Business Law 5 parts
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no mention of adding the torsion bar suspension and that the delivery date in the written contract was September 2. Discuss the application of the parol evidence rule to this problem.
6. Lindsay owns a gift shop where she sells all sorts of new and used products to customers. Business is good, but she needs to be cautious in terms of what products she offers, so as not to be stuck with inventory that does not sell. Alicia approaches Lindsay with a new line of products that she thinks will sell very well in Lindsay’s store. Lindsay is not sure and is worried about taking on the new line of inventory. Advise Lindsay on what type of contract she could enter into with Alicia to sell the goods with the lowest risk.
7. You are the manager for a large appliance big-box store and have many customers who purchase goods and return later to pick them up. On the night in question, a customer purchased a washer and dryer set and agreed to return the next day with a truck. The customer paid in full for the purchase. That night, the store burned down and all the inventory was destroyed. a. Who has the risk of loss in this situation? Why? What rule applies?
b. Assume the same set of facts as above, but this time the buyer purchased the washer and dryer at a garage sale and agreed to return the next day to pick them up. The buyer paid in full for the washer and dryer. That night, the seller’s garage burned down. Who has the risk of loss in this situation? Why? What rule applies?
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Unit IV
Commercial Paper, Banks, and the Banking System
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Chapter 12: Introduction to UCC Article 3: Commercial Paper
In this chapter you will:
Distinguish between an assignment and a negotiation.
Identify the types of commercial paper.
Identify the criteria that make an instrument negotiable.
Chapter 13: Transfer and Negotiation of Commercial Paper and Rights of Holders
In this chapter you will:
Understand how different types of commercial paper are issued and negotiated.
Identify the requirement of endorsements.
Explain how to negotiate paper to a holder in due course and the signi�icance of this negotiation.
Chapter 14: Liability of Parties to Commercial Paper and Warranties of Transfer and of Presentment
In this chapter you will:
Identify all of the parties on a negotiable instrument and their respective rights and liabilities.
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Chapter 15: Banks, the Banking Process, and Electronic Transfers
In this chapter you will:
Identify the types of checks commonly seen in banking.
Understand the debtor–creditor relationship as it relates to businesses and banks.
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Chapter 12
Introduction to UCC Article 3: Commercial Paper This chapter begins a unit dealing with commercial paper: checks, drafts, notes, and certi�icates of deposit. The law governing this area is in Article 3 of the Uniform Commercial Code. Commercial paper is an essential part of the business environment in which you operate. Your company pays its bills, borrows money, and deals with customers using all forms of commercial paper. Although it is technically possible to carry out business strictly on a cash basis, the realities of commerce necessitate the use of readily acceptable substitutes for cash as well as �inancial instruments that make it easy to lend and borrow money. It’s simply not practical—or safe—to carry what can often be very large sums of paper money needed for business transactions. It should come as no surprise, then, that the majority of business transactions are carried out by check or credit.
Commercial paper (which is also called a negotiable instrument) serves two major functions. First, it is a substitute for cash. When your business writes a check to purchase goods, this is a convenient and safe way to send a payment through the mail, for example, as opposed to sending cash. Second, commercial paper is a way to loan money. Notes are a common format for promising to pay someone back for a loan. In order for commercial paper to be readily accepted as a substitute for cash or as a means of extending credit, persons accepting such paper or instruments must have some clear assurance that they will be honored when they are presented for payment.
Although negotiable instruments have been around for many centuries, the UCC has consolidated the common law into a single comprehensive code, updating and modernizing it. As an incentive to make commercial paper attractive to persons who accept it in the normal course of business, the law provides certain guarantees to those who accept such instruments in good faith and pay value for them.
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12.1 Distinguishing Between an Assignment of Rights and a Negotiation In order to understand what makes negotiable instruments "special," it is necessary to understand the difference between an assignment and a negotiation.
In any contract, there is a division of rights and duties between the parties. For example, suppose that the seller agreed to sell 70 new automobiles to the buyer, a wholesaler, for $2,100,000. The seller has the duty under this contract to deliver the automobiles and the right to be paid the $2,100,000. In turn, the buyer has the right to receive the automobiles and the duty to pay, as illustrated in Figure 12.1.
Figure 12.1: Rights and duties of two parties to a transaction
Note that each party to the contract has rights and duties. Every contract can be diagrammed this way. While the seller in the diagram would most likely deliver the cars to the buyer and receive the money, there is another option that occurs in business of which you should be aware: the seller could take the right to the money and assign it to another person so that the latter would have the right to receive the money from the buyer. This is called an assignment of rights. Suppose that this seller owed money to a third party and, instead of receiving the money personally from the buyer, assigned the rights to the money he or she was going to receive from the buyer to that third party. Now the transaction would look like what is shown in Figure 12.2.
Figure 12.2: Rights and duties of parties to a contract assignment
The seller (the party who is assigning his or her rights) is called the assignor. The third party is the assignee. In this illustration, the buyer would pay the assignee the money instead of the seller, but the seller would still have the duty to deliver the automobiles. The assignment of rights illustrated has nothing to do with the duties; in other words, the duties are separate from the rights and must be performed regardless of what the parties "do" with their "rights."
Now let’s assume that the buyer and the seller have entered into the same transaction for automobiles, but this time, instead of the buyer giving the seller a check for $2,100,000, the buyer promises to pay by giving the seller an IOU stating "IOU $2,100,000 in 90 days." We could con�igure this transaction to look like what is shown in Figure 12.3.
Figure 12.3: Buyer–seller transaction
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Now assume that the seller has delivered the automobiles to the buyer and received the IOU. The seller then assigns the IOU (the right to the money) to a third-party assignee. Now the diagram would look like what is shown in Figure 12.4.
Figure 12.4: Third-party transaction
Now suppose that 15 days go by and the buyer goes out to his or her automobile lot and inspects the cars that the seller delivered. He or she discovers that the paint jobs on all of them are substandard, greatly reducing their value. He or she calls up the seller and says, "I don’t want these cars; they are not what I bargained for. I am not paying on that IOU that is due in 90 days." The assignee thinks he or she is going to be paid in 90 days and knows nothing about the disagreement between the seller and the buyer.
So what effect will the substandard cars have on the promised payment to the third party? The answer to the question is this: We say that third parties (assignees) take subject to any disputes or defenses between the buyer and the seller. Thus, if the buyer refuses to pay, the third party will not get paid either. Of course, this is a major problem for the third party, who thought he or she was getting paid $2,100,000 after 90 days passed. Any third party who is aware that he or she might not get paid is going to refuse to be an assignee. Why would a third party want to take paper that is subject to problems between the seller and the buyer? The answer is, he or she would not. There is a solution to this problem, however. Article 3 of the UCC has created a way to transfer paper so that it is just like cash, and so that the assignee will be paid even if there is a problem between the seller and the buyer.
Using the concept of an assignment and the idea that the third party takes "subject to" the problems between the buyer and the seller, assume instead that in Figure 12.4 the buyer gave the seller a note in payment for the cars, a type of commercial paper, and that the note was negotiated (transferred) from the buyer to the seller to the third party. If the third party quali�ies as a special party called a holder in due course, the third party takes free from, and not subject to any disputes between, the buyer and the seller. In other words, the holder in due course gets paid regardless of any disputes between the buyer and the seller. If you think about it, that is just as if cash were being passed down the line, and the third party had the cash in hand. In this way, a note is just like cash, in that it is "taken free" from the dispute between the parties. Indeed, all commercial paper is set up to �low like cash and to give third parties the same bene�its as people receiving cash.
IF a negotiable instrument is negotiated (not assigned) to a holder in due course (not an assignee), then the holder in due course takes free from personal defenses between the buyer and the seller, subject only to real defenses.
Thus, the system of commercial paper rests on four key concepts:
1. You must be able to distinguish between commercial paper that is negotiable and paper that is nonnegotiable;
2. You must be able to distinguish between assigning paper and properly negotiating paper;
3. You must be able to determine if the third party in the chain of holders of paper is a holder in due course as opposed to an assignee; and
4. You must be able to tell if the defense raised between the buyer and the seller is a real defense or a personal defense.
To understand the rule of negotiable instruments, we will �irst discuss how to determine whether paper is negotiable or nonnegotiable.
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12.2 Types of Commercial Paper There are four types of commercial paper: drafts, checks, notes, and certi�icates of deposit. No matter what type of paper, it can be negotiable or nonnegotiable. First we will discuss the different types of commercial paper; then we will discuss what makes each of these negotiable or not.
Drafts and Checks
Drafts and checks are referred to as three-party paper because there are three parties to the instrument: the drawer, the drawee, and the payee. By de�inition, a draft is an order instrument by a drawer to a drawee to pay a speci�ied payee. For example, think about the last time that you wrote a check. You were the drawer because you drew the check; the check says on its face, "Pay to the order of _____." That is the order that you, the drawer, are giving to the bank, the drawee, to pay the payee. Thus we speak of a draft as order paper because it is an order by the drawer to the drawee to pay the payee.
While all drafts are three-party paper, not all drafts are checks. A check is a particular type of draft in which the drawee is always a bank; but a draft can be drawn on a private person or another entity. An illustration of a check appears in Figure 12.5, showing each of the parties.
Figure 12.5: Sample check
Figure 12.6 depicts a draft that is not drawn on a bank, but instead, drawn on "Motley Dutcher."
Figure 12.6: Sample draft
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Are checks and drafts negotiable or nonnegotiable? To be negotiable (negotiability is discussed in Section 12.3), six conditions must be met. If any of the elements are missing, then the instrument is nonnegotiable. Just because paper is a draft or a check does not ensure its negotiability. All checks and drafts are negotiable checks and drafts or nonnegotiable checks and drafts.
Notes
Notes are two-party paper consisting of the person promising to pay (the maker) and the person to be paid (the payee). On the face of the note, the maker says, "I promise to pay." This has great legal signi�icance. Because the maker says, "I promise," the maker is primarily liable on the instrument under a contract theory. Contrast this with a draft, in which the drawer orders the drawee to pay the payee. Since the drawer does not say, "I promise," but instead is ordering the drawee to pay the payee, we say that no one is primarily liable on a draft. This will become important later when we discuss the liability of parties to commercial paper.
Another important characteristic of notes that is not true of drafts is that notes can be used for credit. This is because notes can be payable in the future, for example, "90 days from [date]," which extends credit for 90 days, as illustrated in Figure 12.7.
Figure 12.7: Sample note
After you inspect the instrument in Figure 12.7, notice that it is two-party paper, with a maker and a payee; thus, you can correctly conclude it is a note. Also notice that the maker, Chrissie MacIntosh, says, "I promise to pay," which is the basis for her (primary) liability on the instrument.
Certificates of Deposit
Another type of two-party paper that evidences debt is a certi�icate of deposit (CD). The only difference between a note and a CD is that a CD is issued only by a bank or other �inancial institution as evidence of its debt to a named creditor or depositor. Whenever you invest in a bank CD, you might think of the transaction as a deposit of money. In reality, however, you are lending the bank money under the terms speci�ied by the CD. Under its terms, the bank issues you its promise to repay you, at a stated time in the future, your principal plus interest at a speci�ied rate and sets forth penalties for failing to comply with the terms. This is illustrated in Figure 12.8.
Figure 12.8: Sample certificate of deposit
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Are notes and CDs negotiable or nonnegotiable? Again, to be negotiable, the note or CD must meet six speci�ic conditions. If any of those six elements are missing, then the instrument is considered nonnegotiable. Just because paper is a note or a CD does not necessarily make it negotiable. What makes paper negotiable is discussed in the next section.
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12.3 Negotiability Requirements Regardless of the form of commercial paper (checks, drafts, notes, or certi�icates of deposit), Article 3 of the UCC requires that, to be negotiable, such an instrument must meet all of the following criteria:
It must be in writing;
It must be signed by the maker or drawer;
It must contain an unconditional promise or order to pay a sum certain in money;
It must contain no other promise or obligation;
It must be payable on demand or at a de�inite time; and
It must be payable to order or bearer unless it is a check.
An instrument that meets all these criteria quali�ies as a negotiable instrument. An instrument that fails to meet one or more of the noted criteria may still be a valid instrument, but it will not qualify for the special status of a negotiable instrument but rather be nonnegotiable.
A Signed Writing
The UCC does not de�ine what constitutes a writing for purposes of creating a negotiable instrument. Nonetheless, the requirement of being a signed writing has been liberally construed by the courts to include words written on nearly any portable surface that affords some permanence. No speci�ic words need to be used in creating a negotiable instrument as long as the writing meets all the requirements for negotiability. Thus, even though most checks are routinely written on preprinted forms supplied by the �inancial institution in which the drawee maintains a checking account, a check can technically be written on nearly any surface capable of accepting writing. A valid check, note, draft, or even a CD can be written on a legal pad, loose-leaf paper, a shirt, or even a coconut shell (though it might take some convincing to get someone to accept such an instrument!).
Likewise, the writing can be set down using a typewriter, computer printer (impact, ink-jet, or laser will all do nicely), pen, crayon, pencil, or even lipstick. Using any medium that is easy to erase, however, can lead to problems if the instrument is later altered. And, as with a negotiable coconut, using an exotic writing implement may well make the instrument unacceptable to most payees.
As holds true for type of paper and writing implement, the requirement of a signature is rather liberally construed by the courts. The UCC speci�ically states:
A signature may be made (i) manually or by means of a device or machine, and (ii) by the use of any name, including any trade or assumed name, or by a word, mark, or symbol executed or adopted by a person with present intention to authenticate a writing.
Thus, an X marked on paper, a scanned signature, or a signature reproduced on a rubber stamp are all perfectly valid, as is the signed or printed name or initials of any signer, as long as these are used intentionally as a signature. This de�inition is particularly relevant to the age of electronic transactions in which we live.
Must Contain an Unconditional Promise to Pay a Sum Certain in Money
In order to be negotiable, an instrument must, on its face, make an unconditional promise to pay a speci�ic amount of money. Hence, a check that reads: "Pay to the order of Paul Payee $200 if the U.S. wins the 2015 Soccer World Cup" is not a negotiable instrument because the promise to pay is conditioned on a future event.
A negotiable instrument must be payable in cash. This requirement is met if it is payable in the legal tender of any country; thus, a draft payable in Japanese yen, euros, pounds sterling, or pesos is perfectly negotiable if it meets all the other requirements of a negotiable instrument. An instrument payable in a foreign currency, unless otherwise noted on the instrument itself, can be paid either in the stated currency or in the U.S. equivalent of the currency at the time and place of its presentment for payment.
In addition, the amount payable on the instrument must be ascertainable from the instrument itself, either directly or indirectly. Directly means that if you picked up the instrument, you would be able to �igure out how much it is promising to pay. Indirectly means that if the instrument says, "I promise to pay you the current rate as determined by the current index," then you would have to reference a source for this determination. Therefore, an instrument payable with �ixed or variable interest is still negotiable, even if the interest payable must be ascertained by referring to information not provided in the instrument. This is because the amount can be determined indirectly by referencing a source. If the interest cannot be ascertained from the instrument itself or by reference to outside information, then the instrument is not ascertainable. For example, a note stating, "Payable to Laura R. at the judgment rate at the place of payment when the interest �irst accrues," would be nonnegotiable because it would be impossible to determine the amount owed, even with outside information.
Must Contain No Other Order or Obligations
Negotiable instruments must contain an unconditional promise to pay only a sum certain in money. If the instrument cites other obligations or promises, along with the promise to pay money, then that instrument will not be negotiable. For example, a promise by a carpenter to "pay $50 and build a deck" contains additional promises, making the instrument nonnegotiable.
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Must Be Payable on Demand or at a Definite Time
Negotiable instruments must be payable either on demand or at a de�inite time. Instruments such as checks, which are not usually payable at a speci�ic time, are considered demand instruments: that is, they are payable at any time on demand as soon as they are issued. For instruments that are payable on or after a speci�ic date, all that is required is that the payor clarify on the instrument itself when it is payable. Thus, an instrument that is payable "30 days from today" or "on July 1, 2012" is a time instrument and satis�ies the requirement of speci�icity as to date payable.
It is very common in business to see commercial paper that contains either an acceleration clause or an extension clause. If you read one of these clauses, your �irst reaction would probably be that the instrument is nonnegotiable because these clauses look like they make the date due inde�inite. Nevertheless, extension and acceleration clauses do not necessarily make paper nonnegotiable because they are an exception to the rule of a "de�inite time."
An example of an acceleration clause would be "In the event the maker defaults or is late on payment, the entire note is due and payable." Of course, because the maker’s default date is uncertain, this is not a de�inite time; nevertheless, the note is negotiable.
An extension clause that makes the note payable to a date certain in the future and is extended by the holder does not render the paper nonnegotiable. For example, an extension clause might say: "The holder may, at her option, extend the time of payment to June 15, 2013." Since the holder is extending the date of payment, and the date is certain, the note is still negotiable. However, if the instrument is payable only upon the occurrence of an event that is not certain to occur (such as "when the New York Yankees next win the World Series"), then it is nonnegotiable.
Must Be Payable to Order or to Bearer
An instrument must be payable either to the order of a speci�ic person (or persons) or company, or to bearer. An instrument is payable to order if it states that it is payable to a speci�ically ascertainable person, company, or group of people. An instrument is payable to bearer if it is payable to no speci�ically identi�iable person but rather to anyone who lawfully has it in his or her possession. To make an instrument payable to no speci�ically ascertainable person or company, one uses such terms as "pay to bearer," "pay to the order of bearer," "pay to cash," "pay to the order of cash," or similar language. A check made payable to "Life, the universe, and everything," for example, is a bearer instrument, since it names no speci�ically ascertainable person; its effect is the same as drawing a check to the order of "Cash" as a payee. Alternatively, a check made payable to the order of "First National Bank of Ohio, savings account #A123456" would be payable to the registered owner or owners of the account and would be a negotiable instrument because there is suf�icient information on the face of the instrument.
Commercial Paper
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Key Terms
Click on each key term to see the de�inition.
acceleration clause (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
A contract provision that enables a lender to demand payment of a loan if a certain event happens (e.g., the debtor misses payments), making the entire debt due and payable.
Article 3 of the UCC (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
The section of the Uniform Commercial Code that sets out the rules for commercial paper.
assignee (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
The person who is assigned rights under a contract from an assignor.
assignment of rights (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
Transferring one’s rights under a contract to a third party.
assignor (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
The person who transfers rights under a contract.
bearer instruments (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
Instruments payable to bearer, cash, or the order of cash.
certi�icate of deposit (CD) (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
A type of two-party commercial paper issued by a bank or other �inancial institution as evidence of its debt to a named creditor or depositor. In it, the maker agrees to pay the payee a set amount of money after a certain amount of time.
check (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
Three-party commercial paper in which the drawer orders the drawee (usually a bank) to pay the payee.
commercial paper (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
Also called a negotiable instrument, paper used in business in the place of money: a note, draft, check, or certi�icate of deposit.
demand instrument (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
A type of commercial paper that is payable at whatever time it is presented for payment.
draft (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
Three-party paper in which the drawer orders the drawee to pay the payee; here, the drawee is not a bank, but an individual or a private company.
drawee (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
The party on which an order for payment is made by the drawer. For checks, the drawee is always a bank.
drawer (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
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The maker of a draft ordering the drawee to make payment to a speci�ied payee.
duties (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
The obligation under a contract.
extension clause (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
A contract provision allowing the parties to lengthen the term of the contract, after its expiration date.
holder in due course (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
The third party to a transaction, following a payee, who has elevated status and can get paid on commercial paper even if a dispute arises between the seller and the buyer, in most circumstances.
instrument (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
Another name for commercial paper.
negotiable instrument (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
Instrument meeting all six requirements of negotiability so that the third party receiving it can be a holder in due course.
negotiated (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
The transference of a negotiable instrument by physical delivery or by endorsement plus delivery.
note (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
Two-party commercial paper in which the maker promises to pay the payee.
order instrument (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
Commercial paper ordering the drawee to pay the payee. An instrument is payable to order if it states that it is payable to a speci�ically ascertainable person, company, or group of people.
payee (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
The person who is paid.
rights (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
Entitlements of a person who enters into a contract.
third party (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
The third person in line when commercial paper is transferred from the maker to the payee or from the drawer to the payee.
time instrument (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
An instrument that is payable at a certain time, as stated on the face of the instrument.
Chapter 12 Flashcards
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Critical Thinking and Discussion Questions
1. What are the four types of commercial paper?
2. What is the fundamental difference between an assignment and a negotiation?
3. What are the basic requirements that every instrument must meet in order to be a negotiable instrument?
4. Suppose that Hector wrote a note payable to your company and signed it with an X. All other elements of a negotiable instrument were present. Would this be a negotiable note?
5. Suppose your company sold a product to a buyer who asked whether he could issue a draft payable to your company "on the condition that the product is satisfactory." What would be the rami�ication of accepting such an instrument?
6. Miko issues a note to Lola for $500. The note is made payable one year from the date of issue with interest, but no interest rate is speci�ied. Is the instrument valid, and if so, what interest rate applies?
7. Suppose that Brenda and Miguel enter into a valid, enforceable contract in which Brenda agrees to sell to Miguel 100 cords of wood for $1,000. a. Draw a diagram showing each party’s respective rights and duties under the contact.
b. Now add to that diagram Carla, to whom Brenda promised her money from the wood deal.
c. How does the manner in which Brenda gets paid affect Carla’s rights in the contract?
d. Assume that Miguel promises Brenda in a written IOU that he will pay her in 90 days for the delivery of the wood. Brenda gives the IOU to Carla. Miguel receives the wood and is disgusted by its quality and refuses to pay on his IOU. What recourse does Carla have against Miguel? Against Brenda?
e. Assume that Brenda gave Carla a negotiable note instead of an IOU. Would your answer change? What recourse does Carla have against Miguel? Against Brenda?
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Chapter 13
Transfer and Negotiation of Commercial Paper and Rights of Holders
So far, we have established that if an instrument is negotiated to a third party called a holder in due course, that party has an elevated status over an assignee. For the holder in due course to attain this elevated status, the instrument must be negotiable. This means that it must meet all six requirements, as set forth in Article 3 of the UCC (see Section 12.3 (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/sec12.3#sec12.3) in Chapter 12). This chapter explores yet another requirement: that the instrument must be properly negotiated.
If the instrument is not properly negotiated, then the third party could be an assignee or a holder but not a holder in due course. A proper negotiation is critical to creating holder-in-due-course status. Negotiation is the actual physical transfer of the commercial paper to the third party, which we will discuss in more detail further on. First, however, let us begin with the concept of issuance.
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13.1 Issuance and Negotiation When the drawer makes a check payable to the payee and hands it to the payee, that process is called issuance. Issuance is the physical delivery of the instrument to the payee, as illustrated in Figure 13.1. Since the payee is the second person in line, he or she cannot qualify as a holder in due course.
Figure 13.1: Issuance
When the payee delivers the instrument to a third party, as in Figure 13.2, the rules regarding negotiation and holders in due course come into play.
Figure 13.2: Issuance and negotiation
The UCC de�ines negotiation as "a transfer of possession, whether voluntary or involuntary, of an instrument by a person other than the issuer to a person that thereby becomes its holder" (UCC §3[201]). A proper and effective negotiation depends on whether the paper is order paper or bearer paper.
As noted at the end of Chapter 12, all commercial paper is either order paper or bearer paper. Order paper contains language such as "Pay to the order of ___" or "Pay to [a speci�ic person or entity]," for example, "Pay to the order of Paul Jones" or "Pay to Millennium Enterprises." Bearer paper, on the other hand, includes the word bearer or cash, for example, "Pay to Bearer," "Pay to the Order of Bearer," "Pay to Cash," or "Pay to the Order of Cash." Why is this signi�icant? Because order paper and bearer paper are negotiated differently, as we will now discuss.
Bearer Paper
Bearer paper is negotiated by physical delivery of the instrument alone. For example, if Joe made out a check "Pay to the order of cash" and handed it to Lisa, and Lisa handed the same check to Robert, a proper negotiation has taken place. Merely physically passing the check from one person to the next constitutes negotiation by physical delivery. By the same token, if Joe dropped the check on the street and Michelle picked it up, since it is payable to the order of cash, and therefore bearer paper, she could take it to the bank and cash it. After all, the transfer by delivery is to anyone who holds it. For this reason, bearer paper can create problems if not handled properly. There is a way to convert bearer paper to order paper so that it doesn't fall into the wrong hands, but at this point be mindful that anyone who is in physical possession of bearer paper can cash it.
Order Paper
Unlike bearer paper, order paper cannot be negotiated or transferred by delivery alone but instead requires an endorsement (spelled either endorsement or indorsement).
Let's say that Lisa made a check payable to Amelia and handed it to Amelia (recall that this is called issuance). Because on its face it says, "Pay to the order," if Amelia now wishes to pay her telephone bill with that same check, she will need to indorse it in order to transfer it any further. She could turn it over and write her name on the back. Or she could write on the back, "Pay to the order of AT&T Telephone Co." and sign it Amelia. In any event, on its face, the instrument payable to the order of a speci�ic person or company can be further negotiated only by endorsement plus delivery, and not by delivery alone, as Figure 13.3 illustrates.
Figure 13.3: Issuance with endorsement and delivery
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13.2 Requirements of Endorsements The UCC provides that an endorsement must be written by the endorser (or on his behalf) either directly on the instrument or on a separate piece of paper that is permanently attached to the instrument, called an allonge (from the French allonger, to draw out). In the event that an instrument is made payable to a person with her name misspelled or even with a mistaken name, it is lawful for the payee to indorse the instrument using either her correctly spelled or true name or the misspelled or incorrect name. A person accepting transfer of the instrument, however, can demand that the endorsee in such circumstances sign with both the correct and misspelled or incorrect name.
Blank Endorsements
There are four different types of endorsements that a holder can place on commercial paper. Suppose that a blank endorsement is simply the signature of the payee written on the back of the check. Suppose, for example, that Bobby issues a check that on its face says, "Pay to the order of Sarah Jessica." He then issues the check to Sarah Jessica. On its face, the instrument is order paper because it has the language, order; therefore, it needs an endorsement plus delivery to be further transferred. Sarah Jessica turns over the check and signs just her name—by de�inition, a blank endorsement. By so doing, she changed the order paper into bearer paper. Now this check can be negotiated by mere physical transfer. It also has the vulnerability of being picked up and cashed by anyone in physical possession. In short, a check that is indorsed in blank is a bearer instrument and can be further negotiated merely by physically transferring it to a third party. Figure 13.4 provides an example of a blank endorsement.
Figure 13.4: A blank endorsement
Special Endorsements
Another type of endorsement is called a special endorsement. It speci�ies the person or persons to whom the instrument is made payable. For example, if a check states on its face, "Pay to the Order of Sarah Jessica," and she turns it over and writes, "Pay to the Order of Verizon Wireless," she has endorsed to a speci�ically identi�iable person or company, and now the instrument cannot be further negotiated without that person's endorsement. In Figure 13.5, the front of the check signi�ies order paper, and the special endorsement on the back retains this characteristic. Thus, this check will need another endorsement to properly transfer it to a fourth party. Remember that order paper needs endorsement plus delivery.
Figure 13.5: A special endorsement
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Restrictive Endorsements
The third type of endorsement is called a restrictive endorsement. This places a condition on further negotiating the instrument. For example, the endorsement might say, "Pay to the Order of Robert Bradley if he receives an A in his law course." Interestingly, a restrictive endorsement does not affect the negotiability of the instrument. This is because negotiability is determined only from the front of the instrument, not the back. It also means that Robert Bradley could get a "C" in his law class and still transfer the check to another person. In other words, the named endorsee is free to further negotiate the instrument regardless of whether the restrictive condition is met or not.
The last type of endorsement is one that says, "For deposit only," "Pay any bank," or "For collection." Students �ind this concept confusing because, here too, the check can be negotiated further. A third party could accept the check from Robert Bradley. However, if that party takes the check to the bank looking to cash it, the bank must obey the restrictive endorsement or be held liable. The rule under the UCC is that "Such endorsements are generally valid, and any person, bank, or entity that takes the instrument for value inconsistent with the endorsement converts the instrument." If the bank converted the instrument, it would have to recredit the account.
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13.3 General Rules Applicable to Commercial Paper Numerous mistakes can occur when writing a negotiable instrument. In this section we will look at instruments that have unusual characteristics that may put the holder on notice that there is something amiss or may even affect the negotiability of the paper.
Antedating and Postdating Negotiable Instruments
The negotiability of an instrument is unaffected by postdating or antedating. If, for example, a check issued on August 1 is postdated for September 1, it is still a negotiable instrument.
Incomplete Instruments
A negotiable instrument that has not been completely �illed out by the maker or drawer cannot be enforced until it is complete. However, it is permissible for the holder of an incomplete instrument to complete it by �illing in missing information, as long as the completion is authorized. If a completion is unauthorized, the rules relating to material alteration apply, and the instrument is generally void. The burden of proving an unauthorized material alteration rests with the party making the assertion that the instrument has been materially altered without authorization.
UCC Article 3 (§ 3-302) holds that good-faith additions to negotiable instruments by persons who have the instrument in their possession are generally lawful unless they are unauthorized. A person receiving a check on which the date has been omitted, for example, could safely insert the date on which the check was negotiated to him or her. In addition, a blank check (a check that is signed by the maker but is otherwise incomplete) can be lawfully �illed out by the person to whom it is given, as long as the drawer intended to authorize the person to do so.
Instruments Payable to Two or More Persons
An instrument payable to two or more alternative parties can be negotiated by any of the named parties alone. If an instrument is negotiated to two or more parties jointly, however, the signatures of both parties are necessary to effect lawful negotiation. If, for example, a check is made payable to Jane or John Doe (payable in the alternative), either John or Jane may cash the entire check. If the check is made out to John and Jane Doe (payable jointly), however, both John and Jane's signatures would be required to negotiate the check.
Contradictory Terms of Instrument
When an instrument contains contradictory terms, the rule is that "typewritten terms prevail over preprinted terms, handwritten terms prevail over both, and words prevail over numbers" (UCC Article 3 (§ 3-114)). Consider the check in Figure 13.6. As you can see, there is a con�lict between the amount of $100.00 and the written words "One Thousand and 00/100 Dollars." According to the rule "words prevail over numbers," "One Thousand and 00/100 Dollars" prevails over the dollar amount "$100.00." Likewise, if the words "One Thousand" had been preprinted and "$100.00" was handwritten, then the handwritten dollar amount "$100.00" would have prevailed.
Figure 13.6: Contradictory terms of instrument
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Note that the negotiability of an instrument is unaffected by postdating or antedating. If, for example, a check issued on May 12 is postdated for June 12, it is still a negotiable instrument.
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13.4 Holders in Due Course For a third party to a transaction to be a holder in due course, he or she must �irst be the holder of a negotiable instrument. The UCC de�ines a holder as "the person in possession [of a negotiable instrument] if the instrument is payable to bearer or, in the cases of an instrument payable to an identi�ied person, if the identi�ied person is in possession" (UCC §3[309]). Thus, the original payee of a note or draft is a holder when the instrument is delivered to him or her. Also, all persons to whom instruments are transferred with special endorsements in their bene�it or with blank endorsements become holders.
A holder in due course (HDC) is a very special person in the law, with attendant special rights and privileges. Attaining holder in due course status therefore requires that one meet a number of requirements.
1. The person must be the holder of a negotiable instrument.
2. The holder must give value for the instrument (usually holders pay to receive the paper).
3. The holder must take "in good faith without notice that it is overdue or has been dishonored . . . or has an unauthorized signature or has been altered." For example, if someone hands the holder a check with smudges, crossed-out �igures, or obvious forgeries, one cannot be a holder in due course because one is "on notice" that something is wrong with the instrument.
In summary, to be a holder in due course, one must take:
1. A negotiable instrument;
2. For value; and
3. Without notice that it is "ODD"—overdue, has been dishonored, or has defenses against it.
Significance of Being a Holder in Due Course
Suppose that the following occurred: Millennium Industries entered into a contract to purchase 1,000 units of steel from Mighty Steel Company. Millennium issued an IOU, payable in 90 days (a nonnegotiable instrument), in the amount of $10,000.00 payable to Mighty Steel Company. Millennium endorsed the IOU and delivered it to Lena, the third party, as illustrated in Figure 13.7.
Figure 13.7: Third-party contract with IOU
Is Lena a holder in due course? You should be able to discern that she is not. To be a holder in due course, one must possess a negotiable instrument, pay value, and not be on notice of any defenses against the instrument. While Lena may have paid value, and the face of the instrument may have looked good, it is not negotiable. Therefore, she is merely a holder, not a holder in due course. Nevertheless, if no other problems arose, she might still get paid and remain blissfully unaware that her non–holder in due course status had any signi�icance.
But the story does not end there. Suppose that later a dispute arises between Mighty (the seller) and Millennium (the buyer) about the steel, which Millennium has now received and thinks is of poor quality. A non–holder in due course takes subject to that dispute; that is, if Millennium refuses to pay on the IOU in 90 days, Lena will not get paid. Notice that she won't get paid owing to a dispute going on between two parties, one of whom she probably doesn't even know. Nevertheless, "taking subject to" means she is stuck, without payment or recourse.
Now let's assume a different and better scenario. This time, Millennium issues Mighty a negotiable note, as shown in Figure 13.8.
Figure 13.8: Third-party contract with negotiable note
Lena has now taken a negotiable instrument, paid value, and is not aware of any problems with the note. As a result, she quali�ies as a holder in due course (HDC).
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Defenses to a Contract
Holders in due course take negotiable instruments free from personal defenses (between the seller and buyer) and are subject only to real defenses (between the seller and buyer). Therefore, if the dispute between the seller and the buyer is in the category of personal defenses, Lena will get paid; however, if the dispute is in the category of real defenses, she will not.
Personal defenses include:
Breach of contract or warranty;
Lack or failure of consideration;
Fraud in the inducement;
Illegality;
Mental incapacity;
Discharge by payment or cancellation;
Unauthorized completion of an incomplete instrument;
Nondelivery of the instrument; and
Ordinary duress or undue in�luence.
Real defenses include:
Infancy, to the extent that it is a defense to a simple contract;
Duress, lack of legal capacity, or illegality of the transaction that nulli�ies the obligation of the obligor;
Misrepresentation that induces a party to sign a negotiable instrument without understanding its character or its terms (fraud in the execution); and
Discharge in insolvency proceedings.
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Key Terms
allonge (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
A separate piece of paper that is permanently attached to an instrument.
antedating (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
When a check or other instrument is issued on a particular date but the date written on it is earlier (it is still a negotiable instrument).
bearer paper (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
An instrument that includes the word bearer or cash (e.g., "Pay to Bearer," "Pay to the Order of Cash") but names no speci�ically ascertainable person.
blank endorsement (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
The signature of the payee written alone on the back of the check.
endorsement (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
Writing on a negotiable instrument that has the effect of transferring all the rights represented by that instrument to another party.
holder in due course (HDC) (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
The third party to a transaction, following a payee, who has elevated status and can get paid on commercial paper even if a dispute arises between the seller and the buyer, in most circumstances.
incomplete instrument (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
A negotiable instrument that has not been completely �illed out by the maker or drawer and that cannot be enforced until it is.
issuance (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
The process wherein the drawer makes a check payable to the payee and hands it to the payee.
negotiation (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
The physical transfer of commercial paper to the third party in the transaction.
order paper (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
This type of instrument includes the word order and is payable to a speci�ic person or entity.
personal defenses (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
Defenses that the holder in due course takes "free from"; thus, the holder in due course still gets paid if the defense is personal.
postdating (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
When a check or other instrument is issued on a particular date but the date written on it is later (it is still a negotiable instrument).
real defenses (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
Defenses that the holder in due course takes "subject to"; thus, the holder in due course does not get paid if the defense is real.
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restrictive endorsement (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
Writing that places a condition on further negotiating the instrument.
special endorsement (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
On an instrument, writing that speci�ies the person or persons to whom the instrument is made payable.
void (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
No longer in force. For an instrument, if a completion is unauthorized, it generally becomes void.
Chapter 13 Flashcards
Critical Thinking and Discussion Questions
1. What is the difference between order paper and bearer paper?
2. What are the three requirements one must meet in order to be considered a holder in due course?
3. Your company has received a check for services performed. The name of your company is Millennium Enterprises. The check is made payable to Malleneum Ent. How could you go about depositing this check into your company's account?
4. Your company receives a check that is payable "60 days from [date]." The check is dated. Is this a negotiable instrument? Why or why not? What if the check says, "Payable on June 1, 2013"? Is that a negotiable instrument?
5. A check made payable to Jane Doe has $100.00 written in �igures in the box provided for the amount but states "One Thousand Dollars" on the space provided beneath. Is the check valid? If so, for what amount? If not, why not?
6. Mark Maker issues a note to Percival Payee for $500. The note is made payable one year from the date of issue with interest, but no interest rate is speci�ied. Is the instrument valid, and, if so, what interest rate is payable?
7. Peter receives a check as a birthday gift from his grandmother. The check is made out for $50 to him as payee, but the drawer neglected to write in a date on the space provided and also forgot to write in the amount in words in the space provided on the check. Peter, eager to buy two games for his new game console on sale that week for $25 each, �ills out the missing date and the words "Fifty and NO/100" dollars on the check and negotiates it to his local games dealer. Is the check valid? Has Peter committed an unlawful act in completing the check?
8. Don Drawer gives a check to his friend Pamela Payee as a birthday gift. Pamela endorses the check as follows: "Pay any bank, [signed] Pam Payee." Answer the following questions based on these facts:
a. Is Pamela a holder of the instrument when Don gives her the check?
b. Is Pamela a holder in due course of the instrument? Explain.
c. Is Pamela's bank a holder in due course after it accepts the check and credits her account? Explain.
A separate piece of paper that is permanently attached to an instrument.
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Chapter 14
Liability of Parties to Commercial Paper and Warranties of Transfer and of Presentment
As we have seen throughout this unit, the primary purpose of negotiable instruments is to facilitate commercial transactions by acting as a substitute for cash or as evidence of debt and a guarantee of its repayment. We've also seen that there is an element of risk to persons who issue negotiable instruments. Such persons must generally pay holders in due course under the terms of the instrument and are barred from asserting most defenses to its payment. If we ended our discussion of commercial paper here, it might well seem that the risk inherent in the negotiation of these instruments is an unacceptable one. Fortunately, the makers and drawers of negotiable instruments do have a measure of protection against most adverse circumstances that can arise out of the transfer of these instruments.
Liability is based on two separate theories:
1. Through the contractual and signature liability that arises from the transfer of a negotiable instrument; and
2. From the warranties that automatically attach when such instruments are negotiated or presented for payment to the drawees or makers.
In this chapter, we will explore the liability of parties to commercial paper as well as the warranties of transfer and presentment that arise from their negotiation.
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14.1 Liability of Parties to Commercial Paper There are essentially two types of liability that parties to commercial paper can have: signature liability and contractual liability. Signature liability arises from the act of signing a negotiable instrument in order to create or transfer it. Contractual liability attaches based on the relationship that parties have to one another with regard to the instrument being created or negotiated. We will examine both types of liability in turn.
Contractual and Signature Liability
Before a person can be found to have any liability on a negotiable instrument, either his or her signature must appear on the instrument, or the instrument must be signed by an authorized agent on the person's behalf. The Uniform Commercial Code, which governs negotiable instruments, is rather liberal in determining what constitutes a signature. The UCC essentially holds that any mark made by a party with the intention of having it serve as a signature is valid.
The mere fact that a person's signature appears on commercial paper can subject the signer to incur some type of liability for the instrument. It is not necessary that the signer receive any consideration for signing or have any relationship to the instrument; instead, all that is required is that the signature be genuine and that the signer intentionally placed it on the instrument. So, for example, if Albert asks Betty to carry a check over to Charlie, who is 10 feet away, and Betty signs on the reverse of the check before giving it to Charlie, she has incurred signature liability.
Liability on a Draft
You will recall from Chapter 12 (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/sec12.2#sec12.2) that drafts are a type of three-party paper in which the drawer (who writes the draft) orders the drawee (the entity paying the check) to pay the payee. Although the drawer signs the front of the draft, the drawer's liability is not primary but rather secondary. This means that if someone holding the check wishes to get paid, he �irst has to go to parties primarily liable for payment before he can go to parties secondarily liable for payment. Primary and secondary liability refers to the order in which people are liable for paying: if the party primarily liable refuses to pay, then the party secondarily liable will have to pay (see Table 14.1). The problem is that, on a check, no one is primarily liable.
As a result, people often request a certi�ied or bank check. When this occurs, the drawee or bank becomes primarily liable. If you want to be guaranteed payment on a check, this is the best thing to do. To obtain such a check, the drawer usually goes to his or her bank and presents a personal check and requests that the bank certify the check. If the bank agrees to do so, the bank is in essence guaranteeing payment on the check, or assuming primary liability. The bank will clearly mark the front of the check with a word such as "CERTIFIED" or "ACCEPTED." Why would the bank assume liability? Because it will have �irst checked its customer's account to determine whether the money is available to pay the check. If it is, the bank will move the money out of the customer's account to another account, from which the bank will pay the certi�ied check. The money is now guaranteed because the bank has set it aside. Accordingly, it will charge the customer for this service.
Liability for Unauthorized Signatures
In general, individuals are not liable to pay on negotiable instruments unless they sign them. If an unauthorized signature is placed on a negotiable instrument (forged, for example), the signature is ineffective. If a person's checkbook is stolen during a house burglary, and the thief writes a check for $20,000 from the account, the bank must recredit the account. As long as the owner of the checkbook was not negligent in how she handled her checkbook (e.g., did not leave it lying around), then the bank will be liable for paying out on a forged signature. This is because when the drawer opened an account at the bank, she �illed out and signed a signature card. So now, the bank has the obligation to corroborate the signature when presented with a check for payment. Even if the thief presented the check to another bank, say in a different state, that bank would eventually present the check for payment and the drawer's bank would have a duty to verify the signature.
Liability of Agents
Similarly, if a person claiming to act as an agent on behalf of a principal signs a negotiable instrument on the principal's behalf but does so without the principal's authority, the unauthorized signature is ineffective as to the principal. Suppose an employee steals his employer's checkbook out of his desk drawer and writes a check, signing it as the employer's agent. Because this pseudo-agent had no authority to do so, the bank is liable for paying out on the check. To guard against this type of fraud, banks require that agents with signatory authority �ill out information, including their signatures, and do not pay out on such checks without corroborating the agent's authority and signature. And, as for liability on a forged draft, if a person's negligence contributed to the unauthorized instrument (such as leaving a checkbook out at work, making a signature stamp available to anyone at a business, or leaving company checks lying around), then the defense of unauthorized signature may not be asserted against a holder in due course (for more on holders in due course, see Chapter 13 (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/sec13.4#sec13.4) ).
Liability of Endorsers
Endorsers of negotiable instruments have secondary liability for payment of the instrument. This means that if the party primarily liable fails to pay on the instrument when it is presented, the holder of the instrument can then turn to the party secondarily liable for payment.
Liability of Accommodation Parties
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Often, a seller will require that someone else lend good credit to the buyer. For example, a minor wishing to buy a car might have the parents cosign a note in order to get approval. Parties who cosign are referred to as accommodation parties. An accommodation party can be a codrawer, a coendorser, or a comaker. Depending on which capacity he signs in, he is either primarily or secondarily liable on the instrument. For example, a comaker has primary liability, as does a maker; in contrast, a coendorser has secondary liability, as does an endorser.
Table 14.1: Contractual liability of parties to negotiable instruments
Primary Liability Secondary Liability
Notes or CDs The maker, because he/she says, "I promise to pay . . ." The co-accommodation party because they say, "We promise to pay. . ."
Endorsers
Drafts No one, unless a bank (drawee) accepts a check by certifying it or issuing it as a bank check
Drawers Endorsers Accommodation Coendorsers
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14.2 Warranties on Presentment and Transfer In addition to the contractual liability of parties to commercial paper discussed above, another kind of liability arises for all parties who transfer or present commercial paper, even if they never signed or endorsed the paper. These are called presentment warranties and transfer warranties.
Presentment Warranties
Suppose that an employee receives a paycheck and endorses it to the holder in due course. The holder in due course will then present the check for payment. Note that the holder in due course probably does not know the payee's employer. Nevertheless, when the holder presents the check to the bank, that holder is giving three promises in the simple action of presenting it for payment:
1. The holder has a "right" to payment; that is, all the endorsements are genuine;
2. The instrument has not been altered, meaning, for example, that the presenter has not changed the monetary amount; and
3. If it is a draft, the signature of the drawer is genuine.
If the check turns out to be a fake from the employer/drawer, the bank can then "go after" the holder/presenter for payment, based on the presentment warranty.
Transfer Warranties
The other type of liability one can incur when dealing with commercial paper is a transfer warranty. This refers to passing along the commercial paper. Sometimes, paper is endorsed down a chain of people, although statistically, this is rare. Nevertheless, everyone who touches and transfers commercial paper for consideration (as opposed to giving it as a free gift) has some sort of liability. The �ive transfer warranties are as follows:
1. The transferor is entitled to enforce the instrument;
2. All signatures are authentic and authorized;
3. The instrument has not been altered;
4. The instrument is not subject to a defense or claim in recoupment of any party that can be asserted against the warrantor; and
5. The warrantor has no knowledge of any insolvency proceeding commenced with respect to the maker or acceptor or, in the case of an unaccepted draft, the drawee.
Presentment
Presentment of an instrument is a demand made by a person entitled to enforce the instrument that it be paid or accepted (an acknowledgment by a maker or drawee that the instrument is valid and will be paid when due) (see UCC §3-501(a)). Normally, presentment of an instrument to the party primarily liable for acceptance is a prerequisite to invoking secondary liability on that instrument. Presentment has several criteria: it may be made at the place of payment of the instrument (if the instrument is payable at a bank in the United States, it must be made at the place of payment), may be made by any commercially reasonable means, and is effective when the demand for payment or acceptance is received (UCC § 3-501(b)(1)).
If the party to whom presentment is made is a bank, then it may treat presentment as occurring on the next business day after the day of presentment if it has established a cutoff hour not earlier than 2:00 p.m. for the review and processing of instruments presented for payment or acceptance and the presentment is made after the cutoff hour (UCC § 3-501(4)).
Notice of Dishonor
If an instrument is presented for payment, but payment is refused, we say the instrument has been dishonored. Notice of dishonor may be given by any commercially reasonable means, including written, oral, and electronic communications (UCC § 3-405(b)) to the party who is liable on that instrument or to a third party who may be compelled to pay it.
The UCC sets forth various rules for giving this notice. For example, if the notice of dishonor is given by a bank that has taken the instrument for collection, it must give such notice by midnight of the next banking day following the banking day on which the bank itself received notice of dishonor of the instrument (UCC § 3-503(c)). Notice of dishonor given by any other person taking an instrument for collection must be given within 30 days following the day the person receives the notice of dishonor (UCC § 3-503(c)). For any other instrument (e.g., those not taken for collection), notice of dishonor must be given within 30 days following the day on which dishonor occurs (UCC § 3-5-3(c)). Note, however, that an endorser can disclaim his or her contractual liability by endorsing the instrument "without recourse" (UCC § 3-415(b)).
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Key Terms
Click on each key term to see the de�inition.
accommodation parties (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
Parties who cosign a note. They can be a codrawer, a coendorser, or a comaker. Depending on their signing capacity, they are either primarily or secondarily liable on the instrument.
certi�ied or bank check (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
A negotiable instrument that is clearly marked "CERTIFIED," "ACCEPTED," or similarly. The bank agrees to guarantee payment on the check and to assume primary liability. The bank will set aside funds from the customer's account for this and charge the customer a convenience fee.
contractual liability (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
The obligation that arises on a negotiable instrument because of the relationship between the parties.
dishonor (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
Refusal to make payment on a negotiable instrument when it is presented for payment.
endorser (or indorser) (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
Someone who lends a signature to an instrument and thereby has secondary liability for payment of the instrument.
notice of dishonor (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
Communication that an instrument presented for payment has not been honored, given by a bank or other party to the person who may be liable on the instrument or any other holder or third party.
presentment (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
A demand, made by a person entitled to enforce an instrument, that it be paid or accepted.
presentment warranty (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
Promises made in the action of presenting a check for payment. They include the right to payment, the fact that the instrument is genuine and has not been altered, and a valid signature.
primary and secondary liability (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
The order in which people are liable for paying; if the party primarily liable refuses to pay, then the party secondarily liable will have to pay.
signature liability (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
This sort of obligation arises from the act of signing a negotiable instrument in order to create or transfer it.
transfer warranty (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
The chain of endorsements for commercial paper that gives everyone who touches it some liability.
Chapter 14 Flashcards
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Critical Thinking and Discussion Questions
1. What are the two types of liability of parties to commercial paper?
2. Which parties to commercial paper have primary liability for its payment?
3. What two basic types of warranties are involved in commercial paper transactions?
4. What are the three warranties of presentment, and when are they available?
5. What are the �ive warranties of transfer, and to whom do they apply?
6. When must presentment be made if the instrument does not specify a time for presentment?
7. Sam Slick, a crook, �inds a check made out to Pamela Payee in the amount of $10 on Pamela's desk at work. He steals the check, changes the amount to $100, forges Pam's signature, and specially endorses the check to himself as endorsee. The next day, Sam negotiates the instrument to Ignacio Innocent, a coworker who does not know of the theft or alteration of the check and who proceeds to pay Sam $100 for the instrument. a. What transfer warranties has Sam breached in negotiating the check to Ignacio?
b. What transfer warranty or warranties has Sam not breached in negotiating the instrument?
8. Examine the sample instrument that follows and then answer the questions that relate to it.
a. What type of instrument is this?
b. If Pedro deposits the check in his account and it turns out that Diane did not have suf�icient funds to cover the instrument, how long does Pedro's bank have to notify him of the dishonor when it learns of it?
c. How may the bank notify Pedro of the dishonor?
Parties who cosign a note. They can be a codrawer, a coendorser, or a comaker. Depending on their signing capacity, they are either primarily or secondarily liable on the instrument.
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Chapter 15
Banks, the Banking Process, and Electronic Transfers As a manager, depending on the type of business you are involved with, you will probably have frequent interaction with banks and �inancial institutions. Understanding fundamental banking processes, then, is essential to carrying out your day-to-day activities.
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15.1 The Debtor–Creditor Relationship Between a Business and a Bank The �irst essential ingredient of your relationship with a bank is that it is a debtor–creditor relationship. This is the relationship that exists when one person (the creditor) loans money, provides services, or extends credit to another (the debtor). The debtor, in turn, is the person who owes the money or some other obligation to the creditor. The act of loaning a friend $10 is an example of how simple it is to create this relationship; no other formalities need be involved. So, when a business deposits money in a bank account, the business becomes a creditor of the bank and the bank is the debtor. As a result of that relationship, the creditor has the right to demand its money from the bank and concomitantly the bank has the duty to pay the money out of the account. The debtor– creditor relationship can also be an informal arrangement created by a private transaction (see Chapter 16 (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/sec16.2#sec16.2) for further explanation).
The debtor–creditor relationship is governed by UCC Article 4. The rules of Article 4 are often modi�ied by the contract entered into by the bank and the customer. Although every agreement between a bank and a customer has unique features, the following is representative of the clauses that often appear.
USA PATRIOT Act
Since passage of the USA PATRIOT Act, banks have been under intense government scrutiny. One result of that scrutiny is increased identi�ication requirements. Therefore, businesses dealing with banks may be required to produce identi�ication every time they deal with their bank, as will all employees authorized to deal with the bank. It is essential that the business implement policies regarding the identi�ication of employees. A passage in a commercial contract may appear like this:
IDENTIFICATION NOTICE (USA PATRIOT ACT) To help the government �ight the funding of terrorism and money-laundering activities, Federal law requires all �inancial institutions to obtain, verify, and record information that identi�ies each person who opens an account.
What This Means for You When you open an account, we will ask for your name, address, date of birth, and other information that will allow us to identify you. We may also ask to see other identifying documents like a driver's license or documents showing your existence as a legal entity.
Existing Customers Even if you have been a customer of ours for many years, we may ask you to provide this kind of information and documentation because we may not have collected it from you in the past or we may need to update our records.
Failure to Provide Information If, for any reason, any owner is unable to provide the information necessary to verify their identity, their account(s) may be blocked or closed, which may result in additional fees assessed to the account(s).
When the business sets up the account and thereafter, the bank will want to know who is authorized to access the account. Each owner of your account is independently permitted to authorize someone else to access your account. For example, here is a passage from a commercial agreement establishing which persons will have access to your account:
1. Any person listed on a signature card, resolution, or certi�icate of authority as being authorized to make withdrawals or transfers, by check or otherwise, from your account;
2. Any person that you authorize to make withdrawals or transfers from the account by whatever means the account allows (for example, preauthorized withdrawals, wire transfers, ATM card, or check card transactions);
3. Any person you give rights to act on your behalf, such as a power of attorney;
4. Any person to whom you make your checkbook or your checking account number available for purposes of transacting business on the account. We discourage this type of "authorization" because it is possible that we will detect such transactions and treat them as unauthorized. If you give any such person "authority," we are not responsible whether we honor the transactions or dishonor them; and
5. Any person to whom you make your ATM card or check card personal identi�ication number available. By allowing this type of "authorization" the person to whom you make your personal identi�ication number available may be able to access all of your accounts held with us by using the telephone, ATM, Internet, or other banking access channels. If you give any person such "authority," we are not responsible for actions they take with respect to your account.
Authorization is usually accomplished by use of signature cards or the use of a power of attorney form. Note under paragraph 4 of the above agreement that the bank deems simply making a checkbook, account number, or ATM card available to an employee "authorization," thus exculpating the bank from any liability for a wrongful unauthorized withdrawal.
Overdrafts
An overdraft occurs when you take more money out of your account than is available to you for withdrawal, or if it is available to you but is later reversed. The relationship between the bank and the customer is that of a debtor to a creditor, but when an overdraft occurs, that relationship is reversed, and the
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customer becomes the debtor. As such, the customer is required to pay any overdrafts and the penalties that result. Note from the agreement below that anyone who works for the business is liable to the bank for any employee who overdraws the account. The following sample contract passage relates to overdrafts:
The account owner(s) is responsible to us to repay any overdraft and any fees charged to an account, no matter which owner caused it or why. That repayment is due immediately, and we will take it from your next deposit or whenever funds become available in your account. If there is more than one owner, each owner is separately, and all owners are jointly, responsible for an overdraft and any account fees (this means we can collect the total from any owner, but we won't collect it more than once).
Banking is a business, and just like any other business, banks need to make a pro�it to remain solvent. As such, the bank "controls" the agreement, and there is little room for negotiation about most aspects of the contract. Thus, the bank sets the limits of its liability and protects itself from all foreseeable problems. Banks do have more leeway with regard to charges and lending costs than they do with regard to the contract that customers sign. For this reason, high-volume customers may expect that the bank will make up for some of the stringent aspects of the contract by giving them more lenient rates.
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McClatchy Tribune/Getty Images
Cashier's checks are guaranteed because a bank has agreed to be primarily liable.
15.2 Types of Checks Commonly Seen in Banking In previous chapters we discussed the most common type of paper seen in banking transactions: the check (see also Chapter 12 (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/sec12.2#sec12.2) ). A check is three-party paper in which the drawer orders the drawee to pay the payee. The distinguishing feature of a check is that the drawee is always a bank. In this section we will discuss speci�ic types of checks.
Cashier's Checks
A type of instrument commonly seen in banking transactions is the cashier's check. A cashier's check is a check in which the bank is both drawer and drawee. While at �irst blush this might sound strange, it makes a lot of business sense. Suppose that a person or a business did not have a bank account but instead had only cash from a transaction. That person needs to make the cash usable in commerce (or perhaps mail it), so he or she needs the cash converted into a check. The customer can give the bank the money to deposit into its own accounts, and the bank can then draw from that account. Thus, the bank is both drawer (writing the check) and drawee (drawing from its own account). The customer receives a bank check even though he or she has no account at the bank, and the check is highly acceptable because the bank has agreed to be primarily liable on it by virtue of its being a cashier's check. The money is guaranteed.
Certified Checks
When the payee wants to make sure that the drawer's check won't "bounce" (be dishonored for insuf�icient funds), the payee can insist that the drawer pay for goods with a certi�ied check. This instrument is similar to a cashier's check, except that in this case, the drawer is a customer with an account at that bank. Usually the customer writes the check from his or her checkbook and hands it to the teller. The teller then moves the money out of the customer's account into a special bank account. In this way, the funds are guaranteed and the drawer no longer has access to them. The teller then writes "CERTIFIED," "ACCEPTED," or some other word on the front of the check as public notice that the bank is now primarily liable on the instrument.
One word of caution about certi�ied and cashier's checks: It is always wise to have these checks made payable to the drawer himself, rather than the payee. In the event that the sale falls through, the drawer can then deposit the check back into his account. If the check is made payable to the payee, and the payee becomes angry with the drawer, the payee may refuse to endorse the check. Now the drawer has in his hands a check made payable to a very uncooperative payee. By making the check payable to himself, the drawer can then show up to buy the goods and complete the transaction by endorsing the check to the seller.
Invalid Checks
As discussed throughout this unit, no one is liable on commercial paper unless that person's signature appears on it. However, several special circumstances can render such an instrument invalid in a business transaction.
Forged Checks
If the bank pays out from a customer's account and the customer did not sign the check as the drawer, then the bank is in the wrong. This is referred to as a forged drawer's signature. In these cases, someone has usually stolen the drawer's checkbook and forged his or her name on the front of the check in the signature line—a serious crime in all jurisdictions.
How does a bank doing hundreds of transactions a day watch out for such forgeries? One way is by requiring identi�ication. But some thieves are very good at their trade. Banks usually check the cards they have on �ile, called signature cards, that the customer signed when �irst opening the account. If there is a discrepancy, the bank may refuse to pay. In addition, bank customers have a positive duty to inspect their bank statements to be watchful for unauthorized activity and must report any errors to the bank within 30 days. If they fail to do so, the bank will not be liable. However, if such an error is discovered after the fact but before the 30 days expire, the bank is obligated under the UCC to "recredit" the customer's account.
However, if the forgery on the front of the check was somehow the fault of the drawer, then the bank has no liability for crediting the drawer's account. For example, some businesses have check machines that process checks and sign them. Others have stamps with an authorized employee's name that can take the place of an actual signature. Failing to protect apparatuses such as these and allowing them to fall into the wrong hands is negligent and no fault of the bank.
Sometimes, a bank will pay out on a forged endorsement. This involves different legal liability than for a forged drawer's signature. Erroneous payouts fall under the theory of presentment warranties (see Chapter 14 (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/ch14#ch14) ). Recall that the person presenting the instrument for payment is guaranteeing that it was not stolen and that it is genuine. Therefore, the bank can sue the "presenter" on
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the basis of breaching this warranty, even if the presenter was completely unaware of any problem with the instrument. Here, too, the bank will have to recredit the drawer's account.
Altered Checks
Another problem that banks have is when people alter the face value of checks. If the bank pays out of a customer's account on an altered check, the bank must recredit the customer's account for whatever the bank erroneously paid. There are two amounts involved in these situations. One is called the original tenor, which is the amount that the drawer drew the check for. Suppose the drawer wrote a check for $45.00 and it was changed by a thief to $450.00. The amount of $45.00 is the original tenor and the amount of $450.00 is the altered amount. Unless the customer's negligence led to the alteration, the bank will have to recredit the difference between the altered amount and the original tenor. In this context, negligence by the drawer may include writing in pencil, leaving large gaps or spaces when writing checks, thereby facilitating alterations, or failing to inspect monthly bank statements.
Stop Orders
Banks are also liable for paying on a check after a stop order has issued. Stop orders take two forms: one is in writing and is effective for six months, and the other is oral and is effective for 14 days. Customers must follow strict bank rules to invoke a stop order. When the order expires, a customer may renew the order, but fees are involved with all of these requests because they require extensive monitoring and employee time.
Stale Checks
According to the UCC, checks that are more than six months old are "stale," and the bank does not have to accept them. If a customer requests the bank to credit his or her account, or to provide cash for a stale check and the bank refuses, the customer will have no "case" against the bank for its refusal. On the other hand, if the bank does pay out on a stale check, it has no liability for doing so. In short, the bank is not liable whether it pays out on a stale check or whether it refuses.
Postdated Checks
People often write what are called "postdated checks" on their account. Such checks are dated in the future, when the customer expects he or she will have money in the account to cover the amount. Is a bank liable for immediately paying out on a check that is dated in the future? The answer is no, unless the drawer noti�ies the bank not to pay either orally or in writing. Otherwise, the bank has no liability, even if the transaction overdraws the customer's account.
Posthumous Checks
Sometimes a business will receive a check from a customer who dies soon after. The family members may trace the check back to the business and ask for a refund of their deceased family member's money. Perhaps the business has already deposited the check into its account and the family wants the bank to stop payment. If the bank is unaware that a customer has died and it processes such a check, the bank has no liability, even for 10 days after learning of the death. Nor will the bank have liability for crediting the business's account. As with overdrafts, a bank can pay out of a customer's account even if it creates a de�icit; alternatively, if it chooses, the bank may dishonor the check after learning of the drawer's death.
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15.3 Special Business Problems With Banking On occasion, the news will cover a scheme by a �ictitious payee. Sometimes these schemes are right out of Hollywood—as clever as they are diabolical. A �ictitious payee scheme is one of an employer's worst nightmares. In it, a trusted employee (who usually works in the payroll of�ice and handles checks on a regular basis) goes to a bank and sets up a bank account in a fake name. Then the employee makes checks payable from the business to the fake named account, deposits them, and spends the proceeds. As a general rule, the employer usually discovers the scheme and races to the bank, demanding that the bank recredit the employer's account for the thousands of dollars stolen. Unfortunately for the employer in this situation, the bank is not liable. By law, the loss usually falls on the person hiring the errant employee. The employer suffers the loss for having used bad judgment in hiring a thief to work in the payroll of�ice.
Another popular scam is for a thief to pose as a charity or a needy relative. Suppose a thief shows up at a business and claims to be representing the United Way or another wellknown cause. The employer, wishing to be charitable, gives the thief a check. In cases such as these, where the drawer purposefully made the check out to the poseur without questioning his or her identity, the drawer will suffer the loss. Employees and employers, for that matter, are supposed to use common sense and not hand checks to people without �irst verifying who they are. The bank in these cases has no obligation to recredit the donor's account.
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Key Terms
Click on each key term to see the de�inition.
cashier's check (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
A check in which the bank is both the drawer and drawee.
certi�ied check (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
Similar to a cashier's check, except that the drawer is a customer with an account at that bank.
creditor (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
The party to a �inancial relationship who has the right to demand money at a given time.
debtor (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
The party to a �inancial relationship who has the duty to pay the creditor money.
debtor–creditor relationship (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
A contractual arrangement between, for example, a customer and a bank, where the creditor can demand money from the debtor, who has the duty to pay from that account. Can also be an informal relationship created by a private transaction.
�ictitious payee (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
A sham account holder created by an employee who then deposits company checks into that account for personal use.
guaranteed (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
Funds that are certain to be paid on an instrument because they are backed up by a bank's special account or certi�ication.
original tenor (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
The amount the drawer drew the check for; its face value.
overdraft (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
Taking more money out of your account than is available for withdrawal, or that is available to you but is later reversed.
postdated check (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
A check that is dated in the future, when the writer expects he or she will have money in the account to cover the amount.
power of attorney (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
An instrument in writing by which one person, as principal, appoints another as his or her agent and confers upon the agent authority to perform speci�ied acts or kinds of acts on behalf of the principal.
stale check (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
A check that is outstanding for longer than six months.
stop order (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
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A request made in writing, valid for six months, or made orally, valid for 14 days, for a bank to refuse payment on an outstanding check.
USA PATRIOT Act (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/sections/fm/books/AUBUS670.12.2/section
A 2001 federal act to combat terrorism. It requires strict oversight of banks' standards for identifying customers in transactions and verifying their signatures.
Chapter 15 Flashcards
Critical Thinking and Discussion Questions
1. Why is the relationship between a business and a bank known as a debtor–creditor relationship?
2. Who is the drawer of a cashier's check? Who is the drawee?
3. List three circumstances when a check would be considered invalid.
4. How can employers and managers ensure against �ictitious payee schemes? As a manager, how would you advise your supervisor with regard to preventing these schemes from occurring at your workplace?
5. Your business deals with numerous buyers every day, and it is customary in your business to take checks in payment. Write a company policy regarding stale, postdated, and antedated checks so that your employees have some guidance about which checks to accept.
6. Your supervisor asks you to place a stop order on a check that your business has written. Discuss whether you would place an oral or written stop order; what the process would be to place the order; how much it would cost; and what the advantages and disadvantages are to each type of stop order.
7. Glenda is in need of a car to get to school and back. Finally, the perfect car was advertised and she went to test-drive it. The car was perfect! Now she wishes to buy it. The seller insists that Glenda give him either a certi�ied or a cashier's check. a. What is the difference between these checks, and how would she go about getting each one of these?
b. How would you advise Glenda to draw the check? In other words, who would you advise her to name as the payee on the instrument? Why?
c. Now Glenda arrives on the big day to pick up her car, but the seller has sold it to someone else! Glenda has a check in her hand in the amount of $12,500 to pay for the car. Now what are her options with regard to the check?
8. Bobby lives in a very overcrowded dormitory and has a roommate who leaves the door unlocked. Bobby's roommate has dozens of friends who also have access to the room. One day, Bobby returns to �ind that his checkbook is missing. a. Bobby does not check any bank statements for six months. When he �inally does check his statements, he realizes that someone has written and cashed a check for $1,000 on his account. In a lawsuit between Bobby and his bank, who would be liable for this money? What factors would the court consider in such a case?
b. Suppose that Bobby found his checkbook and made out a check to his girlfriend for $50. His girlfriend then altered the check so that it appeared to be for the amount of $5,000. In a lawsuit between Bobby and his bank, who would be liable for the money?
c. Assume that Bobby kept his checkbook locked in his desk drawer. Nevertheless, someone stole a check out of it and cashed it at the bank. Bobby immediately noticed the withdrawal from his account and reported it to the bank, which refused to recredit his account. In a lawsuit by Bobby against his bank, who would win and why?
A check in which the bank is both the drawer and drawee.
C l i c k c a rd t o s e e t e r m 👆
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Unit V
Property Rights
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Chapter 16: Creditors and Debtors
In this chapter you will:
Distinguish between secured and unsecured debt.
Understand the process of collecting on a debt.
Chapter 17: Secured (Article 9) Transactions
In this chapter you will:
Explain an Article 9 transaction, how it is created, and its relationship to collecting money from a debtor.
Chapter 18: Bankruptcy
In this chapter you will:
Understand the three major chapters in bankruptcy, including their similarities and differences.
Understand the purpose and components of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.
Chapter 19: Real and Personal Property
In this chapter you will:
Identify the difference between real and personal property and how each is transferred.
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Chapter 20: Intellectual Property
In this chapter you will:
Distinguish between the forms of protection for intellectual property: patents, copyrights, trademarks, and service marks.
Identify international issues related to intellectual property.
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Chapter 16
Creditors and Debtors As discussed in Chapter 15 (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/sec15.1#sec15.1) , one of the most signi�icant relationships in business is that of creditor and debtor. All of us enter into debtor–creditor relationships in our daily lives, whether using a credit card to purchase goods or dropping off clothing at the dry cleaners. As a student, you may have borrowed money to attend college and will have an obligation to pay back the loan over a period of time. In short, buying items on credit is such a common, everyday occurrence that most people who transact business this way think nothing of it. At least, that is true until the debtor defaults. It is then that the creditor becomes painfully aware that the money he or she thought was forthcoming is now in doubt; also, the debtor feels the weight of a debt that is being called in immediately.
The cost of recovering bad debts is very expensive and time consuming. The purpose of this chapter is to discuss some of the different forms of debtor– creditor relationships; how to recoup money loaned; the rights and obligations of each of the parties; and the major federal and state legislation governing the relationship.
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16.1 Types of Debt: Unsecured and Secured The law draws an important distinction between two types of debts: unsecured debts and secured debts. An unsecured debt simply means that when the creditor loaned the debtor money, the creditor did not receive any property (collateral) to secure or guarantee repayment. Although the two parties have an underlying contract to enforce payment, the creditor would have to resort to suing in court to recover the money loaned. The practice of making small, unsecured loans may justify such a risk, but larger loans that take place in a business do not. Not only is the lawsuit to recover the debt expensive and time consuming, but there is no guarantee at the end of a trial that there will be any money to collect. Therefore, to decrease the risk incurred when a debtor defaults, many creditors, especially business creditors, enter into secured loans, also called secured debts or secured transactions.
For the purposes of debtor–creditor law, a secured transaction is one in which the debtor gives collateral as a pledge to the creditor. If the debtor defaults on the loan, the creditor can sell the collateral to recover the money lost. If the collateral used to secure the loan is personal property, we say that the debtor has given the creditor a security interest in personal property; if the property that secures the loan is real property, that security is called a mortgage. Although a secured loan does not prevent the debtor from defaulting, it does help the creditor recover the money.
In a default situation with an unsecured loan, the debtor has little recourse but to end up in court to try to recover the debt. In a secured situation, by contrast, the creditor can sell the collateral and use the proceeds to cover at least part of the debt. (For the basics of setting up a secured transaction, see Chapter 17 (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/ch17#ch17) .) Consider the following example.
Carla Consumer owns a boat worth $5,000 and wants to buy a car for $6,500 with a loan from Convenient Credit Union (CCU). She could use the boat as collateral for the loan of $6,500 to purchase the car. Then, if Carla the buyer (now the debtor) defaulted, CCU could sell the boat to defray the loss of the $6,500. Now suppose CCU sold the boat for $4,000. On a loan of $6,500, the creditor has lost only $2,500 as opposed to the full $6,500 that would have been lost had the loan been unsecured.
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16.2 Collecting on a Debt If the creditor did not enter into a secured transaction before making the loan, there are still options available, but all of these involve going to court. Before proceeding down that road, the creditor should �irst make absolutely sure that the debtor has assets to pursue, such as a home, money, savings, stock, or wages from employment. Many litigants fail to consider that winning a lawsuit is of absolutely no value if the defendant has no assets.
Determining the Debtor's Assets
How can a creditor determine whether a debtor has any assets prior to suing? One way is to use online databases such as Dun & Bradstreet (http://www.dandb.com (http://www.dandb.com) ). Such services charge a fee to investigate and prepare a report showing the defendant's assets and where they are located. However, the cost of obtaining such information may be well worth it if it saves needless litigation expenses.
When real estate is bought and sold, such a transaction is recorded in a local of�ice, usually of the county clerk. Access to these records is open to the public and can be searched by using the seller's or the buyer's name. Many counties have now placed real estate records online. This is a good place to look for a potential defendant's assets. And, since the information is readily available, the search costs nothing. At the same location, there may be corollary resources or books that list mortgages and other liens against property. Using them, one could determine if there is any equity in the debtor's real property. If a judgment has been entered by the court against the debtor, such books also list creditors and debtors.
Examples of counties that provide such services online are Broward County, Florida, whose website can be viewed here (http://205.166.161.12/oncoreV2/Search.aspx) , and Denver County, Colorado, can be found here (http://www.denvergov.org/assessor/TheRealPropertySec tion/RealPropertySearch/tabid/442284/Default.aspx) .
If the creditor determines that the debtor has assets available, and the loan initially made was unsecured, there are a number of ways to proceed. The collection of a debt can be organized into three phases: prejudgment, judgment, and postjudgment (see Table 16.1). Each phase represents a unique opportunity to recover assets.
Table 16.1: Phases in a debt collection action
LAWSUIT FILED PREJUDGMENT JUDGMENT POSTJUDGMENT
The creditor �iles suit (a summons and complaint) in court (e.g., trial, small claims) against the debtor, who has defaulted on a loan.
After the lawsuit is �iled but before the actual trial takes place. No judgment has been awarded yet.
The lawsuit has been heard in court by a judge or jury, which has awarded money to the plaintiff/creditor.
The plaintiff/creditor has won the lawsuit and is seeking to collect the money from the debtor.
Prejudgment Remedies
You will recall from Chapters 2 (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/sec2.2#sec2.2) and 3 (http://content.thuzelearning.com/books/AUBUS670.12.2/sections/ch03#ch03) on litigation that to begin a civil lawsuit, the plaintiff �irst serves the defendant with the summons and complaint stating the cause of action. In a debt collection case, the papers would indicate that the plaintiff is suing for breach of contract on a debt. Once the papers are served, however, many years may go by before the case is actually heard in court. We refer to this phase as the prejudgment period because it occurs after the summons and complaint are �iled but before the case has actually gone to trial. Once the debtor receives the papers, his or her �irst reaction might be to hide, sell, or dispose of all his assets to keep them away from the creditor. Years later, when the creditor "wins" the lawsuit and turns around to collect money from the debtor, he or she might discover that all the debtor's money and assets have magically disappeared. The following prejudgment remedies are intended to protect the creditor from such an outcome.
The Writ of Attachment
One way to avoid the Case of the Missing Assets is through the use of a prejudgment tool called a writ of attachment. This is a statutory device to seize personal property or freeze �inancial assets before going to trial. Every state has its own rules for how to obtain a writ of attachment, but in general, these may involve giving the debtor notice of the lawsuit; going to court for a hearing; or the creditor posting a signi�icant bond and, if granted, having the sheriff seize speci�ic property. Some states allow a prejudgment writ of attachment without a hearing or notice to the debtor if the creditor can show that the debtor is likely to hide, destroy, or convert assets to another purpose. If the court grants the writ, the sheriff physically seizes the property and holds it, or has it held in a secure facility, so that in the event the plaintiff/creditor prevails in the lawsuit, there are some assets to sell to make the creditor whole.
A writ of attachment confers two obvious advantages:
1. There will be assets left at the end of trial; and
2. Tactically, if the writ involves the seizure of business assets (property the defendant needs to operate a business), the defendant may be eager to settle the lawsuit without going to court, encouraging resolution of the dispute much more quickly than waiting for a trial.
For example, suppose the debtor's assets are dump trucks. The plaintiff obtains a writ and the trucks are seized so that the debtor cannot operate his or her business. That debtor might be willing to arrange to pay the debt quickly in order to resume his or her livelihood. On the other hand, every situation has to
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be considered individually. If the debtor owns nothing but a radio and a broken-down car, the debtor will probably not care too much about getting them back, and retrieving these paltry assets certainly won't propel that person to seek a settlement. Note again the importance of gathering information about the value and type of assets in the defendant's name, because it indicates the value of pursuing this writ.
Writ of Garnishment/Levy on Earnings
Another remedy (also subject to state law) is a prejudgment writ of garnishment. The difference between garnishment and attachment is that in an attachment, the creditor goes after property of the defendant/debtor, whereas in a garnishment, the creditor goes after the property of a third party. For example, the creditor might seek money from the debtor's employer by having money deducted from the debtor's paycheck (called a levy on earnings). Some states make this remedy available only if there is no personal property to attach. For garnishment to be available as a remedy, states also require that the debtor/defendant must be employed and receive a regular paycheck.
A writ of garnishment involves three parties: the creditor, the debtor, and someone who controls the debtor's assets, such as the debtor's employer. The creditor seeks to take money directly out of the debtor's paycheck in order to pay the debt. This is a common procedure in child support cases, for example, where the state will garnish the debtor's paycheck for back payments. Likewise, a private creditor can pursue this remedy, if he or she follows the state law. There are four states (North Dakota, South Dakota, Texas, and Pennsylvania) that do not allow wage garnishment on such a "private debt." A sample writ of garnishment appears in Figure 16.1. (The phrase choses in action, which appears in this writ, means the right to bring a lawsuit to recover chattels, money, or a debt.)
Figure 16.1: Sample writ of garnishment
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Garnishment, like attachment, has limitations. These may include a court requirement for the creditor to post a signi�icant bond, and in some cases, the debtor may be given notice and the opportunity to show up at a hearing to defend against the procedure. On the positive side, the writ ensures that the creditor gets paid, but unfortunately, the payment occurs over a very long period of time. In addition, all the defendant has to do is quit his or her job, and garnishment will no longer be in force.
Judgment
If obtaining a writ of attachment or garnishment is too expensive or fails to recover any property, a creditor may have no alternative but to proceed to court to try to collect the debt. This will involve �iling a civil suit in which the creditor will have to convince the judge or jury (depending on whom the plaintiff decides to hear the case) by a preponderance of the evidence that the debtor does indeed owe the creditor the money. While litigants who are bringing a suit often think they have a guaranteed case, many are often surprised when a jury does not agree with them. Thus, to collect a debt by way of a judgment, not only must the debtor have assets, but the creditor must be willing to go to the expense of suing for those assets and actually win in court. If all these factors pan out in the creditor's favor, then the court will issue a judgment to the plaintiff/creditor. The judgment is �iled with the local court and, in some states, places an automatic lien on the defendant's real estate. Note that the judgment by itself is not a guarantee that the plaintiff will ever receive any money, however. Instead, the judgment is just the �irst step toward acquiring assets from the defendant in the postjudgment phase.
Postjudgment
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Once a judgment has been acquired, the creditor can place a lien against the defendant's property. A lien is a legal interest in property that is granted to the creditor until the debtor pays off the debt. A lien is "placed on property" by �iling paperwork with the clerk of the court where the property is located. The clerk will enter the information about the lien in a book (or online) so that anyone searching the defendant's name will see the lien. Thus, one will know that there is a problem with the defendant and his or her property in that a lien exists, the defendant has not paid on a debt, and the creditor has gone to the time and expense of pursuing the lien against the defendant in court.
By this phase, statistically speaking, the creditor has gone to extraordinary steps to try to collect on the debt. So for anyone seeing this information in the clerk's records, the lien by a creditor (other than the mortgagee) should act like a siren accompanied by a �lashing red light. If the debtor has a simple mortgage, by contrast (the most common type of lien against real property), this does not indicate credit problems unless the debtor has defaulted on the loan. At that time, the creditor (mortgagee) has the right under the mortgage to sell the house to pay off the debt owed, so there may be nothing left for the creditor seeking a judgment against the same debtor.
Judgment Liens
When a creditor takes a debtor to court and obtains a judgment, the creditor's next option is to �ile liens against the defendant's property. A lien does not pay the creditor any money. Instead, a lien gives the creditor rights in the property or the proceeds if the property is sold.
Depending on the state, a judgment lien may be �iled against either real or personal property, usually by �iling notice of the judgment with the local clerk of land records. For example, if the lien is against real property, then when the debtor tries to sell the house or land, the buyer will be informed by the buyer's attorney that there is a lien against the property that must �irst be paid before the title can transfer. If the buyer of the house is seeking a loan from a bank to purchase the property, the bank will not allow such a loan until the matter of the lien is cleared up. In this way, the creditor will eventually get paid. (Note, however, that if the property is never sold, or the debtor never tries to borrow more money from a bank, the lien can remain in effect inde�initely, without any payment to the creditor.)
Writs of Execution
It is also possible to place a lien on personal property, although this remedy is not as common as for real estate. To place a lien on personal property, commonly called a writ of execution, the creditor must �irst identify the property to the court. Depending on the state and the court, one common procedure is for the sheriff to seize the property for sale, with the proceeds going to pay off the debt owed to the creditor. The writ can cover property such as bank accounts, artwork, or, if a business is involved, a "till tap," which is the money in the cash register.
Fair Debt Collection Practices
A business involved in debt collection (or that outsources its debt collection functions to another �irm) has to be very careful not to violate the Fair Debt Collection Practices Act (FDCPA). If a business is attempting to collect a debt from a consumer or another business, this law mandates what actions are allowable and imposes strict liability on collectors. The purpose of the FDCPA, enacted in 1978 as Title VIII of the Consumer Credit Protection Act and amended in 2006, is to lessen abusive debt collection practices. For example, debt collectors are not allowed to threaten, intimidate, or harass debtors. Violations of the law may result in substantial �ines, and businesses engaged in debt collection should obtain legal advice about permissible behavior under the statute. For a sample video demonstrating illegal tactics used in debt collection, watch the ABC News coverage of "Outrageous Calls from Debt Collectors (http://www.youtube.com/watch?v=KJS9c0jgosQ&feature=related) ". For full text of the law, click here (http://www.law.cornell.edu/uscode/text/15/1692) .
The following case excerpts are an excellent example of what happens when employers fail to properly monitor their employees in how to carry out otherwise legal debt collections.
Cases to Consider: Smith v. Greystone Alliance LLC
Smith v. Greystone Alliance LLC, N.D.Ill. (2011)
I. Factual Background
***
On August 13, 2009, Greystone mailed Smith a collection letter concerning a credit card debt belonging to her that had been placed with Greystone for collection. That letter identi�ied Greystone as a "debt collector" and informed Smith that the letter was an attempt to collect a debt and that any information she provided would be used for that purpose.
The next day, a Greystone employee, Andre Garner, called Smith's residential telephone and left a voice message for her. In that message, Garner identi�ied himself by name and informed Smith that he represented Greystone. Garner did not, however, inform Smith that Greystone was a debt collector. Rather, he simply stated his name, his employer's name, provided a phone number, and asked her to return his call "in regards to a �ile that has been placed in [his] of�ice."
Shortly after leaving a message on Smith's home answering machine, Garner attempted to contact Smith at a telephone number ending in 2882. Garner was unable to reach Smith at the number and changed its status from unknown to bad. Garner then attempted to contact Smith at a telephone number ending in 7876. Garner left a message at the 7876–number. A few minutes later, Oneta Sampson, who was Smith's business partner, returned Garner's call. According to Sampson, she asked Garner why he had called. Garner informed Sampson that
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his call related to a personal matter. After learning the nature of his call, Sampson told Garner that he could not reach Smith, her business partner, at that number. According to Sampson, Garner retorted that Sampson should "know who [she is] doing business with." Moreover, Garner did not update Greystone's �iles to indicate that the 7876–number was not a number at which he could contact Smith. Instead, Garner added the 7876–number to Greystone's records.
Later that evening, Smith returned Garner's call. Garner discussed with Smith the debt Greystone was attempting to collect. According to Smith, Garner also informed her that he had spoken with Sampson about the debt and that she was not pleased. After Smith told Garner that she was not able to pay the debt at that time, Garner informed Smith that her account was being documented as a refusal to pay. On August 17, Smith twice called Greystone to speak with Garner. During the �irst call, Smith requested information so that she could send payments. After making the �irst call, Smith called back ten minutes later to request Garner's name and terminated the conversation after yelling at him.
The next day, August 18, another Greystone employee, Michael Raylea, left an automated message on Smith's residential answering machine. Raylea, like Garner, informed Smith of both his and Greystone's names, but did not inform her that Greystone was a debt collector. On August 21, Victoria Pearson left a message at the 7876–number. Pearson, like Raylea and Garner, informed Smith of her and Greystone's names, but did not inform her that Greystone was a debt collector. Sampson returned Pearson's call and again informed Greystone not to call that number in the future. Greystone continued to call Smith over the next several weeks. When it called, Greystone sometimes left an automated message, sometimes left no message, and sometimes had its employee leave a live voice message. Only the automated message identi�ied Greystone as a debt collector.
Greystone trains its employees regarding compliance with the FDCPA and its internal policies and procedures. Among other things, Greystone employees must pass a written examination regarding FDCPA requirements. To ensure compliance with the FDCPA and its internal policies, Greystone employs a Call Monitoring Program and Remedial Response Process. Pursuant to that policy, Greystone monitors a minimum of six calls per month made by each of its collectors and nine calls per month made during a collector's �irst month of employment. Greystone utilizes several scripts that its employees follow when leaving voice messages for debtors. From March 2009 to September 2009, Greystone required its employees to use the "Greystone Alliance Foti Message" when making a �irst attempt to contact a debtor and on any additional attempt to contact the debtor until a "right party contact" had been established. . . . The Foti Message Policy thus clearly directs employees to mention neither that the caller is calling on behalf of Greystone nor that Greystone is a debt collector once a right party contact has been established.
It is clear that none of the Greystone employees followed any of the scripts when contacting Smith. Moreover, it is also clear that although each of the employees identi�ied himself or herself as a Greystone employee, contrary to the direction in Greystone's Foti Message Policy for calls made after a "right party contact," none of the collectors ever explained to Smith that Greystone is a debt collector. Finally, it is clear that Greystone's Foti Message Policy does not require callers to identify Greystone as a debt collector after a "right party contact" is made.
Congress passed the FDCPA to curtail abusive debt-collection practices. The Act imposes strict liability on collectors, and a consumer need not show intentional or even negligent conduct by the debt collector to be entitled to damages. Section 1692e prohibits debt collectors from using "any false, deceptive, or misleading representation or means in connection with the collection of any debt." Among other things, § 1692e requires a debt collector to disclose in all communications other than formal pleadings made in connection with a legal action that the communication is from a debt collector. Smith claims that Greystone violated Section 1692e(11) of the FDCPA by leaving voice messages that do not disclose that the call is from a debt collector.
The test for whether a communication violates a provision of the FDCPA is an objective one. Id. For purposes of determining whether a communication from a debt collector violates § 1692e, prohibiting false, deceptive, or misleading representations, courts ask whether the communication would deceive or mislead an unsophisticated, but reasonable consumer. The state of mind of a reasonable debtor, therefore, is relevant. . . . In order to deceive or confuse the unsophisticated consumer, the false, misleading or deceptive statement must be material. The Seventh Circuit has held that FDCPA claims alleging deceptive or misleading statements fall into three categories: (1) statements that plainly on their face are not deceptive or misleading or where the false statement is immaterial; (2) statements that are not plainly misleading but extrinsic evidence, such as consumer surveys, might demonstrate that an unsophisticated consumer would be misled; (3) statements that are plainly misleading where extrinsic evidence is not necessary to prove what is already clear. This dispute, however, presents a wrinkle. Here, the alleged misleading statement is not a statement at all, but an omission.
Greystone �irst argues that it has adequately disclosed that it is a debt collector and therefore has not in fact violated § 1692e(11). Greystone suggests that it identi�ied itself as a debt collector in its initial communication and in subsequent communications identi�ied itself by name. Greystone suggests that because it clearly identi�ied itself as a debt collector in its initial communication that an unsophisticated consumer would not be deceived or mislead [sic] by any omission in its subsequent communication. In short, Greystone suggests that its omission falls into the �irst category of statements identi�ied in Ruth [a previous case serving as precedent in this case], suggesting that the communication is on its face not deceptive because it previously disclosed it is a debt collector.
Greystone's omission, however, is not like that made by the debt collector in Epps [another case serving as precedent in this case]. Unlike the communication in Epps, the context of Greystone's subsequent calls to Smith provided no clue as to its identity as a debt collector—none of the messages left by its employees referenced Smith's debt and Greystone's name did not imply that it was a collection agency. Instead,
6/30/2019 Print
https://content.ashford.edu/print/AUBUS670.12.2?sections=fm,copyright,author,ack,intro,unit01,ch01,sec1.1,sec1.2,sec1.3,ch01summary,ch02,s… 200/439
Greystone informed the consumer that it was a debt collector only in its initial dunning letter and asks the Court to conclude that the omission in its subsequent communications would not confuse or mislead the unsophisticated consumer.
. . . Section 1692e(11) requires certain disclosures in an initial communication to a consumer. It also requires similar, but less substantial, disclosures in subsequent communications, notwithstanding the fact that these disclosures were made previously in a collector's initial communication. 15 U.S.C. § 1692e(11). Under Greystone's theory, all a debt collector would ever have to do to comply with the "subsequent communications" prong of § 1692e(11) is to make the initial disclosures. That would effectively read the language requiring disclosures in subsequent communications out of the statute, which of course violates the most basic canons of statutory interpretation. The Court holds that making the disclosures required by § 1692e(11) in an initial communication does not relieve a debt collector from making the disclosures required by § 1692e(11) in subsequent communications.
Read the full text of the case here (http://docs.justia.com/cases/federal/district-courts/illinois/ilndce/ 1:2009cv05585/235280/104/) .
Questions to Consider
1. What was the problem with how some of Greystone's employees went about contacting Smith? What should they have done? What did they do incorrectly?
2. As a manager training employees to call delinquent debtors, what did this case teach you about what your employees should be saying to debtors? What did it teach you about the behavior of some employees?
3. Under the FDCPA, what is the standard imposed to show on debt collectors? What is the test for determining if debt collectors violated this act?
Congress has always been wary of debt collectors preying on unsuspecting debtors who may not be particularly savvy about protecting themselves. Thus, legislation like the Fair Debt Collections Practices Act exempli�ies a federal statute meant to protect consumers. Congress introduces the legislation by saying, "There is abundant evidence of the use of abusive, deceptive, and unfair debt collection practices by many debt collectors. Abusive debt collection practices contribute to the number of personal bankruptcies, to marital instability, to the loss of jobs, and to invasions of individual privacy" (15 U.S.C. § 1692).
