We have written in the past regarding some of the different issues which can arise when trying to determine the legal nature of a sale and the passing of title. Insurers of fine art and specie risks are especially familiar with such questions arising in the context of consignments, loans, entrustments, bailments, and other transfers or exchanges of such property. For insurers of fine art and specie these issues can be central to coverage determinations, recovery/subrogation and when dealing with bankruptcy of an insured or an insured with goods in the possession of a bankrupt third-party.

The fundamental question at issue in these situations is the ownership of the property and the right to possession. This question has long vexed the law and created impediments to the free flow of commerce. In the 1950s the National Conference of Commissioners on Uniform State Laws and the American Law Institute promulgated the Uniform Commercial Code (UCC). The UCC has been adopted in almost every state and, in most instances, governs the passage of title to personal property. While the UCC addresses many issues, Articles 1, 2 and 9 sit at the center of any evaluation of title arising out of goods delivered by memo, consignment, entrustment, or various forms of sale.

A recent case addressing an ownership dispute over a four carat flawless blue diamond raises some questions as to how courts will evaluate ownership disputes relating to diamonds sent out on memo in the future.

In June 2018, the United States Court of Appeals for the 9th Circuit handed down Mellen Inc. v. Biltmore Loan and Jewelry-Scottsdale LLC,726 F.App'x. 635 (9th Cir. 2018). That case affirmed a decision of the United States District Court, District of Arizona, ruling in favor of the plaintiff (the original owner of a diamond) in his suit to recover the diamond from a pawnbroker who had purchased the diamond from a third party. Mellen Inc. v. Biltmore Loan and Jewelry-Scottsdale LLC, 247 F.Supp.3d 1084 (D. Ariz. 2017) (Mellen).

The transactions worked as follows: the original owner sent the blue diamond on memo to a diamond dealer in Florida. The diamond dealer used a front man—representing that he owned the diamond—to obtain a USD 1 million loan from the pawnbroker in Arizona. Later the pawnbroker bought the diamond for USD 1.3 million, which was paid for by forgiving the debt plus payment for the balance owed on the sale price. In a subsequent ownership dispute between the pawnbroker and the original owner, the court ruled in favor of the original owner. In doing so, the court evaluated the respective rights of the parties pursuant to various provisions of the UCC.

To understand the ruling in Mellen it is important to provide a brief review of the purpose and structure of UCC §2-403. As a general matter, §2-403 arises in the article of the UCC dealing with the sale of goods (Article 2). Its purpose is to provide some certainty to sale transactions, in part, by protecting good faith purchasers and those who buy from merchants in the ordinary course of business. The statute has two sections.

Section 2-403(1) addresses the sale of property by someone who obtained that property in a "transaction of purchase." It expressly provides that even if the party obtaining the property does so through larcenous means, that party will have voidable title and can pass good title to a good faith purchaser for value. In doing so, the statute protects the good faith purchaser over the original owner, placing the risk of the transaction on the original owner/seller even if they were tricked into turning over their property rather than the subsequent good faith purchaser. In some ways the provision acts as a very limited exception to the traditional rule that a thief cannot pass good title.

Section 2-403(2) addresses the entrustment of property to merchants who deal in such goods. It provides that if someone holding good title or voidable title to certain goods entrusts those goods to a merchant who deals in goods of that kind, then the merchant can pass good title to a buyer in the ordinary course of business. This is true even if the merchant was given no right to sell the good and would be converting the property by selling it. By allowing the buyer in the ordinary course to take good title the statute protects the finality of the sale and puts the risk of loss on the entrustor rather than the buyer in the ordinary course.

Whether certain goods are considered to fall under 2-403(1) (based upon a transaction of purchase) or 2-403(2) (based upon an entrustment to a merchant dealing in goods of those kind) can impact the outcome of any subsequent evaluation of ownership. This is because section (1) allows a good faith purchaser to take good title and section (2) requires the purchaser to be a buyer in the ordinary course of dealing. A separate article could be written on the distinction between a good faith purchaser and a buyer in the ordinary course of dealing. Though they are often used interchangeably, they reflect different standards. For the purpose of this article we will limit our comment to simply note that the buyer in the ordinary course standard has a narrower and more limited scope and, as such, is generally more difficult to satisfy.

The Mellen Court did not compare the two standards. Rather the court determined that the only standard at issue was the buyer in the ordinary course standard and ruled that it was not satisfied by the pawnbroker. It is not clear whether the pawnbroker would have satisfied the good faith purchaser standard, but there are some facts in the case which suggest that he might have.

In Mellen, the primary issue of the case was whether or not the rights of the parties were governed by 2-403(1) or 2-403(2). We address the 2-403(1) analysis first.

Though it is not discussed in the case, it should be understood that by giving the diamond to a front man to use as collateral for a loan and subsequently selling it for his own benefit, the diamond dealer committed a conversion of the diamond. These acts were clearly beyond the scope of his agency. However, the pawnbroker argued that his rights were governed by §2-403(1) and as such he argued that he took good title as a good faith purchaser. As noted above, the court avoided the issue of whether the pawnbroker qualified as a good faith purchaser by holding that §2-403(1) did not apply at all, which it resolved by ruling that the diamond was not delivered by the original owner to the diamond dealer pursuant to a "transaction of purchase."

The definition of transaction of purchase has been held to be "generally limited to those situations in which the party who delivered the goods to the subsequent seller intended, however misguidedly, that the seller would become the owner of the goods." See Zaretsky v. William Goldberg Diamond Corp., 820 F.3d 513, 525 (2d Cir.2016).

In reaching its holding that the delivery of the blue diamond on memo did not qualify as a "transaction of purchase" the Mellen Court focused on the following language included in the memo:

The merchandise described below, is delivered to you on memorandum…only for examination and inspection by prospective purchasers, upon the express condition that all such merchandise shall remain the property of [XYZ] and shall be returned on demand, in full in its original form… You acquire no right or authority to sell, pledge, hypothecate or otherwise dispose of the merchandise, or any part thereof, by memorandum or otherwise… A sale of all or any of the merchandise shall occur only if and when we agree and you shall have received from us a separate invoice…

The court ruled that by its express terms the quoted language in the memo ruled out the possibility that the diamond had been delivered in a "transaction of purchase."

The pawnbroker then argued that if it was not a transaction of purchase the delivery of the diamond was an entrustment to a merchant and under §2-403(2) he should be allowed to take good title as a buyer in the ordinary course of dealing from a merchant. Here, the court focused on the fact that the merchant used a front man for the transaction, who himself was not a merchant dealing in goods of that kind (according to the record he was in the vitamin supplement business), in order to hold that the pawnbroker did not buy the diamond from a merchant at all. In addition, the court relied upon the fact that the pawnbroker paid for a portion of the purchase price using credit it was owed from the original pawn loan, which under the statute meant it was not a transaction in the ordinary course of business.

Finally, the pawnbroker argued that under the UCC definition of a consignment, UCC §9-102(a)(20), he was able to take good title in his transaction. Under the UCC, subject to certain qualifications, a delivery of goods to a merchant for the purpose of sale is deemed a consignment. Notably, under the express statutory terms any efforts by the consignor/original owner to retain title when delivering goods to a merchant for the purpose of sale is treated as leaving the original owner with a mere security interest. Put another way, the statute provides that the consignee obtains whatever interest the consignor had and can transfer same. Again, the Mellen Court relied upon the above quoted memo language to reach the conclusion that the blue diamond was not delivered to the diamond dealer for "the purpose of sale."

Notably, the UCC expressly calls for the consideration of course of dealing, course of performance and usage of trade to provide the commercial context in which such an agreement is to be interpreted. §1-303(f). This means that when considering the language in a memo a court can go beyond what the words say and consider how the parties actually treat those words in practice. For example, if a memo contains language requiring a memo holder to seek permission before selling a diamond delivered under that memo, a court can consider evidence showing that sales were regularly made without seeking such permission. The same evidence would be relevant in considering the purpose or meaning of memo language stating that the memo holder does not have authority to sell the diamond. The statute allows a court to consider what the parties actually intended a transaction to be, and to give that intention greater weight than boilerplate language that is routinely ignored by the parties.

In its evaluation of the memo language the Mellen Court did not address any course of dealing between the original owner and the diamond dealer. It may be that there was no meaningful history of transactions between those parties. Were there such a history it may have impacted the ultimate conclusion of the court. The Court did address a usage in trade argument advanced by the pawnbroker, wherein he maintained that within the industry the term memo and consignment were interchangeable. The court rejected this argument by citing to an integration clause in the memo which expressly stated that no term could be varied based on custom of the trade.

As noted above, the UCC is designed to provide some uniformity across different states in how sale transactions and credit transactions are dealt with. Generally it succeeds in this regard. However, to the extent that the statute may also be designed to bring clarity to these situations, its ability to do so is always limited by the clarity of the underlying transactions themselves. In Mellen, the court chose to take the language in the memo at its face value and, in doing so, was able to bring some clarity to an otherwise complicated set of facts. In the broader context, the clarity of memo transactions will often depend upon how the memo terms are enforced by the parties in their day-to-day course of dealing and whether such enforcement or lack thereof creates a gap between what the memos say and what the parties actually do. Only after that determination is made, and a court understands the true purpose of the transaction, will it be able to know which UCC provision (if any) to apply and what it all means.

Though we do not address it here, in adopting the UCC states can modify the provisions and/or may have adopted different versions as the statutes is periodically updated. As such, any evaluation of these issues must begin with the relevant state version of the UCC. In addition, you must also consider any other statutes which might apply, including but not limited to, pawn broker statutes, second-hand dealer statutes and lost property statutes under state law and, on the federal level, the bankruptcy laws and forfeiture laws and any other statutes, rules or treaties, which might be relevant under the circumstances.