Module 6
Negotiable Instruments and Unincorporated Entities
A. Form and Content
Negotiable instruments, also referred to simply as instruments, include drafts,
checks, promissory notes, and certificates of deposit. These instruments are widely used
by individuals and businesses in paying for goods and services as well as in financing
numerous types of transactions. For a number of reasons, payment by noncash means is
preferable in many transactions and in the United States in 2012 totaled approximately
123 billion in number and $79 trillion in value. Noncash payments take two forms: paper
(checks and drafts) and electronic (debit cards, credit cards, automated clearinghouse
[ACH], prepaid cards, and online payment such as online banking and PayPal).
The starting point for an understanding of negotiable instruments is recognizing
that four or five centuries ago in England, a contract right to the payment of money was
not assignable because a contractual promise ran to the promisee. The fact that
performance could be rendered only to him constituted a hardship for the owner of the
right because it prevented him from selling or disposing of it. Eventually, however, the
law permitted recovery upon an assignment by the assignee against the obligor. An
innocent assignee bringing an action against the obligor was subject to all defenses
available to the obligor. Such an action would result in the same outcome whether it was
brought by the assignee or assignor. Thus, a contract right became assignable but not very
marketable because merchants had little interest in buying paper that may be subject to a
defense.
Negotiability invests negotiable instruments with a high degree of marketability
and commercial utility. It allows negotiable instruments to be freely transferable and
enforceable by a person with the rights of a holder in due course against any person
obligated on the instrument, subject only to a limited number of defenses. To illustrate,
assume that George sells and delivers goods to Elaine for $50,000 on sixty days’ credit
and that, a few days later, George assigns this account to Marsha. Unless Elaine is duly
notified of this assignment, she may safely pay the $50,000 to George on the due date
without incurring any liability to Marsha, the assignee. Assume next that the goods were
defective and that Elaine, accordingly, has a defense against George to the extent of
$20,000. Assume also that Marsha duly notified Elaine of the assignment. The result is
that Marsha can recover only $30,000, not $50,000, from Elaine because Elaine’s defense
against George is equally available against George’s assignee, Marsha. In other words, an
assignee of contractual rights merely “steps into the shoes” of her assignor and, hence,
acquires only the same rights as her assignor—and no more
A draft involves three parties, each in a distinct capacity. One party, the drawer,
orders a second party, the drawee, to pay a fixed amount of money to a third party, the
payee (see Figure 26-2). Thus, the drawer “draws” the draft on the drawee. The drawee is
ordinarily a person or an entity that either is in possession of money belonging to the
drawer or owes money to him. The same party may appear in more than one capacity; for
instance, the drawer may also be the payee.
A check is a specialized form of draft, namely, an order to pay money drawn on a
bank and payable on demand (i.e., upon the payee’s request for payment). Section 3-
104(f ). Once again, parties are involved in three distinct capacities: the drawer, who
orders the drawee, a bank, to pay the payee on demand. Checks are by far the most
widely used form of negotiable instruments. In 2012, the number of checks paid in the
United States was approximately 18.3 billion with a value of approximately $26 trillion.
An increasing number of checks are now converted into an electronic payment that is
processed through the ACH Network. In 2012, the percentage of checks converted to
ACH-based electronic payment had increased to 13 percent.
A promissory note is an instrument involving two parties in two capacities. One
party, the maker, promises to pay a second party, the payee, a stated sum of money, either
on demand or at a stated future date (see Figure 26-5). The note may range from a simple
“I promise to pay $X to the order of Y” form to more complex legal instruments such as
installment notes, collateral notes, mortgage notes, and judgment notes. Figure 26-6 is a
note payable at a definite time— six months from the date of April 7, 2017—and thus is
referred to as a time note. A note payable upon the request or demand of the payee or
holder is a demand note.
A note or certificate of deposit must be signed by the maker; a draft or check must
be signed by the drawer. As in the case of a writing, extreme latitude is granted in
determining what constitutes a signature, which is any symbol a party executes or adopts
with the present intention to authenticate a writing. Section 1-201(39). Revised Article 1
changes the word authenticate to adopt or accept. Revised Section 1-201(b)(37).
Moreover, it may consist of any word or mark used in place of a written signature,
Section 3-401(b), such as initials, an X, or a thumbprint. It may be a trade name or an
assumed name. Even the location of the signature on the document is unimportant.
Normally, a maker or drawer signs in the lower right corner of the instrument, but this is
not required. Negotiable instruments are frequently signed by an agent for her principal.
The requirement that the promise or order be unconditional is to prevent the
inclusion of any term that could reduce the promisor’s obligation to pay. Conditions
limiting a promise would diminish the payment and credit functions of negotiable
instruments by necessitating costly and time-consuming investigations to determine the
degree of risk such conditions imposed. Moreover, if the holder (transferee) had to take
an instrument subject to certain conditions, her risk factor would be substantial, and this
would lead to limited transferability. Substitutes for money must be capable of rapid
circulation at minimum risk.
A negotiable instrument must contain a promise or order to pay money, but it may
not “state any other undertaking or instruction by the person promising or ordering
payment to do any act in addition to the payment of money.” Section 3-104(a)(3).
Accordingly, an instrument containing an order or promise to do an act in addition to or
in lieu of the payment of money is not negotiable. For example, a promise to pay $100
“and a ton of coal” would be nonnegotiable.
A negotiable instrument must contain words indicating that the maker or drawer
intends that it may pass into the hands of someone other than the payee. Although the
“magic” words of negotiability typically are to the order of or to bearer, other clearly
equivalent words also may fulfill this requirement. The use of synonyms, however, only
invites trouble. Moreover, as noted above, indorsements cannot create or destroy
negotiability, which must be determined from the “face” of the instrument. Words of
negotiability must be present when the instrument is issued or first comes into possession
of a holder.
B. Transfer and Holder in Due Course
The primary advantage of negotiable instruments is their ease of transferability.
Nonetheless, although both negotiable instruments and nonnegotiable undertakings are
transferable by assignment, only negotiable instruments can result in the transferee
becoming a holder. This distinction is highly significant. If the transferee of a negotiable
instrument is entitled to payment by the terms of the instrument, he is a holder of the
instrument. Only holders may be holders in due course and thus may be entitled to greater
rights in the instrument than the transferor may have possessed. These rights, discussed in
the second part of this chapter, are the reason negotiable instruments move freely in the
marketplace.
Until the necessary indorsement has been supplied, the transferee has nothing
more than the contract rights of an assignee. Negotiation takes effect only when a proper
indorsement is made, at which time the transferee becomes a holder of the instrument.
Assume that a thief steals a paycheck from Poe prior to indorsement. The thief then
forges Poe’s signature and transfers the check to a grocer, who takes it in good faith, for
value, without notice, and without reason to question its authenticity. Negotiation of an
order instrument requires a valid indorsement by the person to whose order the
instrument is payable, in this case, Poe. A forged indorsement is not valid. Consequently,
the grocer had not taken the instrument with all necessary indorsements; therefore, he
could not be a holder or a holder in due course.
A blank indorsement, which specifies no indorsee, may consist solely of the
signature of the indorser or an authorized agent. Such an indorsement converts order
paper into bearer paper and leaves bearer paper as bearer paper. Thus, an instrument
indorsed in blank may be negotiated by delivery alone without further indorsement.
Hence, the holder should treat it with the same care as cash. In an unqualified
indorsement, indorsers promise that they will pay the instrument according to its terms at
the time of their indorsement to the holder or to any subsequent indorser who paid it.
Section 3-415(a). In short, an unqualified indorser guarantees payment of the instrument
if certain conditions are met.
The law requires a holder in due course to give value. An obvious case of the
failure to do so is when the holder makes a gift of the instrument to a third person. The
concept of value in the law of negotiable instruments is not the same as that of
consideration under the law of contracts. Value, for purposes of negotiable instruments, is
defined as (1) the actual performing of the agreed promise (executory promises are
excluded because they have not been performed), (2) the acquiring of a security interest
or other lien in the instrument other than a judicial lien, (3) the taking of the instrument in
payment of or as security for an antecedent debt, (4) the giving of a negotiable
instrument, and (5) the giving of an irrevocable obligation to a third party.
Revised Article 3 defines good faith as “honesty in fact and the observance of
reasonable commercial standards of fair dealing.” Section 3-103(4). Thus, Revised
Article 3 adopts a definition of good faith that has both a subjective and objective
component. (This is the same definition adopted by Revised Article 1.) The subjective
component (“honesty in fact”) measures good faith by what the purchaser knows or
believes. The objective component (“the observance of reasonable commercial standards
of fair dealing”) is comparable to the definition of good faith applicable to merchants
under Article 2 in that it includes the requirement of the observance of reasonable
commercial standards of fairness. Buying an instrument at a discounted price does not
demonstrate lack of good faith.
To be a holder in due course, the purchaser must take the instrument without
notice that it is overdue. This requirement is based on the idea that overdue paper
conveys a suspicion that something is wrong. Time paper is due on its stated due date if
the stated date is a business day or, if not, on the next business day. It “becomes overdue
on the day after the due date.” Section 3-304(b)(2). Thus, if an instrument is payable on
July 1, a purchaser cannot become a holder in due course by buying it on July 2, provided
that July 1 was a business day. In addition, in the case of an installment note or of several
notes issued as part of the same transaction with successive specified maturity dates, the
purchaser has notice that an instrument is overdue if he has reason to know that any part
of the principal amount is overdue or that there is an uncured default in payment of
another instrument of the same series.
Revised Article 3 provides that a party may become a holder in due course only if
the instrument issued or negotiated to the holder “does not bear such apparent evidence of
forgery or alteration or is not otherwise so irregular or incomplete as to call into question
its authenticity.” Section 3-302(a)(1). According to the comments to this section, the term
authenticity clarifies the idea that the irregularity or incompleteness must indicate that the
instrument may not be what it purports to be. The Revision takes the position that persons
who purchase such instruments do so at their own peril and should not be protected
against defenses of the obligor or claims of prior owners. In addition, the Revision takes
the position that it makes no difference if the holder does not have notice of such
irregularity or incompleteness; it depends only on whether the instrument’s defect is
apparent and whether the taker should have reason to know of the problem.
Through operation of the shelter rule, the transferee of an instrument acquires the
same rights in the instrument as the transferor had. Section 3-203(b). Therefore, even a
holder who does not comply fully with the requirements for being a holder in due course
nevertheless acquires all the rights of a holder in due course if some previous holder of
the instrument had been a holder in due course. For example, Prosser induces Mundheim,
by fraud in the inducement, to make a note payable to her order and then negotiates it to
Henn, a holder in due course. After the note is overdue, Henn gives it to Corbin, who has
notice of the fraud. Corbin is not a holder in due course, because he took the instrument
when overdue, did not pay value, and had notice of Mundheim’s defense. Nonetheless,
through the operation of the shelter rule, Corbin acquires Henn’s rights as a holder in due
course, and Mundheim cannot successfully assert his defense against Corbin. The
purpose of the shelter provision is not to benefit the transferee but to assure the holder in
due course of a free market for the negotiable instrument he acquires.
Defenses to an instrument may arise in many ways, either when the instrument is
issued or later. In general, the numerous defenses to liability on a negotiable instrument,
which are similar to those that may be raised in an action for breach of contract, are
available against any holder of the instrument unless she has the rights of a holder in due
course. Among the personal defenses are (1) lack of consideration; (2) failure of
consideration; (3) breach of contract; (4) fraud in the inducement; (5) illegality that does
not render the transaction void; (6) duress, undue influence, mistake, misrepresentation,
or incapacity that does not render the transaction void; (7) setoff or counterclaim; (8)
discharge of which the holder in due course does not have notice; (9) nondelivery of an
instrument, whether complete or incomplete; (10) unauthorized completion of an
incomplete instrument; (11) payment without obtaining surrender of the instrument; (12)
theft of a bearer instrument or of an instrument payable to him; and (13) lack of authority
of a corporate officer, agent, or partner as to the particular instrument, where such officer,
agent, or partner had general authority to issue negotiable paper for his principal or firm.
The preferential position enjoyed by a holder in due course has been severely
limited by a Federal Trade Commission (FTC) rule restricting the rights of a holder in
due course of an instrument concerning a debt arising out of a consumer credit contract,
which includes negotiable instruments. The rule, entitled “Preservation of Consumers’
Claims and Defenses,” applies to sellers and lessors of consumer goods, which are goods
for personal, household, or family use. It also applies to lenders who advance money to
finance a consumer’s purchase of consumer goods or services. The rule is intended to
prevent consumer purchase transactions from being financed in such a manner that the
purchaser is legally obligated to make full payment of the price to a third party, even
though the dealer from whom she bought the goods committed fraud or the goods were
defective. Such obligations arise when a purchaser executes and delivers to a seller a
negotiable instrument that the seller negotiates to a holder in due course. The buyer’s
defense that the goods were defective or that the seller committed fraud, although valid
against the seller, is not valid against the holder in due course.
C. Liability of Parties
The preceding chapters discussed the requirements of negotiability, the transfer of
negotiable instruments, and the preferred position of a holder in due course. When parties
issue negotiable instruments, they do so with the expectation that they, either directly or
indirectly, will satisfy their obligation under the instrument. Likewise, when a person
accepts, indorses, or transfers an instrument, he incurs liability for the instrument under
certain circumstances. This chapter examines the liability of parties arising out of
negotiable instruments and the ways in which liability may be terminated. Two types of
potential liability are associated with negotiable instruments: contractual liability and
warranty liability. The law imposes contractual liability on those who sign, or have a
representative agent sign, a negotiable instrument. Because some parties to a negotiable
instrument never sign it, they never assume contractual liability.
Primary liability means that a party is legally obligated to pay without the
holder’s having to resort first to another party. Indorsers of all instruments incur
secondary, or conditional, liability if the instrument is not paid. Secondary liability means
that a party is legally obligated to pay only after another party, who is expected to pay,
fails to do so. The liability of drawers of drafts and checks is also conditional because it is
generally contingent upon the drawee’s dishonor of the instrument. A drawee has no
liability on the instrument until he accepts it. An accommodation party signs the
instrument to lend her credit to another party to the instrument and is a direct beneficiary
of the value received.
A person is obligated by a signature on an instrument if the signature is her own
or if an agent with authority signs the instrument. Authorized agents often execute
negotiable instruments on behalf of their principals. The agent is not liable if she is
authorized to execute the instrument and does so properly (e.g., “Prince, principal, by
Adams, agent”). If these two conditions are met, then only the principal is liable on the
instrument.
An unauthorized signature, with two exceptions, is totally ineffective and does not
bind anybody. Unauthorized signatures include both forgeries and signatures made by an
agent without authority. Though generally not binding on the person whose name appears
on the instrument, the unauthorized signature is binding upon the unauthorized signer,
whether her own name appears on the instrument or not, to any person who in good faith
pays or gives value for the instrument. Section 3-403(a). Thus, if Adams, without
authority, signed Prince’s name to an instrument, Adams, not Prince, would be liable on
the instrument. The rule, therefore, is an exception to the principle that only those whose
names appear on a negotiable instrument can be liable on it.
There is a primary party on every note: the maker. The maker’s commitment is
unconditional. Section 3-412. No one, however, is unconditionally liable on a draft or
check as issued. A drawee is not liable on the instrument unless he accepts it. Section 3-
408. If, however, the drawee accepts the draft, after which he is known as the acceptor,
he becomes primarily liable on the instrument. Acceptance or, in the case of a check,
certification is the drawee’s signed promise to pay a draft as presented. Section 3-409(a),
(d). Presentment (i.e., a demand for payment) is not a condition to the holder’s right to
recover from parties with primary liability.
A drawee has no liability on the instrument until she accepts it, at which time she
becomes an acceptor and, like a maker, primarily liable. The acceptor becomes liable on
the draft according to its terms at the time of acceptance or as completed according to the
rules for incomplete instruments as discussed in Chapter 27. Section 3-413(a).
Nevertheless, if the acceptor does not state the amount accepted and the amount of the
draft is later raised, a subsequent holder in due course can enforce the instrument against
the acceptor according to the terms at the time the holder in due course took possession.
Section 3-413(b). Thus, an acceptor should always indicate on the instrument the amount
that it is accepting. The acceptor owes the obligation to pay to a person entitled to enforce
the instrument or to the drawer or an indorser who paid the draft under drawer’s or
indorser’s liability.
Parties with secondary (conditional) liability do not unconditionally promise to
pay the instrument; rather, they engage to pay the instrument if the party expected to pay
does not do so. The drawer is liable if the drawee dishonors the instrument. Indorsers
(including the payee if he indorses) of an instrument are also conditionally liable; their
liability is subject to the conditions of dishonor and notice of dishonor. If an instrument is
not paid by the party expected to pay and the conditions precedent to the liability of a
secondary party are satisfied, a secondary party is liable unless he has disclaimed his
liability or he possesses a valid defense to the instrument.
Conversion is a tort by which a person becomes liable in damages because of his
wrongful control over the personal property of another. The law applicable to conversion
of personal property applies to instruments. Section 3-420(a). An instrument is so
converted if the instrument “is taken by transfer, other than by negotiation, from a person
not entitled to enforce the instrument or a bank makes or obtains payment with respect to
the instrument for a person not entitled to enforce the instrument or receive payment.”
Section 3-420(a) (emphasis added). Examples of conversion thus would include a drawee
bank that pays an instrument containing a forged indorsement or a bank that pays an
instrument containing only one of two required indorsements.
Eventually, every commercial transaction must end, terminating the potential
liabilities of the parties to the instrument. The Code specifies the various methods by and
extent to which the liability of any party, primary or secondary, is discharged. Discharge
means that the obligated individual is released from liability on the instrument due to
either Article 3 or contract law. The Code also specifies when the liability of all parties is
discharged. No discharge of a party is effective against a subsequent holder in due course,
however, unless she has notice of the discharge when she takes the instrument. Section 3-
601(b). In addition, discharge of liability is not always final; liability under certain
circumstances (e.g., coming into possession of a subsequent holder in due course) can be
revived. Discharge applies to the individual and not the instrument, and discharge of
individuals may occur at different points in time. Moreover, a person’s liability may be
discharged with regard to one party but not to another.
Any person who transfers an instrument, whether by negotiation or assignment,
and receives consideration makes certain transferor’s warranties. Section 3-416. Any
consideration sufficient to support a contract will support transfer warranties. If transfer
is by delivery alone, warranties on transfer run only to the immediate transferee. If the
transfer is made by indorsement, whether qualified or unqualified, the transf warranty
runs to “any subsequent transferee.” Transfer means that the delivery of possession is
voluntary. Sections 3-201(a), 1-201(14). The warranties of the transferor are as follows.
Any person who transfers a negotiable instrument warrants that he has no
knowledge of any insolvency proceedings instituted with respect to the maker, acceptor,
or drawer of an unaccepted instrument. Section 3-416(a)(5). Insolvency proceedings
include bankruptcy and “any assignment for the benefit of creditors or other proceedings
intended to liquidate or rehabilitate the estate of the person involved.” Section 1-201(22).
Thus, if Marcia makes a note payable to bearer and the first holder, Taylor, negotiates it
for consideration without indorsement to Ursula, who then negotiates it for consideration
by qualified indorsement to Valerie, both Taylor and Ursula warrant that they do not
know that Marcia is in bankruptcy. Valerie could not hold Taylor liable for breach of
warranty, however, because Taylor’s warranty runs only in favor of her immediate
transferee, Ursula, because Taylor transferred the instrument without indorsement. If
Valerie could hold Ursula liable on her warranty, Ursula could thereupon hold Taylor,
her immediate transferor, liable.
Any party who pays or accepts an instrument must do so in strict compliance with
the orders that instrument contains. For example, the payment or acceptance must be
made to a person entitled to receive payment or acceptance, the amount paid or accepted
must be the correct amount, and the instrument must be genuine and unaltered. If the
payment or acceptance is incorrect, the payor or acceptor potentially will incur a loss. In
the case of a note, a maker who pays the wrong person will not be discharged from his
obligation to pay the correct person. If the maker pays too much, the excess comes out of
his pocket. If a drawee pays the wrong person, he generally cannot charge the drawer’s
account; if he pays too much, he generally cannot charge the drawer’s account for the
excess. Indorsers who pay an instrument may make similar incorrect payments.
In all instances other than a drawee of an unaccepted draft or uncertified check,
the only presentment warranty that is given is that the warrantor is a person entitled to
enforce the instrument or is authorized to obtain payment on behalf of the person entitled
to enforce the instrument. Section 3-417(d). This warranty is given by the person
obtaining payment and prior transferors and applies to the presentment of notes and
accepted drafts for the benefit of any party obliged to pay the instrument, including an
indorser. It also applies to presentment of dishonored drafts if made to the drawer or an
indorser. The warranties of no alteration and authenticity of the drawer’s signature are not
given to all other payors. These warranties are not necessary for makers and drawers
because they should know their own signature and the terms of their instruments.
Similarly, indorsers have already warranted the authenticity of signatures and that the
instrument was not altered. Finally, acceptors should know the terms of the instrument
when they accepted it; moreover, they did receive the full presentment warranties when
they as a drawee accepted the draft upon presentment.
D. Bank Deposits, Collections, and Funds Transfers
In twenty-first-century society, most goods and services are bought and sold
without a physical transfer of cash. In some sales, credit is extended by the seller or a
third party. In other sales, a noncash payment is made either by paper (checks and drafts)
or electronically (debit cards, credit cards, automated clearinghouse [ACH], and prepaid
cards). But even credit sales ultimately must be settled— when they are, payment is
frequently made by check. When a check is issued, if the parties to the transaction happen
to have accounts at the same bank, settlement of the check is easily accomplished. In the
vast majority of checks, however, the parties have accounts at different banks. In those
cases, the buyer’s check must journey from the seller-payee’s bank (the depositary bank),
where the check is deposited by the seller for credit to his account, and then to the
buyerdrawer’s bank (the payor bank) for payment. In this collection process, the check
frequently passes through one or more other banks (intermediary banks), each of which
must accurately record its passing before it may be collected. The U.S. banking system
has developed a network to handle the collection of checks and other instruments
When a person deposits a check in his bank (the depositary bank), the bank
credits his account by the amount of the check. This initial crediting is provisional.
Normally, a bank does not permit a customer to draw funds against a provisional credit;
by permitting its customer to thus draw, the bank will have given value and, provided it
meets the other requirements, will be a holder in due course. Under the customer’s
contract with his bank, the bank is obligated to make a reasonable effort to obtain
payment of all checks deposited for collection. When the amount of the check has been
collected from the payor bank (the drawee), the credit becomes a final credit.
A collecting bank is any bank, other than the payor bank, handling an item for
payment. In the usual situation where the depositary and payor banks are different, the
depositary bank gives a provisional credit to its customer, transfers the item to the next
bank in the chain, and receives a provisional credit or “settlement” from it; the process
repeats until the item reaches the payor bank, which gives a provisional settlement to its
transferor. When the item is paid, all the provisional settlements given by the respective
banks in the chain become final, and the particular transaction has been completed.
Because this procedure simplifies bookkeeping by necessitating only one entry if the item
is paid, no adjustment is necessary on the books of any of the banks involved. If,
however, the payor bank does not pay the check, it returns the item, and each
intermediary or collecting bank reverses the provisional settlement or credit it previously
gave to its forwarding bank. Ultimately, the depositary bank will charge (remove the
provisional credit from) the account of the customer who deposited the item. The
customer must then seek recovery from the indorsers or the drawer.
An item restrictively indorsed with words such as “pay any bank” is locked into
the bank collection system, and only a bank may acquire the rights of a holder. When
forwarding an item for collection, a bank normally indorses the item “pay any bank,”
regardless of the type of indorsement, if any, that the item carried at the time of receipt.
This protects the collecting bank by making it impossible for the item to stray from
regular collection channels.
The payor or drawee bank, under its contract of deposit with the drawer, agrees to
pay to the payee or his order a check issued by the drawer, provided that the order is not
countermanded and that there are sufficient funds in the drawer’s account. The
tremendous increase in volume of bank collections has necessitated deferred posting
procedures, whereby items are sorted and proved on the day of receipt but are not posted
to customers’ accounts or returned until the next banking day. The UCC not only
approves such procedures but also establishes specific standards to govern their
application to the actions of payor banks.
The relationship between a payor bank and its checking account customer is
primarily the product of their contractual arrangement. Although the parties have
relatively broad latitude in establishing the terms of their agreement and in altering the
provisions of the Code, a bank may not validly (1) disclaim responsibility for its lack of
good faith, (2) disclaim responsibility for its failure to exercise ordinary care, or (3) limit
its damages for a breach comprising such lack or failure. Section 4-103(a). The parties by
agreement, however, may determine the standards by which the bank’s responsibility is
to be measured, if these standards are not clearly unreasonable.
The Check Clearing for the 21st Century Act (also called Check 21 or the Check
Truncation Act) permits banks to truncate original checks, which means removing an
original paper check from the check collection or return process and sending in lieu of it
(1) a substitute check or, (2) by agreement, information relating to the original check
(including data taken from the MICR line of the original check or an electronic image of
the original check). The Act sets forth a statutory framework under which a substitute
check is the legal equivalent of an original check for all purposes if the substitute check
(1) accurately represents all of the information on the front and back of the original check
as of the time the original check was truncated and (2) bears the legend “This is a legal
copy of your check. You can use it the same way you would use the original check.” The
Act defines a substitute check as a paper reproduction of the original check that (1)
contains an image of the front and back of the original; (2) bears an MICR containing all
the information appearing on the MICR line of the original check; (3) conforms, in paper
stock, dimension, and otherwise, with generally applicable industry standards for
substitute checks; and (4) is suitable for automated processing in the same manner as the
original. Thus, a substitute check is basically a copy of the original check that shows both
the front and back of the original check.
If a payor bank pays an item over a stop payment order, after an account has been
closed, or otherwise in violation of its contract with the drawer or maker, the payor bank
is subrogated to (obtains) the rights of (1) any holder in due course on the item against
the drawer or maker, (2) the payee or any other holder against the drawer or maker, and
(3) the drawer or maker against the payee or any other holder. Section 4-407. For
instance, over the drawer’s stop payment order, a bank pays a check presented to the
bank by a holder in due course. The drawer’s defense is that the check was obtained by
fraud in the inducement. The drawee bank is subrogated to the rights of the holder in due
course, who would not be subject to the drawer’s personal defense, and thus can debit the
drawer’s account. Section 4-407(1). The same would be true if the presenter were the
payee, against whom the drawer did not have a valid defense.
The general rule is that death or incompetence revokes all agency agreements.
Furthermore, adjudication of incompetency by a court is regarded as notice to the world
of that fact. Actual notice is not required. Section 4-405 of the Code modifies these
stringent rules in several ways with respect to bank deposits and collections. First, if
either a payor or collecting bank does not know that a customer has been adjudicated
incompetent, the existence of such incompetence at the time an item is issued or its
collection is undertaken does not impair either bank’s authority to accept, pay, or collect
the item or to account for proceeds of its collection. The bank may pay the item without
incurring any liability. Second, neither death nor adjudication of incompetence of a
customer revokes a payor or collecting bank’s authority to accept, pay, or collect an item
until the bank knows of the condition and has a reasonable opportunity to act on this
knowledge. Finally, even though a bank knows of the death of its customer, it may for ten
days after the date of his death pay or certify checks drawn by the customer unless a
person claiming an interest in the account, such as an heir, executor, or administrator,
orders the bank to stop making such payments.
Although new EFTs may appear in the coming years, six main types of EFTs are
currently in use: (1) automated teller machines (ATMs), (2) point-of-sale systems (POS),
(3) direct deposit and withdrawal of funds, (4) pay-by-phone systems, (5) personal
computer (online) banking, and (6) wholesale EFTs.
Congress determined that the use of electronic systems to transfer funds provided
the potential for substantial benefits to consumers. Existing consumer protection
legislation failed to account for the unique characteristics of such systems, however,
leaving the rights and obligations of consumers and financial institutions undefined.
Accordingly, Congress enacted Title IX of the Consumer Protection Act, the EFTA, to
“provide a basic framework establishing the rights, liabilities, and responsibilities of
participants in electronic fund transfers” with primary emphasis on “the provision of
individual consumer rights.” Because the EFTA deals exclusively with the protection of
consumers, it does not govern electronic transfers between financial institutions, between
financial institutions and businesses, and between businesses. The Act is similar in many
respects to the Fair Credit Billing Act (see Chapter 41), which applies to credit card
transactions. The EFTA has been administered by the Board of Governors of the Federal
Reserve System, which is mandated to prescribe regulations to carry out the purposes of
the Act. Pursuant to this congressional mandate, the Federal Reserve has issued
Regulation E. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
(Dodd-Frank Act) transferred administration of the EFTA to the Consumer Financial
Protection Bureau (CFPB), an independent executive agency housed within the Federal
Reserve.
The EFTA is primarily a disclosure statute and as such requires that the terms and
conditions of EFTs involving a consumer’s account be disclosed in readily
understandable language at the time the consumer contracts for such services. Included
among the required disclosure are the consumer’s liability for unauthorized transfers, the
kinds of EFTs allowed, the charges for transfers or for the right to make transfers, the
consumer’s right to stop payment of preauthorized EFTs, the consumer’s right to receive
documentation of EFTs, rules concerning disclosure of information to third parties,
procedures for correcting account errors, and the financial institution’s liability to the
consumer under the Act.
A consumer’s liability for an unauthorized EFT is limited to a maximum of $50 if
the consumer notifies the financial institution within two days after he learns of the loss
or theft. If the consumer does not report the loss or theft within two days, he is liable for
losses up to $500 but no more than $50 for the first two days. If the consumer fails to
report the unauthorized use within sixty days of transmittal of a periodic statement, he is
liable for losses resulting from any unauthorized EFT that appeared on the statement if
the financial institution can show that the loss would not have occurred had the consumer
reported the loss within sixty days; thus, there is unlimited liability on unauthorized
transfers made after sixty days following the bank’s sending the periodic statement.
Rights and obligations arise as a result of a receiving bank’s acceptance of a
payment order. The effect of acceptance depends upon whether the payment order was
issued to the beneficiary’s bank or to a receiving bank other than the beneficiary’s bank.
If a receiving bank is not the beneficiary’s bank, the receiving bank does not subject itself
to any liability until it accepts the instrument. Acceptance by a receiving bank other than
the beneficiary’s bank occurs when the receiving bank executes the sender’s order.
Section 4A-209(a). Such execution occurs when the receiving bank “issues a payment
order intended to carry out” the sender’s payment order. Section 4A-301(a). When the
receiving bank executes the sender’s payment order, the bank is entitled to payment from
the sender and can debit the sender’s account.
E. Formation and Internal Relations of General Partnerships
A business enterprise may be operated or conducted as a sole proprietorship, an
unincorporated business association (such as a general partnership, a limited partnership,
a limited liability company, or a limited liability partnership), or a corporation. The
choice of the most appropriate form cannot be determined in a general way but depends
on the particular circumstances of the owners. We begin this chapter with a brief
overview of the various types of business associations and the factors that are relevant to
deciding which form to use. The rest of this chapter and the next chapter will examine
general partnerships.
In choosing the form in which to conduct business, the owners should consider a
number of factors, including ease of formation, Federal and State income tax laws,
external liability, management and control, transferability of ownership interests, and
continuity. The relative importance of each factor will vary with the specific needs and
objectives of the owners. In addition, for multinational enterprises (entities that transact
business across national boundaries), a number of considerations determine which form
of business organization is best to use in conducting international transactions. These
factors include financing, tax consequences, legal restrictions imposed by the host
country, and the degree to which the multinational enterprise wishes to control the
business.
Most business entities are not considered to be separate taxable entities, and
taxation is on a “pass-through” basis. In these cases, the income of the business is
conclusively presumed to have been distributed to the owners, who must pay taxes on
that income. Losses receive comparable treatment and can be used to offset some of the
owners’ income. Passthrough tax treatment results in only the owners being taxed and
thus avoids double taxation on the business income. In the United States, approximately
95 percent of all business entities are taxed on a pass-through basis.
An ownership interest in a business consists of a financial interest, which is the
right to share in the profits of the business, and a management interest, which is the right
to participate in control of the business. In some types of business associations, the
owners may freely transfer their financial interest but may not transfer their management
interest without the consent of all of the other owners. In other types of business
associations, the entire ownership interest is freely transferable.
A limited partnership is an unincorporated business association consisting of at
least one general partner and at least one limited partner. It is formed by filing a
certificate of limited partnership with the State. A limited partnership may elect not to be
a separate taxable entity, in which case only the partners are taxed. Publicly traded
limited partnerships, however, are subject to corporate income taxation. General partners
have unlimited liability for the partnership’s debts; limited partners have limited liability.
Each general partner has an equal right to control of the partnership; limited partners have
no right to participate in control. Partners may assign their financial interest in the
partnership, but the assignee may become a limited partner only if all of the members
consent. The death, bankruptcy, or withdrawal of a general partner dissolves a limited
partnership; the limited partners have neither the right nor the power to dissolve the
limited partnership.
A corporation is a legal entity separate and distinct from its owners. It is formed
by filing its articles of incorporation with the chosen State of incorporation. Some
corporations are taxed as separate entities, and shareholders also are taxed on corporate
earnings that are distributed to them. Most corporations, however, are eligible to elect to
be taxed as Subchapter S corporations, which results in only the shareholders being taxed
and thus avoids double taxation on corporate income. More than 70 percent of all
corporations are taxed as Subchapter S corporations. The shareholders have limited
liability for the corporation’s obligations. The board of directors elected by the
shareholders manages the corporation. Shares in a corporation are freely transferable. The
death, bankruptcy, or withdrawal of a shareholder does not dissolve the corporation.
The business trust, sometimes called a Massachusetts trust, was devised to avoid
the burdens of corporate regulation, particularly the formerly widespread prohibition
denying to corporations the power to own and deal in real estate. The business trust is
used in the twenty-first century primarily for asset securitization ventures in which
income-generating assets, such as mortgages, are pooled in a trust. Like an ordinary trust
between natural persons, a business trust may be created by a voluntary agreement
without any authorization or consent of the State. A business trust has three
distinguishing characteristics: (1) the trust estate is devoted to the conduct of a business;
(2) by the terms of the agreement, each beneficiary is entitled to a certificate evidencing
his ownership of a beneficial interest in the trust, which he is free to sell or otherwise
transfer; and (3) the trustees have the exclusive right to manage and control the business
free from control of the beneficiaries.
In 1914, the Uniform Law Commission (ULC), which is also known as the
National Conference of Commissioners on Uniform State Laws, promulgated the
Uniform Partnership Act (UPA). Since then, it had been adopted in all States (except
Louisiana) as well as by the District of Columbia, the Virgin Islands, and Guam. In
August 1986, the ULC and the UPA Revision Subcommittee of the Committee on
Partnerships and Unincorporated Business Organizations of the American Bar
Association’s Section of Corporation, Banking, and Business Law decided to undertake a
complete revision of the UPA. The revision was approved in 1997 and was amended in
2011 and 2013 as part of the Harmonization of Business Entity Acts project. These
amendments harmonize the language in the 1997 Revised Act with the language of
similar provisions in the other uniform unincorporated entity acts and make additional
updates. At least thirty-seven States have adopted the 1997 Revised Act. This chapter
discusses the 1997 Revised Uniform Partnership Act, or RUPA. Where the RUPA has
made significant changes, the original 1914 UPA also is discussed. (References to
provisions of the RUPA state the section number only; references to the original UPA
include the “UPA” designation.) The chapter summary reflects the RUPA. Though fairly
comprehensive, the RUPA and UPA do not cover all legal issues concerning
partnerships. Accordingly, both the RUPA (Section 104) and the UPA (Section 5)
provide that unless displaced by particular provisions of the Partnership Act, the
principles of law and equity supplement the Partnership Act.
RUPA Section 202 provides that the association of two or more persons to carry
on as co-owners a business for profit forms a partnership, whether or not the parties
intend to form a partnership. The formation of a partnership is relatively simple and may
be done consciously or unconsciously. A partnership may result from an oral or written
agreement between the parties; from an informal arrangement; or from the conduct of the
parties, who become partners by associating themselves in a business as co-owners.
Consequently, if two or more individuals share the control and profits of a business, the
law may deem them partners without regard to how they themselves characterize their
relationship. Thus, associates frequently discover, to their chagrin, that they have
inadvertently formed a partnership and have thereby subjected themselves to the duties
and liabilities of partners. The legal existence of the relationship depends merely upon the
parties’ explicit or implicit agreement and their association in business as co-owners.
Partnership property is property acquired by a partnership. Section 203. Property
acquired by the partnership is conclusively deemed to be partnership property. Property
becomes partnership property if acquired in the name of the partnership, which includes a
transfer to (1) the partnership in its name or (2) one or more partners in their capacity as
partners in the partnership, if the name of the partnership is indicated in the instrument
transferring title to the property. Section 204. Property also may be partnership property
even if it is not acquired in the name of the partnership. Property is partnership property
if acquired in the name of one or more of the partners with an indication in the instrument
transferring title of either (1) their capacity as partners or (2) the existence of a
partnership, even if the name of the partnership is not indicated.
The principal legal duties imposed upon partners in their relations with one
another are (1) the fiduciary duty (the duty of loyalty), (2) the duty of obedience, and (3)
the duty of care. In addition, each partner has a duty to inform his copartners and a duty
to account to the partnership. (These additional duties are discussed later, in a section
covering the rights of partners.) All of these duties correspond precisely with those duties
owed by an agent to his principal and reflect the fact that much of the law of partnership
is the law of agency.
A partner owes his partners a duty to act in obedience to the partnership
agreement and to any business decisions properly made by the partnership. Any partner
who violates this duty is liable individually to his partners for any resulting loss. For
example, a partner who, in violation of a specific agreement not to extend credit to
relatives, advances money from partnership funds and sells goods on credit to an
insolvent relative would be held personally liable to his partners for the unpaid debt.
A distribution is a transfer of money or other partnership property from the
partnership to a partner in the partner’s capacity as a partner. Section 101(3).
Distributions include a division of profits, a return of capital contributions, a repayment
of a loan or advance made by a partner to the partnership, and a payment made to
compensate a partner for services rendered to the partnership. The RUPA’s rules
regarding distribution are subject to contrary agreement of the partners. Section 103. A
partner has no right to receive, and may not be required to accept, a distribution in kind.
Section 402. The RUPA provides that each partner is deemed to have an account that is
credited with the partner’s contributions and share of the partnership profits and charged
with distributions to the partner and the partner’s share of partnership losses.
Each of the partners, unless otherwise agreed, has equal rights in the management
and conduct of the partnership business. Section 401(f ). The majority governs the actions
and decisions of the partnership with respect to matters in the ordinary course of
partnership business. Section 401(j). All the partners must consent to any act outside the
ordinary course of partnership business and to any amendment of the partnership
agreement. Section 401(j). In their partnership agreement, the partners may provide for
unequal voting rights. For example, Jones, Smith, and Williams form a partnership,
agreeing that Jones will have two votes, Smith four votes, and Williams five votes. Large
partnerships commonly concentrate most or all management authority in a committee of a
few partners or even in just one partner. Classes of partners with different management
rights also may be created. This practice is common in accounting and law firms, which
may have two classes (e.g., junior and senior partners) or three classes (e.g., junior,
senior, and managing partners).
F. Operation and Dissolution of General Partnerships
The operation and management of a general partnership involve interactions
among the partners as well as their interactions with third persons. The previous chapter
covered the rights and duties of the partners among themselves. The first part of this
chapter focuses on the relations among the partnership, the partners, and third persons
who deal with the partnership. These relations are governed by the laws of agency,
contracts, and torts as well as by the partnership statute. The second part of the chapter
addresses the dissociation and dissolution of general partnerships.
The act of every partner binds the partnership to transactions within the scope of
the partnership business unless the partner does not have actual or apparent authority to
so act. If the partnership is bound, then each general partner has unlimited, personal
liability for that partnership obligation unless the partnership is a limited liability
partnership (LLP) and the LLP statute shields contract obligations. Under the Revised
Act, the partners are jointly and severally liable for all contract obligations of the
partnership. Section 306(a). Joint and several liability means that all of the partners may
be sued jointly in one action or that separate actions, leading to separate judgments, may
be maintained against each of them. Judgments obtained are enforceable, however,
against property of only the defendant or defendants named in the suit, and payment of
any one of the judgments satisfies all of them.
Partnership by estoppel imposes partnership duties and liabilities upon a
nonpartner who has either represented himself or consented to be represented as a
partner. It extends to a third person to whom such a representation is made and who
justifiably relies upon the representation. Section 308(a). For example, Marks and
Saunders are partners doing business as Marks and Company. Marks introduces Patterson
to Taylor, describing Patterson as a member of the partnership. Patterson verbally
confirms the statement made by Marks. Believing that Patterson is a member of the
partnership and relying upon Patterson’s good credit standing, Taylor sells goods on
credit to Marks and Company. In an action by Taylor against Marks, Saunders, and
Patterson as partners to recover the price of the goods, Patterson is liable although he is
not a partner in Marks and Company. Taylor had justifiably relied upon the
representation that Patterson was a partner in Marks and Company, to which Patterson
actually consented. If, however, Taylor had known at the time of the sale that Patterson
was not a partner, his reliance on the representation would not have been justified, and
Patterson would not be liable.
A person admitted as a partner into an existing partnership is not personally liable
for any partnership obligations incurred before the person’s admission as a partner.
Section 306(b). This means that the liability of an incoming partner for antecedent debts
and obligations of the firm is limited to his capital contribution. This restriction does not
apply, of course, to subsequent debts (obligations arising after his admission into the
partnership), for which obligations his liability is unlimited. For example, Nash is
admitted to Higgins, Cooke, and Jackson Co., a partnership. Nash’s capital contribution
is $7,500, which she paid in cash upon her admission to the partnership. A year later,
when liabilities of the firm exceed its assets by $40,000, the partnership is dissolved.
Porter had lent the firm $15,000 eight months before Nash was admitted; Skinner lent the
firm $20,000 two months after Nash was admitted. Nash has no liability to Porter except
to the extent of her capital contribution, but she is personally liable to Skinner.
Dissociation occurs when a partner ceases to be associated in the carrying on of the
business. A number of events that were considered causes of dissociation or dissolution
under the common law are no longer considered so under the RUPA. For example, the
assignment of a partner’s interest, a creditor’s charging order on a partner’s interest, and
an accounting are not considered a dissociation or dissolution.
A partner’s dissociation is wrongful if it breaches an express provision of the
partnership agreement. In addition, dissociation is wrongful in a term partnership if
before the expiration of the term or the completion of the undertaking (1) the partner
voluntarily withdraws by express will unless the withdrawal follows within ninety days
after another partner’s dissociation by death, bankruptcy, or wrongful dissociation; (2)
the partner is expelled for misconduct by judicial determination; (3) the partner becomes
a debtor in bankruptcy; or (4) the partner is an entity (other than a trust or estate) and is
expelled or otherwise dissociated because its dissolution or termination was willful.
Section 602(b). A term partnership is a partnership for a specific term or particular
undertaking. The partnership agreement may eliminate or expand the dissociations that
are wrongful or modify the effects of wrongful dissociation, except for the power of a
court to expel a partner for misconduct.
pate in the management and conduct of the partnership business terminates.
Section 603(b). If, however, the dissociation results in a dissolution and winding up of
the business, all of the partners who have not wrongfully dissociated may participate in
winding up the business. Section 804(a). The duty not to compete terminates upon
dissociation, and the dissociated partner may immediately engage in a competitive
business, without any further consent. The partner’s other fiduciary duties and duty of
care continue only with regard to matters arising and events occurring before the
partner’s dissociation, unless the partner participates in winding up the partnership’s
business. For example, a partner who leaves a partnership providing consulting services
may immediately compete with the firm for new clients, but must exercise care in
completing current transactions with clients and must account to the firm for any fees
received from the old clients on account of those transactions.
Dissolution refers to those situations in which the Revised Act requires a
partnership to wind up and terminate. In accordance with the Revised Act’s emphasis on
the entity treatment of partnerships, only a limited subset of dissociations requires the
dissolution of a partnership. In addition, some events other than dissociation can bring
about the dissolution of a partnership under RUPA. The following sections discuss the
causes and effects of dissolution.
The basic rule under the RUPA is that a partnership is dissolved and its business
must be wound up only if one of the events listed in Section 801 occurs. The events
causing dissolution may be brought about by (1) an act of the partners (i.e., some
dissociations), (2) operation of law, or (3) court order. The provisions of Section 801 that
involve an act of the parties are default provisions: the partners may by agreement modify
or eliminate these grounds. The partners may not vary or eliminate the grounds for
dissolution based on operation of law or court order.
A partnership continues after dissolution only for the purpose of winding up its
business. The partnership is terminated when the winding up of its business is completed.
Section 802. The remaining partners have the right, however, to continue the business
after dissolution if all of the partners, including any dissociating partner other than a
wrongfully dissociating partner, waive the right to have the partnership’s business wound
up and the partnership terminated. Section 802(b). In that event, the partnership resumes
carrying on its business as if dissolution had not occurred.
As mentioned, the RUPA uses the term dissociation instead of the UPA term
dissolution to denote the change in the relationship caused by a partner’s ceasing to be
associated in the carrying on of the business. Under the RUPA, a dissociation of a partner
results in dissolution only in limited circumstances, discussed previously. Thus, in many
instances, dissociation will result merely in a buyout of the withdrawing partner’s interest
rather than a winding up of the partnership.
In a term partnership, if within ninety days after any specified cause of dissolution
occurs fewer than half of the remaining partners express their will to wind up the
partnership business, then the partnership will not dissolve. These causes include the
following: a partner’s dissociation by death, bankruptcy, or incapacity; the distribution by
a trust-partner of its entire partnership interest; the termination of an entitypartner; or a
partner’s wrongful dissociation. (A wrongful dissociation includes a partner’s voluntary
withdrawal in violation of the partnership agreement and the judicial expulsion of a
partner.)
A partner’s dissociation does not of itself discharge the partner’s liability for a
partnership obligation incurred before dissociation. Section 703(a). A dissociated partner
is not liable for a partnership obligation incurred more than two years after dissociation.
For partnership obligations incurred within two years after a partner dissociates without
resulting in a dissolution of the partnership business, a dissociated partner is liable for a
partnership obligation if, at the time of entering into the transaction, the other party (1)
reasonably believed that the dissociated partner was then a partner, (2) did not have
notice of the partner’s dissociation, and (3) is not deemed to have had constructive notice
from a filed statement of dissociation.
Dissolution may be brought about by (1) an act of the partners, (2) operation of
law, or (3) court order. UPA Section 31. Because a partnership is a personal relationship,
a partner always has the power to dissolve it by his actions, but whether he has the right
to do so is determined by the partnership agreement. A partnership is dissolved by
operation of law upon (1) the death of a partner, (2) the bankruptcy of a partner or of the
partnership, or (3) the subsequent illegality of the partnership. A court-ordered
dissolution may be sought by a partner, an assignee of a partner’s interest, or a partner’s
personal creditor who has obtained a charging order against the partner’s interest.
Whenever a dissolved partnership is not to be continued, the partnership must be
liquidated. The process of liquidation, called winding up, involves completing unfinished
business, collecting debts, taking inventory, reducing assets to cash, auditing the
partnership books, paying creditors, and distributing the remaining assets to the partners.
During this period, the fiduciary duties of the partners continue in effect. Dissolution
produces one of two outcomes: either the partnership is liquidated or the remaining
partners continue the partnership. Whereas liquidation sacrifices the value of a going
concern, continuation of the partnership after dissolution avoids this loss. The UPA,
nonetheless, gives each partner the right to have the partnership liquidated except in a
few instances in which the remaining partners have the right to continue the partnership.
G. Limited Partnerships and Limited Liability Companies
The limited partnership has proved to be an attractive vehicle for a variety of
investments because of its tax advantages and the limited liability it confers upon limited
partners. Unlike general partnerships, limited partnerships are statutory creations. Before
1976, the governing statute in all States except Louisiana was the Uniform Limited
Partnership Act (ULPA), which was promulgated in 1916. At that time, most limited
partnerships were small and had only a few limited partners. But over time, limited
partnerships became much larger, typically involving a small number of major investors
and a relatively large group of widely distributed investors who purchase limited
partnership interests. This type of organization has evolved to attract substantial amounts
of investment capital. As a result, limited partnerships have been used to muster the
sizable investments necessary in areas such as real estate, oil and gas, motion pictures,
professional sports, and research and development. The large-scale and multistate
operations of the modern limited partnership, however, have severely burdened the
framework established by the ULPA.
A limited partnership is a partnership formed by two or more persons under the
laws of a State and having one or more general partners and one or more limited partners.
Section 101(7). A person includes a natural person, partnership, limited partnership, trust,
estate, association, or corporation. Although the formation of a general partnership calls
for no special procedures, the formation of a limited partnership requires substantial
compliance with the limited partnership statute. Failure to so comply may result in the
limited partners’ not obtaining limited liability.
Because limited partnerships are organized pursuant to statute, the rights of the
parties are usually set forth in the certificate of limited partnership and the limited
partnership agreement. Unless otherwise agreed or provided in the Act, a general partner
of a limited partnership has all the rights and powers of a partner in a partnership without
limited partners. Section 403. A general partner also may be a limited partner; as such, he
shares in profits, losses, and distributions both as a general partner and as a limited one.
A limited liability company (LLC) is another form of unincorporated business
association. Prior to 1990, only two States had statutes permitting LLCs. By 1996, all
States had enacted LLC statutes. Since then, many States have amended or revised their
LLC statutes. Until 1995, there was no uniform statute on which States might base their
LLC legislation, and since its promulgation, twelve States have adopted the Uniform
Limited Liability Company Act (ULLCA), which was amended in 1996. In 2006, the
Revised ULLCA was completed and at least fourteen States have adopted it. (In 2011 and
2013, the 2006 Revised ULLCA was amended as part of the Harmonization of Business
Entity Acts project. These amendments coordinate the language in the 2006 Revised
ULLCA with the language of similar provisions in the other uniform and model
unincorporated entity acts.) Therefore, LLC statutes vary from State to State with respect
to such matters as LLC management, admission and withdrawal of members, power of
members and managers to bind the LLC, duties imposed on managers and members, and
the LLC’s right to merge with other business entities. Nevertheless, the LLC statutes
generally share certain characteristics.
The formation of an LLC requires substantial compliance with a State’s LLC
statute. All States permit an LLC to have only one member. Once formed, an LLC is a
separate legal entity that is distinct from its members, who are normally not liable for its
debts and obligations. An LLC can contract in its own name and is generally permitted to
carry on any lawful purpose, although some statutes restrict the permissible activities of
LLCs.
As with general partnerships and limited partnerships, the duties of care and
loyalty also apply to LLCs. In most States, the LLC statute expressly imposes these
duties. In other States, the common law imposes these duties. Many statutes also
expressly impose an obligation of good faith and fair dealing. Who has these duties in an
LLC depends upon whether the LLC is a manager-managed LLC (analogous to a limited
partnership) or a member-managed LLC (analogous to a partnership).
All of the States have enacted statutes enabling the formation of limited liability
partnerships (LLPs). Until 1997, there was no uniform LLP statute, so the enabling
statutes vary from State to State. In 1997, the Revised Uniform Partnership Act (RUPA)
was amended to add provisions enabling general partnerships to elect to become LLPs,
and more than thirty States have adopted this version of the RUPA. A registered limited
liability partnership is a general partnership that, by making the statutorily required filing,
limits the liability of its partners for some or all of the partnership’s obligations. A limited
liability limited partnership (LLLP) is a limited partnership in which the liability of the
general partners has been limited to the same extent as in an LLP. About half of the
States allow limited partnerships to become LLLPs. Some States have statutes expressly
providing for LLLPs. In other States, by operation of the provision in the RULPA that a
general partner in a limited partnership assumes the liabilities of a general partner in a
general partnership, the LLP statute may provide limited liability to general partners in a
limited partnership that registers as an LLLP under the LLP statute. Where authorized,
the general partners in an LLLP will obtain the same degree of liability limitation that
general partners can achieve in LLPs. Where available, a limited partnership may register
as an LLLP without having to form a new organization, as would be the case in
converting to an LLC
