Bus 311 Business Law
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Chapter Overview
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10.1 Requirements for Commercial Paper
10.2 Parties to Commercial Paper
10.3 Types of Commercial Paper • Note • Draft • Check • Certificate of Deposit (CD)
10.4 Holder in Due Course
10.5 Characteristics of Negotiable Instruments
10.6 Negotiation and Indorsers’ Liability • Types of Indorsements (§§ 3-204–3-205) • Liability of Indorsers (§§ 3-415, 3-501) • Warranties of Presentment and Transfer (§ 3-417)
10.7 Chapter Summary • Focus on Ethics • Case Study: Seigel v. Merrill Lynch, Pierce,
Fenner & Smith • Case Study: Atlantic National Trust, LLC v. McNamee • Critical Thinking Questions • Hypothetical Case Problems • Key Terms
10 Learning Objectives
After studying this chapter, you will be able to:
1. Name the necessary criteria for defining commercial paper.
2. Define and distinguish between notes, drafts, checks, and certificates of deposit.
3. Define the term “holder in due course” and explain the significance of this status.
4. Explain the difference between blank, special, and restrictive indorsements.
Commercial Paper
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CHAPTER 10Section 10.1 Requirements for Commercial Paper
Money has been used as a medium of exchange for more than 4,000 years. The exchange of hard currency for goods and services facilitates commerce, but there are many circumstances in which doing business on a cash basis is inconvenient or impossible.
Consider the sale of an office building for $50 million. In hundred dollar bills, the pay- ment would take up about the same space as 25 boxed washing machines. It is unlikely either buyer or seller would want to lug that around, or that a bank would want to count it out. And of course there would be major security issues with such a large cash transaction.
One way to avoid the problems of transferring large sums of money is to deal on a credit basis: the buyer could give the seller an I.O.U. that the seller could collect on at his conve- nience. While much business is carried out on a credit basis, most sellers prefer something more substantial than a simple I.O.U. that may or may not be paid upon demand. The solution is often commercial paper, which is a contract to pay money. There are a number of different types that function as good substitutes for cash and facilitate business transac- tions. They are transferable and can easily be exchanged for cash, and are the subject of Article 3 of the Uniform Commercial Code.
What distinguishes these instruments from other valid instruments that evidence debt, such as a simple I.O.U., is that negotiable instruments can give special protection to par- ties who accept them in the regular course of business. This makes them readily acceptable as substitutes for cash in business transactions. When an instrument is negotiated (trans- ferred from one person to another for value), the person who receives the instrument in good faith and gives consideration in return for its acceptance, and all others with whom that person may subsequently negotiate the instrument, receive certain legal protections that make it fairly safe to accept the instrument as a substitute for cash.
10.1 Requirements for Commercial Paper
Commercial paper consists of four types of written instruments: drafts, checks, cer-tificates of deposit, and notes. Each will be examined in turn in the discussion that follows. Section 3-104 of the UCC sets up the criteria that negotiable instruments must meet. All negotiable instruments must:
1. Be in writing. But the writing need not be in any official form, and it need not even be on paper. If you choose to pay your taxes by writing a check for the amount on a shirt (to demonstrate that the government is literally taking the shirt off your back!), the IRS will be able to cash it.
2. Be signed by the maker or drawer (the person writing the instrument). A signature is simply any mark that the issuer intends to represent a signature. An X, initials, or a full autograph can all qualify.
3. Contain an unconditional promise to pay a sum certain in money. “I will pay $50,000 for the yacht Aurealis” or “Sierra promises to pay Rachel $50,000” would qualify. “I will pay $50,000 for the Aurealis as long as the yacht is in good condition” or “I owe Rachel $50,000” would not qualify as an unconditional promise. A prom- ise such as “I will pay Rachel $50,000 worth of precious metals” also does not qualify, because it is not a promise to pay money.
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CHAPTER 10Section 10.1 Requirements for Commercial Paper
4. Contain no other promise, order, obligation, or power not specifically authorized by the UCC.
5. Be payable on demand or at a specific time. “I promise to pay $50,000 June 1, 2014” qualifies. So does “I promise to pay $50,000 to Sierra when she wants it,” which is a demand term. But “I promise to pay $50,000 to Sierra when she finally graduates from college” is not, because Sierra’s graduation date is uncertain (for example, what if she flunks Business Law?!)
6. Be payable to order or bearer. A negotiable instrument must be either order paper, which means it includes the words “pay to the order of,” or bearer paper, which means it either specifies pay to “bearer,” or is not made out to a specific person (pay to the order of cash, for example).
If an instrument does not meet each of the above criteria, it is not a negotiable instrument. An instrument may fail to meet the requirements for a negotiable instrument and still be legally binding as a contract; but it would not give the protection to parties to whom it is transferred that a negotiable instrument provides. Consider the following instruments. Do they meet the requirements for negotiable instruments?
Pay to the order of: Frank Barral July 13, 2010
One hundred and xx/100 dollars when he completes the upcoming
New York Marathon.
First Bank of Tampa
Memo: Go, Frank!
July 13, 2009
To: First Bank of Bullion
Pay to the Order of: Ken Ansley
Three (3) ounces of gold
July 13, 2009
To: Jay Baldauf
I.O.U $50 (fifty dollars)
$100.00
1.
2.
3.
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CHAPTER 10Section 10.2 Parties to Commercial Paper
All of the above documents could be enforceable, as part of a valid contract. None of the samples, however, meets the requirements for a negotiable instrument. Sample 1 is a simple I.O.U. that does not contain an unconditional promise to pay (it purports to owe the money but makes no specific promise as to its repayment); furthermore, it is not pay- able to the order of Jay Baldauf or to bearer. Sample 2 is not payable in money; gold, while valuable, is not legal tender. It need not necessarily be in dollars, but it must be in legal tender of some country. (A note payable in yen, euros, pounds, or pesos is negotiable, but one payable in gold, silver, or any other commodity is not.) Sample 3 is not negotiable because it contains a conditional (not unconditional) promise to pay. Each of the above instruments is valid but will not give any special protection to parties who accept them under assignment in the regular course of business.
10.2 Parties to Commercial Paper
Before we go much further, it is probably a good idea to define who is who when it comes to commercial paper. Maker: The person (or company) who makes or executes a note.
Drawer: The person (or company) who makes or executes a draft.
Drawee: The person (or company) who is directed to pay a draft or a note. (If the draft is a check, the drawee is the bank in which the drawer (the person drafting the check) has the checking account on which the check is drawn.)
Pay to the order of: Frank Barral July 13, 2010
One hundred and xx/100 dollars when he completes the upcoming
New York Marathon.
First Bank of Tampa
Memo: Go, Frank!
July 13, 2009
To: First Bank of Bullion
Pay to the Order of: Ken Ansley
Three (3) ounces of gold
July 13, 2009
To: Jay Baldauf
I.O.U $50 (fifty dollars)
$100.00
1.
2.
3.
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CHAPTER 10Section 10.2 Parties to Commercial Paper
Payee: The person (or com- pany) to whom a note or draft is made payable.
Bearer: The person (or com- pany) in possession of a note or draft made out to him as payee or made out to bearer.
Guarantor: A person who signs a note or draft on its face guaranteeing payment in case the note or draft is dishonored when it is presented for pay- ment. The guarantor is liable to the payee of a note or draft for its face value if the maker or drawee fails to pay the note when the payee properly demands payment. The liability of a guarantor is primary to that of indorsers1 (signers) or accommodation parties.
Accommodati on A person who indorses (signs) a note or draft that is not made pay- able to him in order to guarantee payment if the note or draft is dis- honored when presented for payment. An accommodation party has secondary liability and cannot be made to pay on the note unless the principal parties (maker, drawer, and drawee) have all refused payment.
Acceptor: A drawee of a draft who binds himself to pay the payee the face value of the draft when it is presented for payment by signing as acceptor on the face of the draft. A payee who obtains good faith acceptance of the draft by the drawee receives a guarantee from him that the draft will be paid when it is properly presented for payment.
Indorser: The person who signs her name on the back of a note or draft nam- ing her as payee in order to obtain payment on it or negotiate it to a third party.
Indorsee: The person to whom a negotiable instrument is indorsed as the new payee.
Party:
This happy man is probably the payee!
©2009 Getty Images/Michael Caulfield
1 “Indorse” and “endorse” are synonymous. “Indorse” is used here and throughout this chapter because it is the preferred legal term and the one used by the UCC.
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CHAPTER 10Section 10.3 Types of Commercial Paper
10.3 Types of Commercial Paper
For purposes of our discussion, we’ll focus on these types of negotiable instruments: notes, drafts, checks, and certificates of deposit (CD). Note A note is an unconditional promise to pay a sum certain in money to a named payee or to bearer that is payable on a specific date or on demand. The person or company who drafts a note is called the maker, and the person to whom the note is made payable is the payee. Notes are a primary means of securing credit, with the debtor executing a note in favor of the creditor. The following example is typical:
Example 10.1. Robert wants to buy Aretha’s car for $5,000 but only has $1,000 available in cash. He asks her if she’d be willing to accept a note for the balance payable over a period of three years at ten percent interest. Aretha agrees and turns over the car in exchange for $1,000 in cash and the following negotiable instrument:
In the above example, Aretha is the payee of the note, while Robert is the maker. Once Robert signs the note, Aretha will be able to negotiate it by indorsing it to a third party. Once the note is indorsed and delivered to the third party, that party becomes the note’s holder and can in turn negotiate the note to yet another person, or keep the note and be entitled to payment from Robert under its terms. Aretha can, of course, choose to keep the note and collect the payments from Robert for the entire term.
PROMISSORY NOTE
For good and valuable consideration received, the undersigned promises
to pay to the order of Aretha Jones the sun of $4,000.00 (Four thousand dollars) with
interest at a rate of 10%, payable in equal, consecutive monthly payments of $129.07
(One hundred and tweny-nine and 07/100 dollars) over the next 36 months with the
first payment due on December 1, 2010. In the event that the undersigned fails to
make any payment within 10 days of the date that it is due, the entire balance will be
due at the option of any holder of this instrument.
Upon default, the maker will pay all reasonable costs of collection, includ-
ing court costs and reasonable attorneys’ fees.
Loan principle: $4,000.00 Annual interest rate: 10%
Interest charges: $646.52
Total Payments: $4,646.52
November 1, 2010
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CHAPTER 10Section 10.3 Types of Commercial Paper
Draft A draft is an unconditional written, signed order by a drawer for a drawee to pay a sum certain in money to the order of a named payee or to bearer. Unlike the maker of a note who promises to pay the payee or her assigns a sum of money himself, the drawer of a draft orders a third party—the drawee—to make the payment to the payee or her assigns. If the drawee does not honor the draft for any reason, the drawer of the draft is liable to the payee or her assigns for its payment. Naturally, there must be a contractual obligation between the drawee and the drawer if the drawee is to pay the draft when it is presented. A payee who wishes to determine whether the drawee will in fact pay the draft when it is presented for payment can seek acceptance from the drawee of the draft.
The following example illustrates a simple draft. Note that none of the parties is a bank or large company, although they could be:
In this example, Danielle is the drawee (the person ordered to pay), Don is the drawer (the person who drafts the note and orders the drawee to pay), and Pam is the payee. The draft meets all of the requirements for nego- tiability: it is in writing, signed by the drawer, contains an unconditional order to pay a sum certain in money, contains no other promises, and is payable on demand, since no specific date for payment is specified. If Pam Payee takes this draft from Don, she will be able to freely negotiate it. Naturally, both Pam and anyone else to whom she negotiates the draft are likely to want some assurance that the drawee will honor the draft when it is presented for payment. She can get such an assurance by taking the note to Danielle and asking her to accept it. If she agrees, she would simply sign as acceptor on its face as follows:
May 18, 2010
TO: Danielle Drawee
Pay to the order of Pam Payee $100.00 (One hundred dollars)
A check is an example of a draft. The person writing the check is the drawer, the bank is the drawee, and the person to whom the check is written is the payee.
Photodisc/Thinkstock
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CHAPTER 10Section 10.3 Types of Commercial Paper
Even if Danielle is under no obligation to Don to accept the draft, once she signs as accep- tor, her obligation to pay the draft when it is presented will be absolute.
Check A check is simply a draft in which the drawee is a bank. The drawer of a check is a person or company who has an account in a bank against which they are authorized to draw checks. If a payee of a check wants to ensure that there will be enough funds in the account on which the check is drawn to guarantee its payment, the payee can demand that the drawer have the check certified by the bank. A certified check is the equivalent of a draft that has been accepted by the drawee. Section 3-411 of the UCC specifically refers to cer- tification of a check by a bank as acceptance of the check; when a bank certifies a check, it guarantees that there will be sufficient funds in the drawer’s account for the check to be honored when it is presented for payment.
The above sample contains all necessary information for the bank to pay the payee $100 from Don Drawer’s account. It should be noted that, even though all the checks we are likely to come across look pretty much the same, there is no legal requirement that a check be written on a pre-printed, bank-provided form in order to be negotiable. It is perfectly legal to write a check on a coconut by carving the relevant information on it with a sharp knife, or, as we noted earlier in the chapter, write out a check on a shirt to send to the IRS,
May 18, 2010
TO: Danielle Drawee
Pay to the order of Pam Payee $100.00 (One hundred dollars)
Accepted:
May 18, 2010
Pay to the Order of Pam Payee One hundred and xx/100 -----------------------------------------------------Dollars
State Bank One Financial Lane Anytown, USA 12345-6789
Memo: ________________________
$100.00
1235 : 678901234 : 0001
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CHAPTER 10Section 10.4 Holder in Due Course
as some whimsical taxpayers have actu- ally done in the past. In both instances, the checks would be valid (although it will likely take some time to convince a bank teller of that fact when the check is deposited for collection!). Of course, payees need not accept a nonstandard check any more than they are generally obligated to accept a standard one.
Certificate of Deposit (CD) Certificates of deposit, or CDs, are notes issued by both banks and savings and loan associations. The only signifi- cant difference between a CD and a note is that CDs are issued by banks and notes can be issued by any company or individual.
10.4 Holder in Due Course
A holder in due course is a person who has given value for an instrument, in good faith, without notice of outstanding claims or other defects. (A holder in due course somewhat resembles the bona fide purchaser (BFP) we saw with regard to sales.) The UCC gives special protection to such people.
Example 10.2. Daniel hires Catherine to paint his house. After she com- pletes the job, lacking the cash to pay, he writes a note that reads “I prom- ise to pay to the order of Catherine $3,000.” He signs his name and gives the note to Catherine. Catherine is buying Holden’s car, and as payment she now writes on Daniel’s note “Pay to the order of Holden” and gives Holden the note. Holden is a holder in due course.
Holders in due course are in a very strong position when they accept a negotiable instru- ment in that they take the instrument free from all personal defenses that any party might have to payment of the instrument. In many circumstances, a holder in due course receives greater rights and protection in taking negotiable instruments than the original holder of the instrument possessed. In most instances, holders in due course are absolutely entitled to payment of negotiable instruments in their possession, regardless of defects that these may possess.
Example 10.3. Daniel now discovers that the paint on his house is blistering and peeling because Catherine used the wrong type for an exterior. Even though he would have a defense to paying Catherine, it will not apply to Holden.
A certificate of deposit is an agreement between depositor and bank.
Pat Sullivan/Associated Press
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CHAPTER 10Section 10.4 Holder in Due Course
Section 3-302 of the UCC lists the requirements for a person to become a holder in due course. In order to qualify for the special status of holder in due course, a person must take a negotiable instrument:
1. For value. Taking the instrument for value means that some consideration was given by the holder in order to receive the instrument, such as the car Holden gave to Catherine.
2. In good faith. The requirement of good faith is met as long as the holder acted in a just and ethical manner in obtaining the instrument (e.g., if the holder takes an instrument under circumstances that should make her suspicious as to the valid- ity of the instrument, the good faith requirement will not be met).
3. Without notice that it is overdue or has been dishonored or of any defense against or claim to it on the part of any person. Finally, the holder must also take the instrument without the knowledge that it has been dishonored or is overdue, or that there are claims that can be asserted against it by third parties; this requirement can be seen as an extension of the good faith requirement.
Section 3-305 of the UCC outlines the rights of a holder in due course. In essence, a holder in due course takes a negotiable instrument free of all claims and defenses to it by par- ties with whom the holder in due course has not dealt. The only defenses that can be successfully asserted against a holder in due course are those of incapacity, duress, ille- gality of the transaction, forgery of the instrument, and misrepresentation inducing the
drawer or maker of the instrument to execute the same without knowledge that she was executing a nego- tiable instrument. With these exceptions—all of which are real defenses that make the original execution of the instrument void—no other defense may be asserted against a holder in due course. Consider the following circumstances:
Example 10.4. Seller, a jeweler, sells Buyer a coun- terfeit Rolex watch for $7,500 (the watch is an ille- gal import worth $20). Buyer pays by check, and the jeweler cashes the check.
Example 10.5. Tania finds a paycheck on the lec- tern after class, where the duly absent-minded professor left it after indorsing it in blank. (Obvi- ously this was not a business law professor!) Tania takes the check and asks a friend to cash it for her, telling him the truth as to how she came to pos- sess the instrument. Tania’s friend then negotiates the check to his local grocer, who is unaware that the paycheck was acquired through larceny.
Example 10.6. An armed robber forces Jeanette to execute a check at gunpoint.
If Catherine, the house painter, indorses Daniel’s note for $3,000 over to Holden in payment for his car, Holden becomes a holder in due course.
iStockphoto/Thinkstock
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CHAPTER 10Section 10.5 Characteristics of Negotiable Instruments
Example 10.7. Sharlene tricks William into signing a note for $250,000, tell- ing him it’s a petition to save polar bears and other endangered species. William, who trusts Sharlene implicitly, signs the note where she indicates a place for his signature. Sharlene then negotiates the note to a group of innocent investors and leaves the country.
Example 10.8. Slick, an upscale day care center operator, dreams up the brilliant idea of having the children in his care sign notes for $250,000 each, payable in 20 years. (Slick figures that chances are good that most of his kids will be independently wealthy in their mid-20s, and would like to assure himself a cozy retirement at their expense.) Several of the children who signed the notes in fact become quite wealthy and Slick negotiates those notes 19 years later to innocent third parties.
In example 10.4 and 10.5 above, the bank and the grocer are holders in due course, since each acquired the instrument for value, in good faith, and without knowledge that there were any defenses or claims against it. As such, both the grocer and the bank are entitled to payment under the instrument, and the buyer of the counterfeit Rolex as well as the professor will have to bear the loss. (They can, of course, sue the jewelry store owner for fraud and Tania for conversion, respectively, assuming these can be found.)
In examples 10.6, 10.7, and 10.8, however, Jeanette, William, and the persons who executed the notes as children will all have valid defenses, even against holders in due course. A check or note issued under duress is void and of no legal effect; since such an instrument is invalid at its inception, even a holder in due course cannot obtain good title to it. Like- wise, if a maker or drawer is tricked into executing a negotiable instrument without his knowledge or consent, the instrument is void and can never have any effect, even in the hands of a holder in due course. The notes example, 10.8 executed by children of tender years, are void at the inception and will likewise be unenforceable even in the hands of a holder in due course.
10.5 Characteristics of Negotiable Instruments
Negotiable instruments, whether they are notes, drafts, checks, or CDs, can be char-acterized as either bearer or order paper. Order paper is a negotiable instrument that is payable to the order of a specific person or company. A check that reads “Pay to the order of Alice Z. López” is an order instrument, since the drawer is ordering the bank to pay Alice the sum named in the check. “Pay to the order of Internal Revenue Service” is likewise an order instrument for the same reason; the bank is ordered to pay whatever amount is named in the check to a specific payee—in the latter case, a govern- ment agency.
A bearer instrument, on the other hand, is one that is not made out to a specific person or agency. The most common example of bearer paper is a check that is made out to cash: “Pay to the order of cash” means pay to anyone who is in possession of the instrument. “Pay to the order of bearer” would be another example of a bearer instrument. Anytime a specific payee cannot be determined from the words used by the drawer or maker to iden- tify the payee, it is assumed that bearer paper is intended, and the instrument becomes
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CHAPTER 10Section 10.5 Characteristics of Negotiable Instruments
bearer paper. Thus, making a check payable “to the order of 100 rabid raccoons” is bearer paper, since no specific payee can be identified. Despite what a shocked bank teller might think if such a check were presented for collection, it is very much valid and as bearer paper, payable to anyone who has it in her possession.
An instrument that sufficiently identifies a specific person or group of people as payees is deemed order paper, even if it does not specifically name them. A check made out as follows would be order paper: “Pay to the order of the owner of a black Nissan 240 SX NY license plate 1234 ABC.” Once the instrument is executed, it is payable only to the owner of the automobile in question, who will be entitled to demand payment after proving that he owns such a car. It is possible to trace the payee of such an instrument to only one per- son, since there could not be two black Nissan 240 SX automobiles in New York with the same license plate. If the car is registered to two people, such as a husband and wife, then the check would be payable to both of them jointly.
Despite the fact that there is some room for creativity in the drafting of negotia- ble instruments with regard to the iden- tification of payees, it is never a good idea to express one’s creativity in draft- ing such instruments. At the very least, drafting a negotiable instrument in an unusual manner or, for that matter, on an unusual object (such as the negotia- ble coconut and shirt previously alluded to) will cause problems for the payee when she tries to cash or further negoti- ate the check. At worst, litigation may be necessary to be able to enforce the valid- ity of the negotiable instrument. Also, keep in mind that there is generally no obligation for parties with whom we do business to accept our checks or other negotiable instruments; they are free to demand cash from us, if they wish. Therefore, while your corner grocer may willingly accept your check that states “Pay to the order of cash,” “Pay to the order of bearer,” or perhaps even “Pay to the order of anybody,” she is unlikely to accept a check that reads “Pay to the order of life, the universe, and everything,” no matter how much you argue (and rightfully so) that it is a perfectly valid bearer instrument.
Banks often facilitate the transfer of money under different kinds of negotiable instruments.
Frank Franklin II/Associated Press
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CHAPTER 10Section 10.5 Characteristics of Negotiable Instruments
In the Media: Can a Centuries-Old Note Serve As a Negotiable Instrument?
The Battle of Johnstown, one of the later battles of the Revo- lutionary War, took place on October 25, 1781, in New York. The Colonials were led by Colonel Marinus Willett, who was born on Long Island and would became New York City’s mayor in 1807. Willett’s army of 416 not only beat the 700-strong British army and forced a retreat, but also cut them off in their retreat, killing one of the British army’s commanders, Walter Butler, who was a British loyalist and a lawyer from Albany, New York. Although the armies lost 11 soldiers in the battle, the American victory helped propel the eventual Brit- ish surrender. A substantial reason for Colonel Willett’s vic- tory that day was the help given to him by members of the Oneida Indian tribe, who are native to that part of New York. In exchange for their military service, Willett promised each of the 60 Indians a blanket, which he did not have at the time. About a year later, the promise was reaffirmed by the New York government but still went unpaid. In 1792, Colonel Willett wrote and signed a note that said in part:
I do hereby certify that in a pursuit of the enemy in the county of Montgomery the latter end of October in the year 1781. In order to stimulate a party of the Oneida Indians then with me. I promised in case of exerting themselves to overtake the enemy who were put to flight. That they should each of them have a blanket. That in conveyance of this promise they began a vigorous pursuit and in a short time over- took and killed a number of the enemy. That at my return it was not in my power to comply with the promise I had made in behalf of the public. Nor have I since been able to have that engagement complied with.
Despite Willett’s note, the Indians went unpaid for their assistance in helping give birth to the United States America.
Three centuries later, Willett’s note came into the possession of a man named Andre Deeks, who in 2004 sued the United States for payment. Deeks claimed that Willet’s note was a negotiable instru- ment and that he was now the holder. Deeks didn’t want 60 blankets, however; instead, he sought an inflation-adjusted value of the blankets, which he argued was $3 million. But the United State Court of Appeal for the Federal circuit disagreed and found that the handwritten note wasn’t a negotiable instrument because it didn’t constitute an unconditional promise to pay a sum certain. Moreover, the court found that nothing in the note showed an intent that it be circulated as money. And of course, there was a slight statute of limitations problem. For something to be a negotiable instrument, it must constitute an unconditional promise to pay a specific amount of money.
Sources: Deeks v. U.S., 151 Fed. App. 936 (Fed. Cir. 2005); http://www.nyhistory.net/~drums/willett.htm
Although Colonel Willett’s note promised each member of the Oneida tribe a blanket, it did not constitute an unconditional promise to pay a certain sum of money.
iStockphoto/Thinkstock
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CHAPTER 10Section 10.6 Negotiation and Indorsers’ Liability
10.6 Negotiation and Indorsers’ Liability
Negotiable instruments are by their nature freely transferable. Although the vast majority of checks, drafts, notes, and certificates of deposit (CDs) are paid when properly presented to the drawee or maker, some invariably are not. At such times, it is important to determine the liability of parties to the commercial paper. Makers, drawees, acceptors, and guarantors are primarily liable for payment of negotiable instru- ments. If, however, they are unable or unwilling to pay it when it is properly presented for payment by the payee, there are others who are secondarily liable for paying the instru- ment. Secondary liability (meaning these individuals pay only if the one with primary liability does not) exists for drawers of drafts or checks who can be called upon to pay if the drawee refuses to pay (or dishonors) the draft or check when it is properly presented for payment. Likewise, indorsers of negotiable instruments can be called upon to pay if the instruments are dishonored.
Example 10.9. Tania is buying Devan’s coffee café. Tania gives Devan a check for $25,000. At this point, Tania as drawer is not liable to Devan; Devan must present the check to the bank (or drawee). But if the bank dishonors (refuses to cash) the check, Devan has the right to demand the $25,000 from Tania. Note that if Devan is nervous over Tania’s right to pay, he may prefer to specify payment in the form of a cashier’s check or an electronic bank transfer.
The holder of a negotiable instrument can transfer its ownership to another person or company by indorsing the back of the instrument and delivering it to the person to whom it is indorsed. The indorsement of a negotiable instrument followed by its delivery to the person to whom it is indorsed is termed negotiation—the formal name given to the legal transfer of ownership from one holder to another. For an order instrument (one payable to the order of a person or company) to be duly negotiated, indorsement followed by delivery to the indorsee is necessary. A bearer instrument (one that is payable to cash, to the order of cash, to bearer, or otherwise fails to mention a specifically identifiable payee) is negotiated simply by delivery to anyone. Anyone in possession of a bearer instrument is a holder.
Indorsers are basically anyone who has signed the instrument, other than the issuer or acceptor. Indorsers can be secondarily liable to those who follow them in the chain of transfer, but not to those who came before them.
Example 10.10. Tania gives the check for $25,000 to Devan. Devan writes on the back “Pay to Brittany,” signs his name, and gives the check to Brittany in payment for her Porsche automobile. Brittany now signs her name and gives the check to her landlord. If Tania now refuses to pay the landlord, the landlord could demand Devan or Brittany pay. If Brittany pays, she cannot hold Devan liable, because he was a previous indorser.
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CHAPTER 10Section 10.6 Negotiation and Indorsers’ Liability
Types of Indorsements (§§ 3-204–3-205) Indorsements may be blank, special, or restrictive. A blank indorsement specifies no spe- cific indorsee and can consist of a simple signature on the back of the negotiable instru- ment. A special indorsement is one that specifies to whose order an instrument is payable. A restrictive indorsement is one that is conditional, purports to prohibit further transfer of the instrument, or includes the words “for collection,” “pay any bank,” “for deposit” or any
similar term that states the instrument is negotiated to a bank for the purpose of deposit.
Section 3-206 of the UCC clearly states that restrictive indorsements do not prevent an instrument from being fur- ther negotiated. However, a person to whom an instrument is negotiated under a restrictive indorsement must comply with the indorsement if he is to qualify for holder in due course sta- tus. If the bank or individual to whom a negotiable instrument is restrictively indorsed does not treat the instrument consistently with the indorsement, it will be liable to the indorser for any damages that result. Consider the fol- lowing example:
Example 10.11. Dan restrictively indorses his paycheck as follows: “For deposit only into State Bank A/C 1234567.” He then signs his name. On the way to the bank, he is mugged by Thelma, who later takes the check and cashes it at her bank—First Bank of Erehwon. Despite the restrictive indorsement, the bank teller pays the thief the face value of the check. Assuming that the thief then leaves the state and cannot be found, First Bank of Erehwon will have to reimburse Dan the full amount of the check, because it failed to honor the restrictive indorsement.
The following examples illustrate blank, special, and restrictive indorsements made on a check originally payable to Lisa Wong:
Endorsements are part of the process of negotiating paper.
iStockphoto/Thinkstock
For deposit only into
Fourth National Bank A/C
123-4567
Pay to the order
of John Smith
Restrictive Endorsement Special Endorsement Blank Endorsement
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CHAPTER 10Section 10.6 Negotiation and Indorsers’ Liability
Liability of Indorsers (§§ 3-415, 3-501) Indorsers of negotiable instruments are secondarily liable for payment of the instrument if it is dishonored by the drawee or maker. Indorsers of negotiable instruments guarantee to every other indorser that the instrument will be paid as drafted. If the instrument is dis- honored, its holder can force any previous indorser to pay its face value. If an instrument is dishonored, an indorser must pay any person who has indorsed the instrument after him under Section 3-415(a). All that is necessary to preserve this right is giving timely notice that the negotiable instrument has been dishonored. Section 3-501 of the UCC pro- vides that drawers and indorsers are not liable for payment of an instrument that has been dishonored by the drawee upon presentment until they are notified of the dishonor. If a bank refuses to pay a check when it is presented for payment, then the payee must notify the drawer and all indorsers before she can demand payment of the instrument from them. A bank must notify its customer of dishonor by midnight of the day in which the dishonor occurs; all other persons must give notice of dishonor by midnight of the third day following the dishonor (§ 3-508). Under Section 3-508, notice of dishonor by a bank or other individual may be given in any reasonable format, including orally or in writing. If notification is made by mail, the notice is deemed effective as of the time that the letter is mailed.
Warranties of Presentment and Transfer (§ 3-417) The following warranties are made by every transferor of negotiable instruments to the transferee upon negotiation of the instrument under UCC Section 3-417(1):
1. That he has good title to the instrument or is authorized to transfer the instru- ment on behalf of one who has good title to it;
2. That he has no knowledge that the signatures of the maker or drawer are unau- thorized (a holder in due course does not make this warrantee to a maker, drawee, or acceptor of a draft);
3. That the instrument has not been materially altered (a holder in due course does not make this warrantee to the maker of a note or drawer of a draft, to a drawee, or to an acceptor of a draft).
In addition to the above warranties by all transferors, any person who transfers a nego- tiable instrument and receives consideration for the transfer also warrants the following under Section 3-417(2):
1. That she has good title to the instrument or is authorized to obtain payment or acceptance on behalf of one who has good title;
2. That all signatures are genuine or authorized; 3. That the instrument has not been materially altered; 4. That there is no valid defense from any party against her; and 5. That she has no knowledge of any insolvency proceeding instituted with respect
to the maker, acceptor, or drawer of an unaccepted instrument.
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Section 10.7 Chapter Summary CHAPTER 10
Section 3-417(3) provides that a transferor may limit the warranty liability specified under Section 3-4172(2) by transferring the instrument “without recourse.” If the instrument is transferred with the restrictive indorsement “without recourse” above the transferor’s signature, only the warranties under Section 3-417(1) and the warranty in Section 3-417(2) relating to the lack of knowledge of any insolvency proceeding against the maker, accep- tor, or drawer will be made. In other words, by transferring an instrument “without recourse,” no warranties are made as to the transferor’s title, the genuineness of signa- tures, material alterations, or defenses by third parties affecting the instrument.
Example 10.12. Anna writes a check for $300 to Ben, paying him back for money he loaned her last week. Ben alters the amount to read $1,300 and uses the check to pay for a scooter he is buying from Carolina. Carolina deposits the check. When Anna discovers her account has been debited $1,300, she brings it to the attention of the bank, which credits $1,000 back to her account. Carolina must reimburse the bank for the $1,000, but she has the right to collect from Ben.
The warranties of presentment and transfer are implied warranties made by all transferors of negotiable instruments. Dishonor of an instrument when it is presented for payment to a maker or drawee can give rise to an action for breach of one of the above warranties.
10.7 Chapter Summary
The use of commercial paper has been critical to modern commerce, enabling large transfers of money to be made in ways that would hardly be possible through the use of hard currency. There are several different kinds of commercial paper, includ- ing notes, drafts, checks, and certificates of deposit, but all include certain requirements. They must be written and signed by the maker, contain an unconditional promise to pay a definite amount of money, and be payable at a specific time or on demand. A key feature of commercial paper is that these instruments can be negotiated, or transferred readily to different parties, and the law sometimes gives a transferee who qualifies as a holder in due course additional protection. Because of the common nature of com- mercial paper transactions, it is important that businesspersons understand the rights and risks attendant in using commercial paper. As so often with the law, an awareness of what can go wrong should enable people to better structure their business to ensure it more often goes right.
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Section 10.7 Chapter Summary CHAPTER 10
Focus on Ethics
Note that banks are often held liable for paying out on forged checks. The rule was originally based on the idea that banks had a relationship with their account holders, and could either recognize an invalid signature or had the ability to compare it with a signature on record when the check was presented. Years ago, customers probably were known to the tellers at their local bank, and they often did their banking in person.
Today, however, check processing is often done by machine, and many transactions are done electroni- cally, through online banking and ATMs or the use of debit cards; yet banks are still liable in the same way they previously have been.
Questions for Discussion
1. Does it still make sense to presume liability for banks when it comes to forgeries? 2. Do you think a bank should be able to protect itself by having an account holder sign an agree-
ment to not hold the bank liable for such mechanized transactions? 3. If Daria writes a check for $100 to Barry, who alters it to read $10,000, couldn’t we say that
Daria is as much at fault as the bank, since she chose to do business with a crook? Could she have protected herself in this situation?
4. What are the advantages or disadvantages to society of a law that holds the bank responsible (assuming the forger cannot be found or does not have the funds to cover the loss)?
Case Study: Seigel v. Merrill Lynch, Pierce, Fenner & Smith
745 A.2d 301 (D.C. 2000)
Facts: Seigel gambled at casinos in Atlantic City, New Jersey, where gambling is legal. He obtained the gam- bling chips at the casinos by writing checks on his Mer- rill Lynch account. He was not very successful; he ended the night with considerable losses. Apparently Seigel also was a bad loser; he put stop payment orders on the checks and closed the account.
However, Merrill Lynch accidentally paid checks totaling $143,000 (which was only a small portion of the total—as we noted, Seigel was not having a lucky night). Seigel then sued Merrill Lynch for breach of contract and negligence.
Issue: Did Seigel suffer a loss from Merrill Lynch’s mistake?
In the Seigel case, Merrill Lynch’s mistake in not stopping payment on Seigel’s check did not cause a loss for Seigel, since he still owed the money to the payee.
Douglas C. Pizac/Associated Press
(continued)
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Section 10.7 Chapter Summary CHAPTER 10
Case Study: Seigel v. Merrill Lynch, Pierce, Fenner & Smith (continued)
Discussion: The court found that the transaction was controlled by UCC Sections 4-403 and 4-407. In this situation, the drawer was Seigel and the drawee Merrill Lynch. The problem for Seigel was that he really did owe the $143,000 to the casinos, and so even if Merrill Lynch hadn’t paid it by mistake, he would still not be entitled to the money.
Holding: Merrill Lynch, the drawee, cannot be held liable to the drawer, Seigel, because he suffered no actual loss on the transaction.
Questions for Discussion
1. What kind of commercial paper was involved in this case? 2. Merrill Lynch clearly violated Seigel’s express orders by not stopping payment on those checks.
Why isn’t Merrill Lynch liable? 3. In another part of the case, Seigel attempted to argue that his contracts with the casinos
should be void because he was a compulsive gambler. Does that seem like a valid argument? Should the law protect gamblers from themselves?
Case Study: Atlantic National Trust, LLC v. McNamee
984 So. 2d 375 (Ala. 2007)
Facts: McNamee borrowed $150,000 from South Trust Bank (which later became Wachovia) and signed a promissory note. Wachovia gave McNamee a copy of the promissory note that day, but Wachovia eventually lost the original. A few months before the note matured, allowing for demand of repayment of the note, Wachovia assigned it to the Atlantic National Trust, LLC (Atlantic), by using a copy Wacho- via had of the promissory note. When the note became due, Atlantic demanded McNamee repay the remaining balance plus interest, but McNamee refused, arguing that Wachovia had no right to assign the note to Atlantic because Wachovia had lost the original. Atlantic sued McNamee in a federal court. According to McNamee, the plain language of the relevant section of Alabama’s UCC prevented Atlan- tic from having any right to enforce the copy of the note because Atlantic did not possess the original at the time it was lost. That statute (§7-3-309) says in part: “A person not in the possession of an instru- ment is entitled to enforce the instrument if the person was in the possession of the instrument and entitled to enforce it when the loss of the possession occurred. . . .” Before rendering a decision, the federal court sent the case to the Alabama Supreme Court, asking for it to provide an answer to the legal question interpreting Alabama’s UCC, since there was no precedent on the matter.
Issues: (1) Under the Alabama version of the UCC, can an assignee of a promissory note enforce the note that was lost before it has been assigned? (2) Can a party that was entitled to enforce this promis- sory note assign its rights to enforce the note after it was lost?
Discussion: In interpreting the specific UCC section in question, the court noted that though the UCC does not specifically allow the assignment of the right to enforce a lost promissory note, it also does not prohibit it. Furthermore, the court concluded that when the UCC does not address (continued)
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Section 10.7 Chapter Summary CHAPTER 10
Critical Thinking Questions
1. Commercial paper is intended to make business easier. Give three examples of how it does so.
2. Try cashing a check that is not the standard, preprinted kind (for example, one inscribed on a coconut) at your bank, and see if the teller understands what it is. (Make sure you have the funds to cover it!) What advantages are there to allow- ing checks to be written in many forms, as long as the necessary elements are present? What disadvantages are there?
Hypothetical Case Problems
Case 1. Seller offers a used car to buyer, telling him that it is three years old, has 12,000 miles on the odometer, and is in perfect mechanical condition. In fact, the car is eight years old and has over 100,000 miles on it, but the odometer has been tampered with to show 12,000 miles, and the engine burns oil. The buyer buys the car based on the seller’s fraudulent misrepresentations and issues a check for $10,000. The seller then indorses the buyer’s check over to a car wholesaler in return for ten old used cars. The wholesaler, who is unaware of seller’s shady business practices, further indorses and negotiates the check to his bank.
Case Study: Atlantic National Trust, LLC v. McNamee (continued)
an issue, the principles of common law should be used instead. Under Alabama common law, “[a] valid assignment gives the assignee the same rights, benefits, and remedies that the assignor possesses.” So, the court concluded that, since the original note was genuine, the fact of the loss of the original does not make the note unenforceable either by the maker of the note, Wachovia, or by the assignee, Atlantic.
Holding: The Supreme Court of Alabama answered yes to both certified questions.
Questions for Discussion
1. Since McNamee gave a promissory note to Wachovia and later refused to repay the remaining balance, why wasn’t Wachovia a party to this lawsuit?
2. What was McNamee’s argument supporting his refusal to repay the note? 3. What questions did the federal court want the Supreme Court of Alabama to answer? 4. Why did the Alabama Supreme Court answer the questions the way it did? Do you think that
the answers of the Alabama Supreme Court would be different if there was a dispute about the authenticity of the original promissory note?
5. Imagine that Wachovia did not make a copy of the note. Do you think it would be legally right for McNamee to refuse the repayment of borrowed money because there was no written proof of his debt? Even if it was legally permissible, do you think it would be ethical? Would it be ethical for McNamee to escape paying back a loan he acknowledged receiving?
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Section 10.7 Chapter Summary CHAPTER 10
A. Is the used car seller a holder of the check? B. Is the used car seller a holder in due course of the check? C. Is the wholesaler to whom the seller negotiates the check a holder in due
course of the instrument? D. Is the wholesaler’s bank a holder in due course of the instrument? E. If buyer stops payment on the check after the seller has transferred the
instrument to the wholesaler, will he have a valid defense against the wholesaler to refuse payment of the check?
F. Would the buyer have a valid defense to refuse payment to the original seller?
Case 2. The following instrument is presented for payment at State Bank, where Mr. Tai Chung Chang has a checking account (#1-234567). The instrument is drafted on what appears to be a yellow legal pad, and all items except for Tai’s signature are typewritten. The signature is genuine.
A. Is the instrument valid? B. What is the nature of the instrument? C. If the instrument had been written on balsa wood, would it still be valid? D. Assuming the instrument is valid, is it order or bearer paper? Explain. E. Assume Alejandra indorses the instrument by signing her name on the
back, without adding any additional language. What type of indorsement would that be? Would the instrument now be order or bearer paper?
Case 3. Examine the following instrument and answer the questions that follow:
A. Is the instrument involved negotiable? Why? B. What type of instrument is it? C. Who are the various parties to the instrument?
September 1, 2010
Pay to the order of Alejandra Patiño $200.00 (Two hundred dollars and no/100)
To: State Bank, 123 Main Street, Anytown, OH 11111 Account Number: 1-234567
May 18, 2010
Two years from today, the undersigned promises to pay Upinder Singh $10,000 (Ten thousand dollars) with interest thereon at a rate of seven percent per year.
Payment Guaranteed:
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Section 10.7 Chapter Summary CHAPTER 10
Case 4. A thief enters Christine’s home and steals her checkbook. The thief then pro- ceeds to a local electronics store and, posing as Christine, purchases $3,000 in electronics equipment, writing out one of Christine’s checks as payment and forging Christine’s signature. When Christine learns of the robbery, she immediately notifies her bank and places a stop payment order on all checks. When the electronics store’s check is not honored by the bank, the store owner sues Christine for $3,000, claiming that he is a holder in due course with regard to her check and demanding payment.
A. Is the store owner a holder in due course? Explain. B. Is the store owner entitled to payment from Christine? Explain. C. If the thief forced Christine at gunpoint to sign all of her checks in blank,
and then went on a shopping spree, paying for all items with checks con- taining Christine’s real signature, would subsequent holders in due course of the checks be entitled to demand payment from Christine? Explain.
Key Terms
acceptor A drawee of a draft who binds himself to pay the payee the face value of the draft when it is presented for pay- ment by signing as acceptor on the face of the draft. A payee who obtains good faith acceptance of the draft by the drawee receives a guarantee from him that the draft will be paid when it is properly pre- sented for payment.
accommodation party A person who indorses a note or draft that is not made payable to him in order to guarantee pay- ment if the note or draft is dishonored when presented for payment. An accom- modation party has secondary liability and cannot be made to pay on the note unless the principal parties (maker, drawer, and drawee) have all refused payment.
bearer The person (or company) in pos- session of a note or draft made out to him as payee or made out to bearer.
bearer paper A negotiable instrument that is either payable to bearer or not made out to a specific person.
cashier’s check A check drawn by a bank on itself.
certificate of deposit A note issued by a bank.
check A draft in which the drawee is a bank.
commercial paper A contract to pay money.
draft An unconditional written, signed order by a drawer for a drawee to pay a sum certain in money to the order of a named payee or to bearer.
drawee The person who is directed to pay a draft or a note.
drawer The person who makes or exe- cutes a draft.
guarantor A person who signs a note or draft on its face guaranteeing payment in case the note or draft is dishonored when presented for payment.
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Section 10.7 Chapter Summary CHAPTER 10
holder in due course A person who has given value for an instrument, in good faith, without notice of outstanding claims or other defects.
indorsee The person to whom a negotiable instrument is indorsed as the new payee.
indorser The person named as payee who signs the back of a note or draft in order to obtain payment or negotiate to a third party.
maker The person who makes or executes a note.
negotiation A transfer from one person to another for value.
order paper A negotiable instrument with the words “pay to the order of.”
payee The person to whom a note or draft is made payable.
promissory note A unconditional written promise to pay money; an IOU.
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