Lesson One: The Function and Creation of Negotiable Instruments
It is important to understand the distinction between negotiable and non-negotiable instruments, because a holder of a negotiable instrument enjoys greater rights. We examine the essential features of various negotiable instruments and the roles and responsibilities of the parties who create them, the requirements for a negotiable instrument, and some of the omissions and terms that do not affect negotiability of an instrument.
Learning Objectives
By the end of this lesson, you should be able to:
Discuss the significance of Articles 3 and 4 of the UCC
Describe the types and nature of negotiable instruments
Explain the requirements for negotiability
Identify factors not affecting negotiability
Content
Articles 3 and 4 of the Uniform Commercial Code
Article 3 of the UCC governs the transfer of a negotiable instrument. To qualify as a negotiable instrument, the requirements of UCC 3-103 must be met. In 1990, Article 3 was revised, clarifying old sections and altering existing provisions. The revised Article 3 is the basis of our discussion in this lesson regarding negotiable instruments. Article 4 was also revised in 1990, reflecting in part the changes made to Article 3. All references to Article 4 are to the revised provisions. Both articles were updated with proposed amendments in 2002, to conform with the Uniform Electronic Transactions Act (UETA) and meet the needs of e-commerce.
A negotiable instrument functions as a substitute for money and as a credit device. To fulfill these functions, an instrument must be easily transferable and collectible. Types of negotiable instruments include:
A draft(bill of exchange) is an unconditional written order. A time draft is a draft payable at a definite future time. A sight (or demand) draft is payable on sight. A trade acceptanceis a draft often used in sales of goods. The seller is both the drawer and the payee, and the draft orders the buyer to pay a specified sum of money to the seller, usually at a stated time in the future. A checkis a draft drawn on a bank and payable on demand.
A promissory note is a written promise between two parties. Notes are used frequently in credit transactions, often bearing the name of the transaction involved. For instance, a certificate of deposit(CD) is a type of note issued by a bank.
Requirements for Negotiability
Negotiable instruments must be in written form. The writing must be on material that lends itself to permanence; and the writing must have portability.
An instrument is negotiable if it is signed by the maker for notes or signed by the drawer for drafts. Initials, an X, a thumbprint, a rubber stamp, and a trade name or an assumed name (even if false) will suffice. The location of the signature on the document is irrelevant. A handwritten statement such as "I, Jane Doe, promise to pay to the order of John Doe" may constitute Jane's signature.
An instrument is negotiable if it contains an express order or promise to pay. An I.O.U. does not qualify as a negotiable instrument, unless such words as "due on demand" are added. However, a certificate of deposit is an exception, because the bank's acknowledgment of the deposit and the other terms of the instrument clearly indicate a promise. Only unconditional promises or orders are negotiable. Reference to another agreement or to the security for the instrument does not affect negotiability. An instrument is negotiable even if payment is to be made strictly out of a particular fund.
An instrument is negotiable if it states, with certainty, a fixed amount of money to be paid when the instrument is payable. To be fixed, an amount must be ascertainable from the face of the instrument. The amount of interest or its rate may be determined with reference to information not contained in the instrument, but ascertainable from a formula or source described in the instrument. When this information is stipulated, variable interest rate notes are negotiable.
Negotiable instruments are payable on demand or at a definite time. Examples of instruments payable on demand include instruments that contain the words "payable at sight" or "payable upon presentment," instruments that say nothing about when payment is due, and checks. An instrument is payable at a definite time if it states that it is payable on a specified date, within a definite period of time after sight or acceptance, or on a date or time readily ascertainable at the time the promise or order is issued. Instruments that include acceleration clauses are negotiable. Instruments that include extension clauses are negotiable when the right to extend is given to the maker, if the interval of the extension is specified. If only the holder of the instrument can extend it, the maturity date does not have to be specified.
An order instrumentis payable "to the order of an identified person" or "to an identified person or order." An identified person is the person "to whom the instrument is initially payable," as determined by the intent of the maker or drawer. A bearer instrumentdoes not designate a specific payee; a bearer is a person in possession of an instrument that is payable to bearer or indorsed in blank.
Factors notaffecting negotiability include:
the fact that an instrument is undated, unless the date of an instrument is necessary to determine a definite time for payment;
postdating or antedating an instrument;
handwritten terms (in fact, handwritten terms control typewritten and printed terms, and typewritten terms control those that are printed);
the use of words (in fact, words control figures unless the words are ambiguous);
a provision for interest at an unspecified rate (the rate would then be the judgment rate at the place of payment and runs from the date of the instrument or, if undated, from the date of its issue);
a notation on a check that it is "nonnegotiable" has no effect on the negotiability of the check (although any other instrument can be made nonnegotiable by such a note if it is conspicuous).
Lesson Two: Transferability and Holder in Due Course
Following on the last lesson, we begin this lesson with the concept of negotiation, the transfer of a negotiable instrument from one person to another. We will discuss the types of endorsements (information written on the back of the instrument) required when certain types of instruments are being negotiated, some common indorsement problems that may arise, and the consequences of various types of indorsements.
A negotiable instrument is not money but is payable in money. Article 3 of the Uniform Commercial Code (UCC) governs a party's right to payment of a check, draft, note, or certificate of deposit. Problems arise when a holder of a negotiable instrument seeks payment, and learns that a defense to payment exists or that another party has a prior claim to the instrument. It then becomes imperative for the holder seeking payment to have the rights of a holder in due course (HDC). Our discussion in this lesson will distinguish between an ordinary holder and an HDC, and examines the requirements for HDC status.
Learning Objectives
By the end of this lesson, you should be able to:
Explain the process of negotiation
Discuss indorsements and problems that may arise in connection with them
Define "holder in due course" and explain HDC status
Explain issues related to transferability and liability
Content
Negotiation
When a transfer is by negotiation, the transferee may become a holder in due course and acquire greater rights than the transferor. An order instrument is negotiated by delivery with any necessary indorsements. A bearer instrument is negotiated upon delivery. Before negotiation, an order instrument can be converted to a bearer instrument and vice versa, via indorsement.
In general, by indorsing an instrument, an indorser promises to pay the holder, or any subsequent indorser, the amount of the instrument if the drawer or maker defaults. An instrument is most often indorsed on the back, but if there is no room, an indorsement can be written on a separate piece of paper (an allonge) "firmly affixed" to the instrument.
There are five main types of indorsements of particular interest:
A blank indorsementspecifies no particular indorsee and may be a mere signature.
A special indorsementnames the indorsee. An instrument indorsed in this way is an "order instrument." A blank indorsement converted to a special indorsement converts a bearer instrument into an order instrument.
A qualified indorsementdisclaims an indorser's liability. The notation "without recourse" is commonly used, often by persons acting in a representative capacity and means that if payment of the instrument is refused, the indorser will not be responsible to make payment. A qualified indorsement accompanied by a special or a blank indorsement determines further negotiation.
Restrictive indorsements require indorsees to comply with certain instructions.
A conditional indorsement conditions payment on the occurrence of a specified event. A person paying or taking for value the instrument can disregard the condition without liability.
Other noteworthy types of indorsements are indorsements prohibiting further indorsements, indorsements for deposit, and trust indorsements. An indorsement prohibiting further indorsement does not affect negotiation, but has the same effect as a special indorsement. An indorsement for deposit or collection makes the indorsee a collecting agent of the indorser. Indorsements that state they are for the benefit of the indorser or a third person are trust indorsements, and legal title vests in the original indorsee.
To the extent that the original indorsee pays or applies the proceeds consistently with the indorsement, the indorsee is a holder and can become a holder in due course.
Miscellaneous Indorsement Problems
An indorsement should be identical to the name that appears on the instrument. A payee or indorsee whose name is misspelled can indorse with the misspelled name, the correct name, or both. An instrument payable to two or more persons in the alternative requires the indorsement of only one person for negotiation. If an instrument is payable to two or more persons jointly, then all the payees' indorsements are necessary. If an instrument does not clearly indicate that it is payable in the alternative or jointly and there are two or more payees, then it is payable alternatively.
Holder versus Holder in Due Course (HDC)
A holder has the status of an assignee of a contract right, obtaining only those rights that the transferor had in the instrument and normally subject to the same defenses. An HDC has absolute title to a negotiable instrument and takes an instrument free of most defenses against payment on it or claims to it. Therefore, if there is a claim to a negotiable instrument between a mere holder and an HDC, the HDC takes priority.
In order for a holder of an instrument to meet the standard for holder in due course status, the instrument must be negotiable, and the following requirements must be met:
Taking for Value - A holder can take an instrument for value in any one of five ways:
performing the promise for which the instrument was issued or transferred;
acquiring a security interest or other lien in the instrument, except a lien obtained by a judicial proceeding;
taking an instrument in payment of or as security for an antecedent debt;
giving a negotiable instrument as payment; or
giving an irrevocable commitment as payment.
Taking in Good Faith - The holder must have acted honestly in the process of acquiring the instrument. Good faithis "honesty in fact and the observance of reasonable commercial standards of fair dealing". This requirement applies only to the holder.
Taking Without Notice- A person will not be afforded HDC protection if he knew or should have known at the time the instrument was acquired that it was defective because:
it was overdue;
it had been dishonored;
there was an uncorrected default with respect to another instrument issued as part of the same series;
the instrument contains an unauthorized signature or has been altered;
there is a defense against it or a claim to it; or
the instrument is so irregular as to call into question its authenticity.
A person has notice of a fact when he has actual knowledge of the fact, receipt of notice of the fact, or reason to know that the fact exists, given all the facts and circumstances known at the time. A demand instrument is overdue if it is taken after demand has been made or an unreasonable time after its issue (90 days in the case of a check). A time instrument is overdue if it is taken after its expressed due date.
The shelter principle states that anyone who can trace his title to a negotiable instrument back to an HDC has the rights of an HDC. If a holder was a party to fraud or some other illegality affecting an instrument, however, he cannot acquire HDC rights by reacquiring the instrument from an HDC.
Liability, Defenses, and Discharge
Before ending this lesson, we want to examine the liability of the parties who sign the instrument and the warranty liability of those who transfer instruments and present instruments for payment. Focus is on liability on the instrument itself or on the warranties connected with transfer or presentment of the instrument, as opposed to liability on the underlying contract. We will review some defenses against payment on negotiable instruments and ways in which parties may be discharged from liability.
Except for a qualified indorser, every party who signs a negotiable instrument is either primarily or secondarily liable for payment of the instrument when it comes due. Makers and acceptors are primarily liable to pay the instrument, subject to certain defenses. If an instrument is incomplete when the maker signs it, the maker is obligated to pay it as completed. An acceptoris a drawee, who, by signing an instrument, has agreed to pay it when it is presented for payment. A drawee that does not accept dishonors the instrument. On certification of a check, the drawee bank becomes an acceptor and is primarily liable on the check to holders.
Drawers and indorsers have secondary liability. If the drawee fails to pay or to accept a draft, the drawer is liable for the instrument; whereas if the maker defaults on a note, an indorser is liable instead. To trigger liability, the instrument must be properly and timely presented, it must be dishonored, and notice of dishonor must be given in a timely manner to the secondarily liable party.
A note or certificate of deposit must be presented to the maker for payment; a draft to the drawee for acceptance, payment or both. Depending on the instrument, presentment may be made by any commercially reasonable means, through a clearinghouse procedure, or at the place specified in the instrument for acceptance or payment. Unqualified indorsers are most commonly discharged due to failure to present on time.
Dishonor occurs when acceptance or payment is refused, cannot be obtained or is excused, and the instrument is not accepted or paid. Notice, which may be given in any reasonable manner, must be given by a bank before its midnight deadline and by all others within 30 days. If more than one indorsement appears on an instrument, each indorser is liable for the full amount to any later indorser or to any holder.
If an accommodation party signs on behalf of a maker, he is primarily liable but if an accommodation party indorses an instrument on behalf of a payee or other holder, he is secondarily liable. An accommodation party is never liable to the party accommodated, but if the accommodation party pays the instrument, he has a right to recover the amount from the party that was accommodated.
There is a variety of rules with respect to principal and agent indorsements that emphasize the need for clarity about the principal-agent relationship reflected on the indorsement. If the agent includes the principal's name in the signature on an instrument, the principal is liable but not the agent. If the agent signs only his/her own name, the agent is liable to an HDC who has no notice that the agent was not intended to be liable. To avoid liability to other holders, the agent must show that the original parties did not intend the agent to be liable. An exception to this rule exists if the instrument is a check payable from the account of a principal who is identified on the check; in that case, the agent is not liable. If the agent signs the principal's and agent's names without indicating agency status, the agent is liable but not the principal, unless the instrument is a check payable from the account of a principal who is identified on the check, in which case, the principal is liable but not the agent. If the agent indicates agency status without naming the principal, the agent is liable but not the principal, except if the instrument is a check payable from the account of a principal who is identified on the check, making the principal liable and not the agent.
These contingency rules continue in Article 3 of the UCC for situations in which there are unauthorized agents or signatures. It is important to know where to locate these rules if you are in a position that requires justifying payments and managing liability.
Warranty Liability
Transfer warranties arise even when a transferor does not indorse the instrument. Any person who transfers an instrument for consideration warrants to all subsequent transferees and holders who take the instrument in good faith that:
1) the transferor is entitled to enforce the instrument;
2) all signatures are authentic and authorized;
3) the instrument is unaltered;
4) the instrument is not subject to assertable defenses or claims of any party against the transferor; and
5) the transferor has no knowledge of any insolvency proceedings against the maker, the acceptor, or the drawer.
Transfer by indorsement and delivery of order paper extends warranty liability to any subsequent holder who takes the instrument in good faith. The warranties of a person who transfers without indorsement extend only to the immediate transferee.
Any person who seeks payment or acceptance of an instrument implies warrants to any other person who in good faith pays or accepts the instrument that: 1) the party is entitled to enforce the instrument or is authorized to obtain payment or acceptance on behalf of a person who is entitled to enforce the instrument; 2) the instrument has not been altered; and 3) the party has no knowledge that the signature of the issuer is unauthorized.
Defenses
Universal defenses, which are good against all holders, including HDCs and holders who take through HDCs, include:
Forgery of a Maker's or Drawer's Signature
Fraud in the Execution - This defense cannot be raised when a reasonable inquiry would have revealed the nature and terms of the instrument. Important factors include the signer's age, experience, and intelligence.
Material Alteration - this is only a partial defense against an HDC, who can enforce the instrument against the maker or drawer according to the original terms. If the instrument was originally incomplete, the HDC can enforce it as completed.
Discharge in Bankruptcy - This is an absolute defense against all parties, because the purpose of bankruptcy is to settle all of the insolvent party's debts.
Minority - This is a universal defense only to the extent that state law recognizes it.
Illegality - If a statute makes an illegal transaction void, this defense is universal. If the transaction is only voidable, this is a personal defense.
Mental Incapacity - Any instrument issued by a mentally incompetent person is void, and this defense is universal, if the person has been declared mentally incompetent by a court. If not, this defense is personal.
Extreme Duress
Personal defenses include:
Breach of Contract or Breach of Warranty
Lack or Failure of Consideration
Fraud in the Inducement (Ordinary Fraud)
Illegality - If a statute makes an illegal transaction voidable, this is a personal defense.
Mental Incapacity - Any instrument issued by a mentally incompetent person is voidable, and this defense is personal, if the person has not been declared mentally incompetent by a court.
Other Personal Defenses - Ordinary duress, discharge by payment or cancellation, unauthorized completion of an incomplete instrument, and non-delivery.
Discharge
All parties to an instrument are discharged when the party primarily liable on it pays to a holder the amount due in full. Payment by any other party discharges only that party and subsequent parties. A holder can discharge any party by cancellation. Crossing out a party's indorsement cancels that party's liability and the liability of subsequent indorsers who have already indorsed the instrument. Discharge can also occur when a party's right of recourse is impaired.
Lesson Three: Checks and Banking in the Digital Age
Articles 3 and 4 of the Uniform Commercial Code (UCC) govern checks. Article 3 covers the extent to which any party is either charged with or discharged from liability on a check. Article 4 covers the principles and rules of modern bank deposit-and-collection procedures, governs the relationship of banks with one another to process checks, and establishes a framework for deposit and checking agreements between a bank and its customers. If there is a conflict between Articles 3 and 4, Article 4 controls.
Learning Objectives
By the end of this lesson, you should be able to:
Discuss the bank-customer relationship
Explain and evaluate the mechanics of the banking system, including checks, electronic fund transfers, and e-money and online banking
Content
The Bank-Customer Relationship
A checkis a draft drawn on a bank. If an institution other than a bank, as defined in UCC 4-105(l), handles a check for payment or collection, Article 4 does not apply.
The rights and duties of a bank and its customer are contractual and depend on the nature of the transaction. A creditor-debtor relationship exists when the customer makes cash deposits into a checking account, or receives final payment for checks drawn on other banks, while a principal (customer)-agent (bank) relationship exists during check collection. For instance, when a drawee bank wrongfully fails to honor a check, it is liable to its customer for damages resulting from the refusal, unless properly dishonored for insufficient funds, in which case there is no liability to the customer.
A bank may dishonor a check that, if cashed, would create an overdraft in the customer's account, or the bank may charge the customer's account for the amount of the check, provided that the customer has agreed in advance. When a check bounces, the holder can resubmit it, but he should, notify prior indorsers of the dishonor or they will be discharged.
If a bank charges a postdated check against a customer's account, despite the customer's timely notice to the bank, the bank may be liable for any damages to the customer.
A bank is not obligated to pay an uncertified check presented more than 6 months from its date (a "stale check").
If a bank does not know of an adjudication of incompetence when a check is issued or its collection has been undertaken, it may pay the check without liability. However, once a bank knows of a death, it may pay or certify checks drawn on or before the date of death for 10 days after the date of death, unless a person claiming an interest in that account orders the bank to stop.
Only a customer can order his bank to pay a check, and then order a stop-payment but a customer may not order a stop payment on a certified (or otherwise pre-accepted) check. A holder may recover all expenses incurred, interest, and consequential damages from a bank for wrongful dishonor of a check, and he may also sue the drawer. If the bank pays the check over the customer's order, the bank is liable to the customer for the amount of any actual loss.
A forged signature on a check has no legal effect as the drawer's signature, and the bank must determine the authenticity of the signature on a customer's check. If the bank pays on a forged signature, it must recredit the customer's account unless the customer's negligence substantially contributes to the forgery. The customer's liability may be reduced by any loss caused by negligence on the part of a person paying the instrument or taking it for value if the negligence substantially contributed to the loss.
A customer must examine monthly statements and canceled checks and report any forged signatures promptly. If a bank does not send the checks, it must for 7 years keep them or copies. If a customer fails to do this, he is liable for any loss to the bank. To recover for a series of forgeries of the same signature by the same wrongdoer, a customer must report the first item to the bank within 30 calendar days of receipt of the bank statement. A customer who fails to report his forged signature within 1 year of the date that the statement was available for inspection loses the right to have the bank recredit his account.
If the bank is also negligent, the bank is liable on a comparative negligence basis, but negligence is not implicated for failure to examine every signature on every check.
A bank that pays a customer's check bearing a forged indorsement must recredit the customer's account or be liable to the customer for breach of contract, unless the customer fails to report the forgery within 3 years after the item with the forged indorsement was available to the customer). The bank in turn may recover the check from the bank that sent it, and so on up the line to the first party who took the check with the forgery.
If the bank pays an altered check, it is liable for the difference between the check's original amount and the amount paid. The bank may recover from the transferor for breach of warranty, unless the bank is the drawer and the transferor is an HDC. A customer's negligence may shift the loss, unless the bank was also negligent.
Accepting Deposits
Under the Expedited Funds Availability Act 1987 and Regulation CC, any local check must be cleared within 1 business day from the date of deposit. Non-local checks must be cleared within 5 business days. Certain checks, including government checks and cashier's checks, must be cleared before the next day. Exceptions include deposits at non-proprietary ATMs, new accounts, deposits over $5,000 and deposits into accounts with repeated overdrafts.
Banks must pay interest on the full balance of a customer's interest-bearing account each day. The Truth-in-Savings Act 1991 and Regulation DD also require that new customers be given certain information, including the rate of interest (if any) stated in terms of the annual percentage yield on the account, and the amount of fees, charges, penalties, and how they are calculated.
Check collection rules include the following:
Any bank can be a depositary bank, a collecting bank, a payor bank, and an intermediary bank;
An item payable by the depositary (payor) bank that receives it (an "on-us item") that is not dishonored by the opening of the second banking day following its receipt is considered paid; and
Each bank in the collection chain must pass a check on before midnight of the next banking day following its receipt, subject to deferred posting.
Electronic Fund Transfers
There are four principal types of EFT systems:
1) automated teller machines;
2) point-of-sale systems;
3) systems handling direct deposits and withdrawals of funds; and
4) pay-by-telephone systems.
To initiate a transaction, a consumer often uses an access card and a personal identification number (PIN).
The Electronic Fund Transfer Act (EFTA) of 1978 governs consumer electronic fund transfers. The Federal Reserve System's board of governors administers the act and issued Regulation E to protect users of EFT systems. Under the EFTA, the terms and conditions of EFTs must be disclosed in readily understandable language when a customer contracts for the services. A receipt (with certain information) must be provided at an electronic terminal at the time of each transfer. Financial institutions must give customers periodic statements describing transfers for each account through which an EFT system provides access; and some preauthorized payments can be stopped within 3 days before they are made.
A transfer is unauthorized if:
1) it is initiated by a person other than the consumer and without actual authority to initiate such transfer;
2) the consumer receives no benefit from it; and
3) the consumer did not furnish such person "with the card, code, or other means of access" to his account.
The customer's liability may be limited to less than $500 if the institution is notified within 60 days of the date the transaction shows up on the customer's statement.
A customer must check the statements provided by the financial institution and report any errors within 60 days. Generally, the institution must investigate and report the results within 10 business days in a full written report with conclusions. Failure to do so, or to otherwise follow EFTA requirements exactly, may result in liability for actual damages, attorneys' fees, and punitive damages.
UCC Article 4A, adopted by most states, covers transactions not subject to the EFTA or other federal or state law. Typically, these are transfers between commercial parties, often of large sums.
E-money and Online Banking
A significant implication of electronic payments is the potential to replace physical cash with virtual cash (e-money) in the form of electronic impulses, or digital cash. The use of e-money has already fulfilled its promise to change the nature of money and the world of banking, and clearly technology may take those changes further.
Stored-Value Cards are plastic cards embossed with magnetic stripes containing magnetically encoded data for a person to buy specific goods and services offered by the particular issuer. Smart cards are plastic cards containing microchips that can hold more information than a magnetic stripe. They are more versatile than stored-value cards, are less prone to error, and carry and process security programming (such as a digital signature). Debits and credits are automatic and can be immediate, or stored for later use.
An issuer of e-money may be subject to the Right to Financial Privacy Act 1978 if the issuer is deemed to be: 1) a bank by virtue of its holding customer funds or 2) an entity that issues a physical card similar to a credit or debit card. The Financial Services Modernization Act (Gramm-Leach-Bliley Act) 1999 proscribes the disclosure of financial institutions' customer data without notice and an opt-out opportunity.
Online banking services have raised questions about the application of traditional banking regulations to online banks. For example, under the Community Reinvestment Act, a bank must define its market area. What is the market area of an Internet bank?
The Uniform Money Services Act (UMSA)
Money service businesses do not accept deposits, unlike banks, but do issue money orders, traveler's checks, and stored-value cards; exchange foreign currency; and cash checks. The UMSA applies to traditional money services the same regulations that apply to other, traditional financial service businesses.
Internet-based systems subject to the new law may include:
E-money and internet payment mechanisms
Internet scrip
Stored-value products (smart cards, prepaid cards, value-added cards)
The UMSA requires persons engaged in money transmission, check cashing or currency exchange to obtain a license from a state, to be examined by state officials, to report on its activities to the state, and to comply with certain record keeping requirements. Money service businesses would also be covered by rules that govern investments, and be required to follow "safety and soundness rules," which concern the posting of bonds and annual auditing of their books [see UMSA 2-204].
Discussion Question:
All businesses use negotiable instruments to conduct their business, some in more complex ways than others. Choose an example of a negotiable instrument (preferably used by your own organization) that demonstrates how negotiable instruments function as contracts into which the organization enters. Using what we learned about contracts last week, discuss briefly how your example creates obligations for the organization, whether it is the payer or the payee in your example, and how the organization should perform its obligations. In your comments to other classmates use course concepts, including what you learned last week, to discuss what might constitute a breach of the contract and what remedies might be available for the breach.
Textbook and Resources
Roger LeRoy Miller and William Eric Hollowell. Business Law Text & Exercises. 7th edition, 2013. South-Western/Cengage Learning.
ISBN13: 978-1133625957.