commentators (Note, Notice and Good Faith Under Article 3 of the Uniform Commercial Code, 51 Va L Rev 1342, 1353-1354 [1965]; Braucher, UCC Article 3 — Commercial Paper — New York Variations, 17 Rutgers L Rev 57, 67-68 [1962]; Penney, A Summary of Articles 3 and 4 and Their Impact in New York, 48 Cornell L Rev 47, 59-61 [1962]; Penney, New York Revisits The Code: Some Variations in the New York Enactment of the Uniform Commercial Code, 62 Colum L Rev 992, 998-1000 [1962]).


text:
    Thomas Crimmins Contracting Co., Inc., and Cayuga Construction Co., a Joint Venture, Respondent, v City of New York et al., Appellants and Third-Party Plaintiffs, et al., Third-Party Defendant.
    Argued June 7, 1989;
    decided July 13, 1989

      POINTS OF COUNSEL

      Peter L. Zimroth, Corporation Counsel (Barry P. Schwartz, Fay Leoussis, Leonard Koerner and John F. Grubin of counsel), for appellants.
    The alternative dispute resolution procedure here explicitly states that its purpose is to "prevent disputes and litigations”, and that determinations by the Transit Authority’s chief engineer are "final and conclusive”. Controlling precedent establishes that, under such circumstances, the chief engineer’s disallowances of four of plaintiffs 49 claims are final and binding as a matter of law absent proof that they are the result of fraud, bad faith, or palpable error, or are totally irrational or in violation of a strong public policy. The majority of the court below, therefore, erred in affirming the Supreme Court’s denial of defendants’ motion to add as an affirmative defense the finality of the chief engineer’s determinations. (Edenwald Contr. Co. v City of New York, 60 NY2d 957; McCaskey, Davies & Assocs. v New York City Health & Hosps. Corp., 59 NY2d 755; Tankers Intl. Nav. Corp. v National Shipping & Trading Corp., 116 AD2d 40; Herrick v Second Cuthouse, 64 NY2d 692; Hawkins v Genesee Place Corp., 139 AD2d 433; Rothfarb v Brookdale Hosp., 139 AD2d 720; Kaye 1969 Assocs. v Lese, 72 AD2d 728; Oak Point Indus. Park v Massachusetts Bay Ins. Co., 65 AD2d 552; Lovisa Constr. Co. v City of New York, 69 NY2d 801; Grow Tunneling Corp. v City of New York, 70 NY2d 665.)

      J. Robert Ellner for respondent.
    I. Article 24 is a limited Tufano-type provision not intended to cover all disputes. (Tufano Contr. Corp. v Port of N. Y. Auth., 13 NY2d 848.) II. The New York City Charter gives to the Comptroller the exclusive power to deal with disputes and to send claims to an impartial arbitrator, the only alternate dispute resolution method the City Charter authorizes. III. It is an elemental principle of the natural law and a well-recognized public policy that one may not be the Judge of his own cause.

      Tony Berman and Herbert J. Sue for The General Contractors Association of New York, Inc., amicus curiae.

    The City’s representative (here, the Transit Authority’s chief engineer) cannot be the final arbiter of the City’s disputes with Crimmins because public policy would be violated; the chief engineer, by law, has no legal authority to decide the issues in this case; and there simply is no agreement to arbitrate; further, the minority in the court below completely distorted the very purpose of the changed conditions clause. (Naclerio Contr. Co. v City of New York, 116 AD2d 463, 69 NY2d 794; Lovisa Constr. Co. v City of New York, 116 AD2d 1047, 69 NY2d 801; Matter of Cross & Brown Co. [Nelson], 4 AD2d 501; Fuller Co. v Gustafson Co., 55 AD2d 872; Matter of Pisciotta [Newspaper Enters.], 5 AD2d 1014; Ardsley Constr. Co. v Port Auth. of N. Y. & N. J., 54 NY2d 876; Maross Constr. v Central N. Y. Regional Transp. Auth., 66 NY2d 341; Catapano Co. v City of New York, 116 Misc 2d 163; James Julian, Inc. v President & Commrs. of Town of Elkton, 341 F2d 205; Fehlhaber Corp. v United States, 151 F Supp 817, 355 US 877.)
   OPINION OF THE COURT

Kaye, J.

In this action on a construction contract with the City of New York and the New York City Transit Authority, plaintiff contractor seeks to recover damages for additional expenses allegedly incurred as a result of unanticipated subsurface conditions, and for extra and disputed work claims. The question before us is whether a contractual provision — which the City now styles an alternate dispute resolution (ADR) provision — binds plaintiff to the determination made by the Transit Authority’s chief engineer and forecloses judicial review. For the reasons that follow, we agree with the Appellate Division majority that the disputed contract clause should not be construed as having the broad preclusive effect the City urges.

In 1973, plaintiff, a joint venture, entered into a contract with defendants to construct a section of the proposed Second Avenue Subway in New York City. Article 24 of the lengthy contract provides: "To prevent disputes and litigations, the Engineer shall in all cases determine the classification, amount, quality, acceptability and fitness of the several kinds of work and materials which are to be paid for under this contract, shall determine every question in relation to the Works and the construction thereof and shall determine every question which may arise relative to the fulfillment of this contract on the part of the Contractor. His determination and estimate shall be final and conclusive upon the Contractor, and in case any question touching this contract shall arise between the parties hereto, such determination and estimate shall be a condition precedent to the right of the Contractor to receive any money under this Contract.” The "Engineer” referred to in article 24 is the Transit Authority’s chief engineer, a Transit Authority employee.

In the course of the work, plaintiff encountered underground water, soil subsidence and unanticipated rock formations constituting, in its view, a change of subsurface conditions under the contract and entitling it to additional compensation. Plaintiff filed claims for these conditions with the chief engineer, as well as claims for "protest” work allegedly outside the scope of the contract, and for "extra” work involving the protection of open trenches. While many of the claims were accepted by the chief engineer, plaintiff’s changed conditions claims, extra work claim and several of its protest work claims were denied.

In 1979, plaintiff commenced this action for breach of contract to recover damages for its disallowed claims. In 1980, defendants served an answer and an amended answer. More than five years later, but while discovery was not yet completed, defendants moved for leave to amend their answer to add as an affirmative defense that, following the procedure set forth in article 24 of the contract, the chief engineer’s determinations were final and conclusive and precluded plaintiff from further litigating those claims. The trial court initially denied the motion on the basis of defendant’s extraordinary and unexplained delay, which the court believed had prejudiced plaintiff. Upon renewal, the court concluded that it had been factually mistaken in finding prejudice to plaintiff, but again denied the City’s motion, this time holding that the proposed defense was insufficient as a matter of law. A divided Appellate Division affirmed that conclusion, as do we.

Leave to amend pleadings should, of course, be freely given (CPLR 3025 [b]; Edenwald Contr. Co. v City of New York, 60 NY2d 957, 959). Where a proposed defense plainly lacks merit, however, amendment of a pleading would serve no purpose but needlessly to complicate discovery and trial, and the motion to amend is therefore properly denied (Herrick v Second Cuthouse, 64 NY2d 692, 693). On two theories, plaintiff urges that the defense offered by the City is plainly without merit: first, that article 24 does not create an alternate dispute resolution procedure empowering defendant’s own employee to resolve all legal issues of contract interpretation, binding only plaintiff; and second, that if article 24 does in fact authorize such a procedure, it is unenforceable because it violates public policy, is illusory and lacks mutuality. This court has not previously decided either question.

To focus the first issue even more narrowly, plaintiff does not dispute that it is bound by the chief engineer’s factual determinations (see, Tufano Contr. Corp. v Port of N. Y. Auth., 13 NY2d 848; Ardsley Constr. Co. v Port Auth., 54 NY2d 876 [applying Tufano]), but contends that article 24 is not an agreement to be bound on the legal issues of contract interpretation involved in its breach of contract claim. As the Appellate Division noted, should plaintiff fail to sustain its claim that the engineer erroneously construed the contract, the City will prevail, absent a showing that the engineer’s decision was made fraudulently, in bad faith or in palpable error (138 AD2d, at 150). The City, by its proposed affirmative defense, asserts that the court lacks jurisdiction to hear plaintiff’s claims as to the meaning of the contract because article 24 binds the contractor to all of the engineer’s determinations, factual and legal.

An alternate dispute resolution agreement, like an arbitration agreement, "must be clear, explicit and unequivocal * * * and must not depend upon implication or subtlety”. (Matter of Waldron [Goddess], 61 NY2d 181, 183-184.) As we recognized in Matter of Marlene Indus. Corp. (Carnac Textiles) (45 NY2d 327), parties consenting to arbitration surrender many of their "normal rights under the procedural and substantive law of the State, and it would be unfair to infer such a significant waiver on the basis of anything less than a clear indication of intent”. (Id., at 334.) The requirement of explicit and unequivocal agreement when there is to be mutually binding arbitration before a neutral arbitrator obviously takes on even greater significance when resolution of all disputes is to take place before the employee of one contracting party, and bind only the other. That standard has not been met.

Clauses identical to article 24 have been found in City contracts for more than a century (see, e.g., O’Brien v Mayor of City of N. Y., 139 NY 543). That language traditionally was read as conferring upon the designated individuals — typically architects or engineers — the power to make binding decisions as to factual disputes that fell within their particular expertise, but excluding legal matters of contract interpretation (see, O’Brien v Mayor of City of N. Y., supra; Smith Contr. Co. v City of New York, 240 NY 491, 496; Joseph Davis, Inc. v Merritt-Chapman & Scott Corp., 27 AD2d 114, 117-118; but see, Maross Constr. v Central N. Y. Regional Transp. Auth., 66 NY2d 341, 344, where clause specifically provided for resolution of "claims in the nature of breach of contract or fraud or misrepresentation”).

That this has been the meaning assigned to a standard clause found in public works projects since the last century is, at the least, significant in assessing whether the parties here intended that the clause would commit plaintiff to be bound by the chief engineer’s decisions not only on the customary matters within his expertise, such as measurement, quantity and quality of materials, and classification or amount of work performed, but also by his interpretation of legal matters under the contract. Even the City — the drafter of the contract —for more than five years after commencement of this litigation apparently did not regard article 24 as anything more than such a standard clause.

Apart from the historical background of the provision, article 24 of this contract cannot be said to be an explicit and unequivocal agreement to the City’s proposed ADR. Reading the clause in the context of the entire contract, as we must (Rentways, Inc. v O’Neill Milk & Cream Co., 308 NY 342, 347), the lack of such agreement is plain. The contract has 11 chapters and 81 articles, many of them containing "engineer determination” clauses. The clause in issue is found in chapter two of the contract, entitled "Work to be Done, etc.,” which deals with the labor, materials and equipment to be furnished, amplification and alteration of the drawings, compliance with plans and specifications, and inspection of the work and materials. Reading article 24 in its setting, it is reasonable to interpret that provision as having the meaning traditionally assigned to it: that it empowers the chief engineer to make conclusive factual determinations concerning the subjects covered in chapter two — labor and materials, the work to be done, and completion of the work in compliance with the plans and specifications. Notably, neither article 24 nor any provision similar to it is found in chapter five of the contract, which governs "Payments to Contractor” and sets forth a number of procedural hurdles the contractor must surmount in order to "sue” or bring an "action” or "claim” against the City.

Indeed, many of the provisions in chapter five of the contract would be rendered meaningless or useless were we to accept the City’s reading of the standard article 24 clause as precluding all litigation of plaintiff’s claims. Article 42, for example, provides that the contractor’s acceptance of a final payment from the City will operate to release the City from "all claim and liability to the contractor for anything thereto-for done or furnished for, or relating to or affecting the work or for any prior act, neglect, fault or default of the Authority, the City or of any person”. It goes on, moreover, to state that "the Contractor shall not be barred from commencing an action for breach of contract under this provision,” provided it files a proper notice of claim. The following article makes a timely statement filed with the chief engineer a condition precedent to the contractor’s "claim for compensation” for damages. Finally, article 44-A, entitled "Limitations on Right to Sue City,” provides that "No action shall lie or be maintained by the Contractor against the City upon any claim arising out of or based upon this contract * * * unless such action shall be commenced within one year after the date of filing [of the final certificate].”

The City argues that these provisions in chapter five are consistent with its interpretation of article 24. According to the City, they simply set out the conditions pursuant to which the court may entertain a claim by the contractor that the chief engineer’s otherwise binding determination concerning contract claims was infected by fraud, bad faith or gross error. We reject this reading of chapter five. In particular, such a claim would not be one for "breach of contract,” although chapter five explicitly refers to breach of contract claims. A natural and unstrained reading of its provisions indicates that both parties contemplated that the courts would have jurisdiction of a breach of contract claim made by the contractor.

Thus we conclude that article 24, considered in the context of the contractual and historical setting of that standard provision, is not an explicit, unequivocal agreement for alternate dispute resolution — let alone for a dispute resolution procedure that vests final authority for all legal determinations in defendant’s own employee, and binds only plaintiff. The City’s motion to amend its answer to assert such a plainly nonmeritorious defense was therefore correctly denied.

Given this conclusion, it is unnecessary for us to consider the contractor’s second contention — that the procedure proposed by the City in this public works contract is so skewed in its favor as to be unenforceable as a matter of public policy.

Accordingly, the order of the Appellate Division should be affirmed, with costs, and the certified question answered in the affirmative.

Chief Judge Wachtler and Judges Simons, Alexander, Titone, Hancock, Jr., and Bellacosa concur.

Order affirmed, etc.

       In Maross Constr. v Central N. Y. Regional Transp. Auth. (66 NY2d 341), heavily relied on by the City, "the parties expressly agreed to resolve all their disputes by arbitration in the clear and unequivocal language contained in article 2 of the 'General Conditions of the Contract.’ Maross ha[d] not contended otherwise and, moreover, there ha[d] been no challenge made to the lawfulness of the arbitration provision or to its conformity with public policy.” (Id., at 346.)