chp10-13

Negotiable instruments, Credit, and Bankruptcy

Chapter 13

Meiners, Ringleb and Edwards The Legal Environment of Business, 13th Edition

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Negotiable Instruments

Functions of Negotiable Instruments  Substitute for cash (checks for example)  Provides way to extend credit (promissory note)

Types of Negotiable Instruments  3 party instruments used instead of cash & as credit device Orders to Pay: Drafts Orders to Pay: Checks

 2 party instruments used as credit device Promises to Pay: Notes Promises to Pay: Certificates of Deposit

The Concept of Negotiability

Can be transferred to another party  Assigned - Assignee has same rights and responsibilities as assignor  Transferred by negotiation - Transferee takes instruments free of transferor’s

responsibilities

Transfer order instrument by:  Payee endorses and  Delivers instrument to third party

Bearer instruments  Drawer my create “to bearer,” “to the order of bearer,” “payable to bearer,” “to

cash,” or “pay to the order of cash”  Risky – if lost, can be cashed by anyone  Transfer bearer instrument by delivery

UCC Requirements for Negotiable Instruments

• Only negotiable instruments fall under the UCC

• If nonnegotiable, the common law applies

• To be negotiable it must: • Be written • Be an unconditional order or promise to pay • Be signed by the maker or drawer • Be payable on demand or at a specified time • Be made out “payable to order” (order paper) or “to bearer”

(bearer paper) • Must state a certain sum of money

Requirements for Holders in Due Course

• Person in possession of negotiable instrument may be ordinary holder or holder in due course

• Ordinary holder has same contract responsibilities as assignee – holder in due course does not

• To be holder in due course, transferee must: • Give value for instrument • Take instrument without knowledge it is overdue or defective • Take instrument in good faith

Major Types of Negotiable Instruments

Drafts Unconditional written promise to pay

• Drawer orders drawee to pay $$ to payee

• Time draft says at a specified time

• Sight draft gets paid upon presentation

•Sales draft – for sale of goods •In international, called a bill of exchange •Bankers acceptance creates a guarantee by a bank that draft is good.

Checks

• “Draft drawn on a bank and payable on demand”

• Checks used to be the major method of payment.

• Now credit & debit cards have largely replaced checks.

• On a cashier’s check the bank is both drawer and drawee.

Contractors Source v. Amegy Bank National Association

• Contractors Source owned and run by Merri and Gary Brecher. • Company bank account was at Amegy. • Only Brechers could sign checks. • Company hired Straten as bookkeeper. She misappropriated $844,000 in

32 months before her check forgeries were discovered.

• Amegy confirmed that signature on forged checks did not match signatures on file.

• Bank refused to reimburse most of money lost. • Said agreement on account said that forgeries must be reported in 30

days of month statement.

• Contractors Source sued Amegy. Contended it should have seen unapproved signatures, Therefore is responsible for all losses.

• Trial court: Dismissed suit. Contractors Source appealed.

Contractors Source v. Amegy Bank National Association

• Affirmed. Contractors Sources failure to exercise ordinary care. The “repeat wrongdoer” rule of UCC bars recovery.

• When a bank provides periodic statements, customer is required to examine statements. Report any unauthorized transactions promptly.

• Contractors Source did not produce evidence showing Amegy did not act in good faith.

• UCC governs these transactions.

• Unauthorized signature should be reported by customer to bank after a “reasonable period of time, not exceeding 30 days.”

Orders To Pay Drafts

• Binding order to pay fixed sum of money • Three parties

• Drawer: Orders • Drawee: Usually a bank, to pay • Payee: A certain sum of money

• Bill of Exchange: When a draft guarantees payment for goods in international trade

• Sight Draft: Usually paid “on sight” • Time Draft (Term Draft): Payment later, time to make sure ordered goods have

been delivered. Ex: 60 days from date of writing of draft • Confirmation: Legitimate that drawer has funds to cover payment. • Payee may sell draft to another party: Get immediate cash

• Buyer of draft cashes it when it becomes due.

Promises to Pay

NOTES

Notes  promise by the maker to pay

certain $ to payee Often called promissory notes But also have  Collateral note  Real estate mortgage note  Installment note  Balloon note

CERTIFICATES OF DEPOSIT

Certificates of Deposit  Bank is maker of

certificate & promises to repay customer payee

 Most large certificates are negotiable which allows them to be sold, used to pay debts or used as collateral

• Creditor: Lends money • Debtor: To whom money is lent • Principal: The sum of money owed

• Credit Policy focuses on characteristics such as: • Capacity (the debtor’s ability to pay) • Capital (the debtor’s financial condition) • Character (the debtor’s reputation) • Collateral (the debtor’s assets to secure the debt) • Conditions (the economic situation affecting the debtor’s

business)

CREDIT

Credit Accounts

• Open Account • Must pay within fixed time period

• Installment Account • Repay by regular (usually monthly) payments

• Revolving Account • Make minimum payment & can add new debt – i.e.,

credit card

Credit with Security • When creditor can take property of debtor to satisfy debt – can happen

by agreement or by operation of law By Agreement - Depends if property is real or personal Suretyship - Promise by a third party to pay debt if debtor doesn’t Guarantor – Provides a guarantee of payment to creditor should

principal debtor fail to pay (often same as surety) Defenses of Sureties - As debt falls under contract law, there are the

same defenses that the principal (debtor) has – including impossibility, illegality, duress, fraud Surety’s Rights Against the Principal

 If borrower could pay creditor but refuses to, surety is entitled to exoneration (court order for principal to pay)

 Subrogation – Surety is entitled to rights of the creditor against the debtor

General Electric Business Financial Services v. Silverman

• Warren Park Partners, Ltd. borrowed $34.8 million from GE Financial to develop land in Frisco, Texas.

• When loan was made, Silverman and partners signed a guaranty “absolutely, unconditionally” guaranteeing full payment.

• Warren Park defaulted; went into bankruptcy. • GE demanded payment from Silverman. He did not pay; GE sued.

• Silverman claimed affirmative defenses of fraud, extortion, theft, and economic duress.

• Said hours before signing the documents, GE notified them of changes in terms of the agreement.

• They had no time to contest, as loan was needed immediately. • He signed agreement because he was trapped. • Claimed GE employee told him new terms would not be enforced. • GE moved for summary judgment.

General Electric Business Financial Services v. Silverman • HELD: Summary judgment for GE. • GE offered evidence of claims that defendants did not contest. • Instead defendants asserted the affirmative defenses (above). • GE argued even if affirmative defenses are true, allegations are barred

by the Illinois Credit Agreement Act (ICAA). • It bars all actions or defenses by a debtor based on an oral agreement

(similar to Statute of Frauds). • Defendants did not dispute that they made “credit agreements.” • Defendants say ICAA does not bar their affirmative defenses. • They also argue “unclean hands” of the plaintiff, GE. • The court was not swayed. The ICAA bars defendant’s affirmative

defenses—stick to the written document signed by both parties.

Secured Transactions Sales of goods on credit may secured - UCC Article 9 To create security interest - be sure it is:

1. Attached (Attachment)

 Signed by customer  Seller provided value  Customer has legal, transferable rights in collateral

2. Perfected (Perfection)

 Filed with proper official, usually state office Interests in Inventory

 As collateral, equipment, inventory, raw materials (tangible property) are used as security

“Floating Lien” Inventory  Goods held for sale as well as raw materials  Inventory is constantly changing

Fordyce Bank & Trust v. Bean Timberland Fordyce Bank made series of loans to Bean so it could buy timber from

landowners. Bean would cut timber and sell logs to Potlatch and Idaho Timber (P&I) which milled logs into timber. Bean’s proceeds from timber sales would repay loans. Bank perfected its interest by filing UCC Financing Statement with the

Secretary of State’s Office of Arkansas. Bean sold timber but failed to repay loans; went bankrupt. Bank sued P&I because Bank had a priority interest in the timber sale

proceeds. Bank said P&I was negligent in its dealings for failing to do a lien search and did not “exercise good faith” required under the UCC. Trial court held for P&I, ruling they were not negligent. Trial court said that P&I was not required to perform a security interest

search in the “ordinary course of business.” The bank appealed.

Fordyce Bank & Trust v. Bean Timberland

Affirmed. Under Arkansas UCC 4-9-320, a buyer in the ordinary course of business (P&I) “takes free of a security interest created by the buyer’s seller [Bean], even if the security interest is perfected [by the bank] and buyer knows of its existence.” If P&I were buyers in “ordinary course of business”, they had no duty to

perform a lien search. Even if they know of bank’s security interest, P&I can take free of Bank’s security interest. Clear evidence that purchasing logs from timber cutters without

performing a lien search is standard timber industry practice. P&I’s actions were “usual or customary practices” in the timber industry,

and they were therefore “buyers in the ordinary course of business.” Owed no duty to the bank to conduct a lien search every time it bought

logs.

Real Estate Financing • Mortgage: Created when real estate used to secure a debt obligation

• Debtor is the mortgagor; creditor is the mortgagee

• Mortgage is a lien in most states

• In case of default, the mortgagee has the right to foreclose on the property

• Deficiency judgment: If proceeds from foreclosure not sufficient, a separate legal action against a debtor is maintained.

• Most mortgages are non-recourse debt – Lender can seize collateral/property but not seek a deficiency judgment for money owed not covered by sale of property.

• Statutory redemption: Period of time mortgagor has the right to redeem the property by paying the debt (normally within 6 months after default)

Most states have this procedure.

Liens

 Nonconsensual liens Obtained by Operation of Law. No need for debtor’s consent.

 Procedures of using liens detailed under state statutes; highly technical; must be removed before property is sold

 Mechanic’s Lien Party that furnished material, labor, or services for construction or repair of building or other real property places the lien

 Possessory or Artisan’s Lien Party that added value to or cared for personal property puts on lien

 Court-Decreed Liens Attachment lien is court-ordered seizure of goods through writ of attachment Judgment lien when creditor has successful action against debtor; If debtor doesn’t pay judgment, creditor asks court for writ of execution

Summers Group, Inc. v. Tempe Mechanical, LLC

Summers Group d/b/a Rexel, sold electrical materials for construction on property owned by Metro Lofts. Rexel was not paid and recorded a mechanic’s lien on Metro Lots property. Other contractors on the work including Tempe Mechanical, also filed liens against Metro Loft. No payment received so Rexel filed suit six months later against Metro Lots

and other lienholders. Some of lienholders (contractors) did not respond – so had default judgments against them. Tempe answered Rexel’s complaint Metro was in bankruptcy and under control of bankruptcy trustee ML

Manager. Parties agreed bankruptcy court would determine priority of payment of liens. ML Manager argued that it stood first to receive payment, because it should

not be challenged and that Rexel should pay all attorney fees related to litigation. Trial Court agreed. Rexel appealed.

Summers Group, Inc. v. Tempe Mechanical, LLC

Arizona law sets lien procedures, including naming of all other mechanics’ lien claimants if they fail to file a lien themselves. Remaining Lien claimants assert their lien priorities. The bankruptcy court’s decision also affected their claims. Therefore ML

Manager had to defend its lien priority. Statute requires that when sale is ordered in mechanics’ lien foreclosure action, proceeds are prorated over all lienholders that have equal footing with the foreclosing lien. Attorneys fees are apportioned between successful and unsuccessful efforts. HELD: Reversed and Remanded. Trial court erred in holding Rexel solely responsible for payment of ML Manager’s

attorney fees. These fees should be prorated among lien claimants. Intent of statute is to create an even playing field for all who provided services

and materials, regardless of date work was performed. All Remaining Lien Claimants will be liable for ML Manager’s attorney fees in

proportion to their claims.

Purpose: Orderly resolution when debtor owes more than can be paid.

Federal Bankruptcy Code most recent major revision was The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.

Most bankruptcies involve individuals.

A person must take credit counseling before filing bankruptcy.

After filing bankruptcy, there must be debtor education about budgeting, use of credit, etc.

Key feature: fair treatment of creditors

Bankruptcy

Personal Bankruptcy • Dept. of Justice’s U.S. Trustee Program approves organizations to provide

mandatory credit counseling & debtor education. • Credit counseling is taken before filing bankruptcy. • Debtor education is taken after filing. • Income and Means Testing

• Income test determines if person files under Chapter 7 (liquidation) or Chapter 13 (reorganization of debts).

• People with higher income less likely to have debts extinguished.

• There is a test of income against expenditures – to see if person has above average income for a given area.

Chapter 7

Most bankruptcies are voluntary, but creditors may force an involuntary proceeding. Some assets, such as car, clothing, appliances, some home equity and

pension are exempt. Upon filing, there is a freeze on actions against the debtor and the debtor’s

property. Trustee is appointed to administer the debtor’s estate. Non-exempt assets are liquidated and proceeds distributed to creditors. After discharge, debtor is not liable for debts covered by proceeding.

Chapter 13 Available only to individuals; only voluntary option. Sole proprietorship owned

by an individual may file under Chapter 13.

Debtor files plan for payment of creditors over time. Usually over 5 years.

Debtor keeps property and shares administration of the bankrupt estate with court-appointed trustee.

Trustee makes sure payments are made and that creditors don’t try to “go around” fixed payment schedule.

Court protected debt repayment plan. Confirmation Plan that was approved makes these payments.

Debts of the bankrupt not discharged until end of payment plan.

Long-term secured debt (i.e. house mortgage) treated differently.

If plan fails, possible to shift to Chapter 7 for hardship discharge.

Priority Classes of Creditors

Secured creditors

Costs of preserving and administering debtor’s estate

Unpaid wage claims

Certain claims of farmers and fishermen

Refund of security deposits

Alimony and child support

Taxes

Unsecured creditors

All creditors of a particular class must be paid before going to next class

Tetzlaff v. Educational Credit Management Corp.

Tetzlaff is unemployed 56 years old. Lives with his 85-year-old mother.  Income is from her Social Security payments. Earned MBA from Marquette University and law degree from Florida

Coastal. Has not been able to pass the bar exam.

Tetzlaff took out federal guaranteed student loans to finance graduate work.

Filed for Chapter 7 bankruptcy. Owed $260,000 in student loan debt, guaranteed by Educational Credit. He sought discharge of that debt.

Bankruptcy Court held: Could not show undue hardship. Court would not discharge the debt. District Court: Affirmed. Tetzlaff appealed.

Tetzlaff v. Educational Credit Management Corp.

• Affirmed. Student loans generally not dischargeable, unless debtor proves “undue hardship on the debtor” if court does not discharge.

• Brunner test for student loan discharge: 1) Cannot maintain a “minimal” standard of living if forced to repay loan 2) Additional circumstances exist indicating his affairs likely to persist for significant

portion of repayment period. 3) Debtor made a good faith effort to repay loan.

• Tetzlaff met 1st element of Brunner test; failed the other two. • Discharge of student loans based on “certainty of hopelessness, not

simply present inability to fulfill financial commitment.” • Given Tetzlaff’s degrees, work experience, and age, he can earn a living. • Tetzlaff references obstacles related to his mental health but Bankruptcy

court indicated he does not suffer from clinical levels of anxiety or depression. Court states he may be “exaggerating his symptoms.”

Chapter 11

Allows businesses to keep operating, without liquidation of assets

“Prepackaged” bankruptcy filings: debtor & creditors settle issues before debtor files, then court approves plan

Reorganization

Stays further action by creditors Debtor acts as trustee, called debtor in possession, to run

business for benefit of all parties

Creditors are satisfied by class in order of priority of claims

In the Matter of Kmart Corporation

• Kmart consists of parent company and 37 affiliates and subsidiaries. • Kmart requested to pay, in full, claims of “critical vendors.” If it did not pay

these vendors, they would not do business in the future and were necessary for Kmart to stay in operation.

• Bankruptcy judge agreed – granted order. No notice to disfavored creditors. • Kmart determined the critical vendors, paying 2330 suppliers $300 million. • Another 2000 vendors not paid, and 43,000 additional unsecured creditors

received 10 cents on the dollar (mostly in stock of reorganized company).

In the Matter of Kmart Corporation • Some creditors appealed. District court reversed order of payments to

critical vendors. Decision was appealed. • Affirmed. • Kmart argued that the District Court’s reversal order was too late – money

had already changed hands. • To order payment of critical vendors, it is necessary to show

• 1) Disfavored creditors will be as well off with reorganization as with liquidation (not demonstrated), and

• 2) That critical vendors would cease deliveries if old debts were left unpaid during litigation. This was not always true, i.e. some of the critical vendors must continue business due to long-term contracts.