Ebook Business law (14th edition): Part 2

(BQ) Part 2 book Business law has contents: Negotiable instruments; negotiation and holder in due course, checks and electronic transfers, the agency relationship, the agency relationship, history and nature of corporations, management of corporations, administrative agencies, employment law, environmental regulation,...and other contents.

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Commercial Paper chapter 31

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Chances are that you are using a variety of negotiable instruments in your everyday life, perhaps without

realizing the special qualities that have led to their widespread use in commerce and the rules that ern them If you have a job, your employer probably pays you by check, and you likely have a checkingaccount that you use to make purchases and pay your bills If you have accumulated some savings, you may haveinvested them in a certificate of deposit at a bank And, if you have borrowed money, you very likely were asked

gov-to sign a promissory note acknowledging the debt and committing gov-to repay it on specified terms This chapterintroduces the law of negotiable instruments, including:

• The special qualities and benefits of negotiable instruments

• The basic types of commercial paper and their defining characteristics

• The formal requirements that must be met for instruments such as checks, notes, and certificates of deposit

to qualify as negotiable instruments

• What happens if you write or receive a check in which there is a conflict between the amount set forth infigures and the amount set out in words

• Whether it was ethical for the purchaser of two engines to deliberately place two different amounts on acheck (one figure using a check-writing machine and the other by writing numerals in handwriting) that wassent in payment for the engines

chapter 31

NEGOTIABLE INSTRUMENTS

AS COMMERCE AND TRADE developed, people

moved beyond exclusive reliance on barter to the use of

money and then to the use of substitutes for money The

term commercial paper encompasses substitutes in

com-mon usage today such as checks, promissory notes, and

certificates of deposit

History discloses that every civilization that engaged

to an appreciable extent in commerce used some form of

commercial paper Probably the oldest commercial paper

used in the carrying on of trade is the promissory note

Archaeologists found a promissory note made payable to

bearer that dated from about 2100 B.C The merchants of

Europe used commercial paper—which, under the law

merchant, was negotiable—in the 13th and 14th

cen-turies Commercial paper does not appear to have been

used in England until about A.D 1600

This chapter and the three following chapters outline

and discuss the body of law that governs commercial

paper Of particular interest are those kinds of

commer-cial paper having the attribute of negotiability—that is,

they can generally be transferred from party to party andaccepted as a substitute for money This chapter dis-cusses the nature and benefits of negotiable instrumentsand then outlines the requirements an instrument mustmeet to qualify as a negotiable instrument Subsequentchapters discuss transfer and negotiation of instruments,the rights and liabilities of parties to negotiable instru-ments, and the special rules applicable to checks

Nature of Negotiable Instruments

When a person buys a television set and gives themerchant a check drawn on his checking account, thatperson uses a form of negotiable commercial paper Sim-ilarly, a person who goes to a bank or a credit union toborrow money might sign a promissory note agreeing topay the money back in 90 days Again, the bank and bor-rower use a form of negotiable commercial paper

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Chapter Thirty-One Negotiable Instruments 807

unless he could locate the thief By using a check inwhich Searle orders his bank to pay $10,000 from hisaccount to Amado, or to someone designated by Amado,Searle makes the payment in a far more convenient man-ner He sends only a single piece of paper to Amado Ifthe check is properly prepared and sent, sending thecheck is less risky than sending money Even if someonesteals the check along the way, Searle’s bank may not pay

it to anyone but Amado or someone authorized byAmado And, because the check gives Amado the righteither to collect the $10,000 or to transfer the right to col-lect it to someone else, the check is a practical substitutefor cash to Amado as well as to Searle

In this chapter and in the three following chapters, wediscuss the requirements necessary for a contract for thepayment of money to qualify as a negotiable instrument

We also explain the features that not only distinguish anegotiable instrument from a simple contract but also led

to the widespread use of negotiable instruments as a stitute for money

sub-Kinds of Negotiable Instruments

Promissory Notes The promissory note is thesimplest form of commercial paper; it is simply a prom-

ise to pay money A promissory note is a two-party instrument in which one person (known as the maker)

makes an unconditional promise in writing to pay

an-other person (the payee), a person specified by that

per-son, or the bearer of the instrument, a fixed amount ofmoney, with or without interest, either on demand or at aspecified, future time [3–104].1

The promissory note, shown in Figures 1 and 2, is acredit instrument; it is used in a wide variety of transac-tions in which credit is extended For example, if a per-son purchases an automobile using money borrowedfrom a bank, the bank has the person sign a promissorynote for the unpaid balance of the purchase price Simi-larly, if a person borrows money to purchase a house, thelender who makes the loan and takes a mortgage onthe house has the person sign a promissory note for theamount due on the loan The note probably states that it

is secured by a mortgage The terms of payment on thenote should correspond with the terms of the sales con-tract for the purchase of the house

Commercial paper is basically a contract for the

payment of money It may serve as a substitute for money

payable immediately, such as a check Or, it can be used

as a means of extending credit When a television set is

bought by giving the merchant a check, the check is a

substitute for money If a credit union loans a borrower

money now in exchange for the borrower’s promise to

repay it later, the promissory note signed by the borrower

is a means of extending credit

Uniform Commercial Code The law of

commercial paper is covered in Article 3 (Negotiable

Instruments) and Article 4 (Bank Deposits and

Collec-tions) of the Uniform Commercial Code Other negotiable

documents, such as investment securities and documents

of title, are treated in other articles of the Code The

origi-nal Code Articles 3 and 4, adopted initially in the 1960s,

generally followed the basic, centuries-old rules

govern-ing the use of commercial paper; but at the same time they

adopted modern terminology and coordinated, clarified,

and simplified the law However, business practices

con-tinued to evolve and new technological developments

have changed the way that banks process checks

Accord-ingly, in 1990 a Revised Article 3, along with related

amendments to Articles 1 and 4, were developed and have

now been adopted by all states except New York However,

the reader should keep in mind that instruments may be

interpreted under the version of the Code that was in effect

when the instruments were issued

Negotiable Instruments The two basic types

of negotiable instruments are promises to pay money and

orders to pay money Promissory notes and certificates

of deposit issued by banks are promises to pay someone

money Checks and drafts are orders to another person to

pay money to a third person A check, which is a type of

draft, is an order directed to a certain kind of person,

namely a bank, to pay money from a person’s account to

a third person

Negotiability Negotiable instruments are a special

kind of commercial paper that can pass readily through

our financial system and is accepted in place of money

This gives negotiable instruments many advantages

For example, Searle, the owner of a clothing store inNew York, contracts with Amado, a swimsuit manufac-

turer in Los Angeles, for $10,000 worth of swimsuits If

negotiable instruments did not exist, Searle would have

to send or carry $10,000 across the country, which would

be both inconvenient and risky If someone stole the

money along the way, Searle would lose the $10,000

1 The numbers in brackets refer to the sections of the 1990 Revised Article 3 (and the conforming amendments to Articles 1 and 4) of the Uniform Commercial Code.

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Figure 1 Promissory Note

Payee

Maker

Days after Date Promise to Pay to the Order of

Due

Dollars

Amanda Brown One Thousand And No/100 - - - - -

10 October 1, 2010

July 1, 2010

$1,000.00

Certificates of Deposit The certificate of

de-posit given by a bank or a savings and loan association

when a deposit of money is made is a type of note,

namely a note of a bank A certificate of deposit is an

instrument containing (1) an acknowledgment by a bank

that it has received a deposit of money and (2) a promise

by the bank to repay the sum of money [3–104(j)]

Most banks no longer issue certificates of deposit

(CD) in paper form Rather, the bank maintains an

elec-tronic deposit and provides the customer with a

state-ment indicating the amount of principal held on a CD

basis and the terms of the CD, such as the maturity and

interest rate In these instances, the certificate of deposit

is not in negotiable instrument form

Drafts A draft is a form of commercial paper that

in-volves an order to pay money rather than a promise to

pay money [3–104(e)] The most common example of a

draft is a check A draft has three parties to it: one person

(known as the drawer) orders a second person (the

drawee) to pay a certain sum of money to a third person

(the payee), to a person specified by that person, or to

bearer

Drafts other than checks are used in a variety of

com-mercial transactions If Brown owes Ames money, Ames

may draw a draft for the amount of the debt, naming

Brown as drawee and herself or her bank as payee, and

send the draft to Brown’s bank for payment

Alterna-tively, Ames might send a draft providing for payment on

a certain day in the future to Brown for “acceptance.”

Brown could “accept” the draft by signing his name to it,

thereby obligating himself to pay the amount specified in

the draft on that day in the future to Ames or to someone

specified by Ames Automobile dealers selling to each

other, or selling cars at auctions, commonly use drafts, as

do sellers and buyers of livestock

In freight shipments in which the terms are “cash ondelivery,” the seller commonly ships the goods to thebuyer on an “order bill of lading” consigned to himself atthe place of delivery The seller then indorses the bill oflading and attaches a draft naming the buyer as drawee

He then sends the bill of lading and the draft throughbanking channels to the buyer’s bank A bank in thebuyer’s locale presents the draft to the buyer’s bank forpayment, and when the former bank receives payment,delivers the bill of lading to the buyer Through this com-mercial transaction, the buyer gets the goods and theseller gets his money

When credit is extended, the same procedure is lowed, but the seller uses a time draft—a draft payable atsome future time (see Figure 3) In such a transaction,the buyer “accepts” the draft (instead of paying it) andobligates herself to pay the amount of the draft when due

fol-In these cases, the drawee (now called the acceptor)

should date her signature so that the date at which ment is due is clear to all [3–409(c)]

pay-As a consumer, you are most likely to encounterdrafts when your insurance company pays a claim—you’ll see that often it is denoted as a “DRAFT” and in-dicates that it is payable through a particular bank Thisnotation means that the bank will pay the draft to youonly after it has checked with the insurance company(the drawer) and the insurance company authorizes thebank to pay the instrument

Checks A check is a draft payable on demand and

drawn on a bank (i.e., a bank is the drawee or person towhom the order to pay is addressed) Checks are themost widely used form of commercial paper The issuer

of a check orders the bank at which she maintains an count to pay a specified person, or someone designated

ac-by that person, a fixed amount of money from the

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Figure 2 Promissory Note (Consumer Loan Note)

The words I and me mean all borrowers who signed this note The word bank means The National Bank of Washington.

Signed:

Date:

The National

BANK OF WASHINGTON

CONSUMER LOAN NOTE

CONSUMER CREDIT HOTLINE:If you have any questions, please call us immediately at (202) 624-3450.

NBW 437 (Rev 11-78) 1-Bank's copy 2-File copy 3-Customer's copy

This is what I will pay:

Amount of loan Credit Life Insurance (optional) Other (describe) Amount Financed (Add 1 and 2 and 3) FINANCE CHARGE Total of Payments (Add 4 and 5) ANNUAL PERCENTAGE RATE

7,875.00 10.5%

This is how I will repay:

I will repay the amount of this note in equal uninterrupted monthly installments of $

each on the day of each month starting on the day of , 20 and ending

on ,

30 262.50 1st

Prepayment

Any installment not paid within ten days of its due date shall be subject to a late charge of 5% of the payment, not to exceed $5.00 for any such late installment.

Late Charge

To protect the National Bank of Washington, I give what is known as a security interest in my auto and/or other: (Describe)

Promise to Pay life insurance is $ for the term of the loan.

Credit life insurance is not required to obtain this loan.

The bank need not provide it and I do not need to buy

it unless I sign immediately below The cost of credit

Credit Life Insurance

100.00

If for any reason I fail to make any payment on time, I shall be in default The bank can then demand immediate payment of the entire remaining unpaid balance of this loan, without giving anyone further notice If I have not paid the full amount of the loan when the final payment is due, the bank will charge me interest on the unpaid balance at six percent (6%) per year.

Default

If this loan becomes past due, the bank will have the right to pay this loan from any deposit or security I have at this bank without telling me ahead of time.

Even if the bank gives me an extension of time to pay this loan, I still must repay the entire loan.

Right of Offset

If this note is placed with an attorney for collection, then I agree to pay an attorney's fee of fifteen percent (15%) of the unpaid balance This fee will be added to the unpaid balance of the loan.

Collection Fees

If I am signing this note as a co-borrower, I agree to

be equally responsible with the borrower for this loan.

The bank does not have to notify me that this note has not been paid The bank can change the terms of payment and release any security without notifying or re-

als responsible for paying back the full amount.

Source: The National Bank of Washington.

account For example, Elizabeth Brown has a checking

account at the National Bank of Washington She goes to

Sears Roebuck and agrees to buy a washing machine

priced at $459.95 If she writes a check to pay for it, she

is the drawer of the check, the National Bank of

Washington is the drawee, and Sears is the payee By

writing the check, Elizabeth is ordering her bank to pay

$459.95 from her account to Sears or to Sears’s order—that is, to whomever Sears asks the bank to pay themoney (see Figure 4)

An instrument may qualify as a “check” and be erned by Article 3 even though it is described on its facewww.downloadslide.com

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BANK OF WASHINGTON

traditional paper checks This process, called “check

conver-sion,” starts with the buyer giving the seller a paper check The

seller uses special equipment to gather information from the

paper check; this information includes the buyer’s bank

account number, the “routing number” that identifies the buyer’s bank, and the check’s serial number Then, the seller hands the paper check back to the buyer and completes the transaction by naming itself as the payee of the transaction and by coding in the amount of the purchase Check conversion is one of the fastest-growing means of taking payments from consumer buyers and saves the seller time and money it otherwise would spend collecting the paper check from the buyer’s bank The legal rules concerning e-checks are discussed in Chapter 34—Checks and Electronic Transfers.

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by another term, such as “money order.” The Code

defi-nition of a “check” includes a “cashier’s check” and a

“teller’s check.” A cashier’s check is a draft on which the

drawer and drawee are the same bank (or branches of the

same bank); a teller’s check is a draft drawn by a bank

(as drawer) on another bank or payable at or through a

bank [3–104(g) and (h)] For example, a check drawn by

a credit union on its account at a federally insured bank

would be a teller’s check

Benefits of Negotiable

Instruments

Rights of an Assignee of a Contract As

we noted in Chapter 17, Rights of Third Parties, the

as-signee of a contract can obtain no greater rights than the

assignor had at the time of the assignment For example,

Browning Construction Company agrees to build an

in-ground swimming pool pursuant to plans provided by

Geraldo Garcia At the time the contract is signed by the

two parties on March 1, Garcia makes a down payment

of $5,000 and agrees to pay the balance of $20,000 when

Browning Construction completes the pool If on April 1,

Browning Construction assigns its rights under the

con-tract to First Bank—including the right to collect the

money from Garcia—then First Bank will obtain

what-ever rights Browning Construction has at the time First

Bank seeks to collect the balance due on the contract If

Browning Construction has completed its work

consis-tent with the plans, then First Bank is entitled to be paid

the $20,000 However, if the work has not been

com-pleted, or was not done consistent with the plans, then

Garcia may have a valid defense or reason to avoid

pay-ing the full $20,000

Taking an assignment of a contract involves assumingcertain risks The assignee (First Bank) may not be aware

of the nature and extent of any defenses that the party liable

on the contract (Garcia) might have against the assignor

(Browning Construction) An assignee who does not know

what rights he is getting, or which risks he is assuming,

may be reluctant to take an assignment of the contract

Rights of a Holder of a Negotiable

In-strument The object of a negotiable instrument is to

have it accepted readily as a substitute for money In

order to accept it readily, a person must be able to take it

free of many of the risks assumed by the assignee of a

regular contract Under the law of negotiable

instru-ments, this is possible if two conditions are met: (1) the

contract for the payment of money must meet the formal

requirements to qualify as a negotiable instrument; and(2) the person who acquires the instrument must qualify

as a holder in due course Basically, a holder in due course is a person who has good title to the instrument,

paid value for it, acquired it in good faith, and had no tice of certain claims or defenses against payment In ad-dition, the instrument cannot bear facial irregularities(evidence of forgery or alteration or questions concern-ing its authenticity)

no-The next section of this chapter discusses the formalrequirements for a negotiable instrument Chapter 32,Negotiation and Holder in Due Course, outlines the re-quirements that a person must meet to qualify as a holder

in due course

A holder in due course of a negotiable instrumenttakes the instrument free of all defenses and claims to theinstrument except those that concern its validity For ex-ample, a holder in due course of a note given in paymentfor goods may enforce the obligation in spite of thebuyer’s claim that the seller breached a warranty How-ever, if the maker of a note wrote it under duress, such as

a threat of force, or was a minor, then even a holder indue course is subject to the defenses of duress or infancy

to the extent other law (1) would nullify the obligationfor duress or (2) would permit infancy as a defense to asimple contract The person who holds the note could notobtain the payment from the maker but would have to re-cover from the person from whom he got the note.The Federal Trade Commission (FTC) has adopted aregulation that alters the rights of a holder in due course

in consumer purchase transactions This regulation lows a consumer who gives a negotiable instrument touse additional defenses (breach of warranty or fraudu-lent inducement) against payment of the instrumentagainst even a holder in due course Similarly, some stateshave enacted the Uniform Consumer Credit Code(UCCC), which produces a similar result Chapter 32, Ne-gotiation and Holder in Due Course, discusses the rights

al-of a holder in due course, as well as the FTC rule

Formal Requirements for Negotiability

Basic Requirements An instrument such as acheck or a note must meet certain formal requirements to

be a negotiable instrument If the instrument does notmeet these requirements, it is nonnegotiable; that is, it istreated as a simple contract and not as a negotiableinstrument A primary purpose for these formal require-ments is to ensure the willingness of prospectivewww.downloadslide.com

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812 Part Seven Commercial Paper

purchasers of the instrument, particularly financial

insti-tutions such as banks, to accept it as a substitute for

money

For an instrument to be negotiable, it must:

1 Be in writing.

2 Be signed by the issuer (the maker in the case of a

person undertaking to pay or the drawer in the case of

a person giving an order or instruction to pay)

3 Contain an unconditional promise or order to pay a

fixed amount of money, with or without interest or

other charges described in the promise or order

4 Be payable to order or to bearer.

5 Be payable on demand or at a definite time.

6 Not state any other undertaking or instruction by the

person promising or ordering to do any act in addition

to the payment of money (however, it may contain

(a) an undertaking or promise relative to collateral to

secure payment, (b) an authorization for confession of

judgment, or (c) a waiver of benefit of any law

in-tended for the advantage or protection of an obligor)

[3–103; 3–104]

In addition, an instrument that otherwise qualifies as

a check can be negotiable even if it is not explicitly

payable to order or to bearer [3–104(c)] As explained

later, this means that a check that reads “pay John Doe”

could be negotiable even though the normal form for a

check is “pay to the order of _.”

A promise or order other than a check is not a

nego-tiable instrument if at the time it is issued or first comes

into the possession of a holder it contains a conspicuous

statement that the promise or order is not negotiable or is

not an instrument governed by Article 3 [3–104(d)] For

example, if a promissory note contained the legend

“NONNEGOTIABLE,” it would not qualify as a

nego-tiable instrument even if it otherwise met the formal

requirements for one

Importance of Form Whether or not an

instru-ment satisfies these formal requireinstru-ments is important

only for the purpose of determining whether an

instru-ment is negotiable or nonnegotiable Negotiability

should not be confused with validity or collectibility If

an instrument is negotiable, the law of negotiable

instru-ments in the Code controls in determining the rights and

liabilities of the parties to the instrument If an

instru-ment is nonnegotiable, the general rules of contract law

control The purpose of determining negotiability is to

ascertain whether a possessor of the instrument can

be-come a holder in due course

An instrument that meets all of the formal ments is a negotiable instrument even though it is void,voidable, unenforceable, or uncollectible for other rea-sons Negotiability is a matter of form and nothing else.Suppose a person gives an instrument in payment of agambling debt in a state that has a statute declaring thatany instrument or promise given in payment of agambling debt is void The instrument is a negotiableinstrument if it is negotiable in form even though it isabsolutely void Also, an instrument that is negotiable inform is a negotiable instrument even though it is issued

require-by a minor The instrument is voidable at the option ofthe minor if state law makes infancy a defense to a sim-ple contract, but it is negotiable

In Writing

To be negotiable, an instrument must be in writing Aninstrument that is handwritten, typed, or printed is con-sidered to be in writing [1–201(46)] The writing doesnot have to be on any particular material; all that is re-quired is that the instrument be in writing A personcould create a negotiable instrument in pencil on a piece

of wrapping paper It would be poor business practice

to do so, but the instrument would meet the statutoryrequirement that it be in writing

Signed

To qualify as a negotiable instrument, an instrument inthe form of a note must be signed by the person under-taking to pay (the maker) and an instrument in the form

of a draft must be signed by the person giving the struction to pay (the drawer) [3–103] An instrument hasbeen signed if the maker or drawer has put a name orother symbol on it with the intention of validating it[3–401(b)] Normally, the maker or drawer signs an in-strument by writing his name on it; however, this is notrequired A person or company may authorize an agent tosign instruments for it A typed or rubber-stamped signa-ture is sufficient if it was put on the instrument to vali-date it A person who cannot write her name might make

in-an X or some other symbol in-and have it witnessed bysomeone else

In the Interbank of New York case, which follows, the

court considered whether preauthorized checks ing the notation “verbally authorized by your depositor”met the requirement that an instrument must be “signed,”among other things, in order to qualify as a negotiableinstrument

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contain-Interbank of New York v Fleet Bank

45 UCC Rep.2d 167 (New York Civ Ct 2001)

Interbank of New York brought an action against Fleet Bank to recover on four drafts in the total sum of $3,361.25 paid out

by Interbank from the account of its customer Dimittrous Tasoulis Two of the drafts were issued by and made payable to Sprint PCS, and two were issued by and made payable to Atlantic Mobile, Inc The drafts are known commonly in the bank- ing industry as preauthorized drafts or “telechecks.” The drafts are created when a consumer has agreed to pay for goods or services by allowing a vendor to prepare and issue a preauthorized check drawn on the consumer’s account at the consumer’s designated financial institution The consumer provides the vendor with the necessary account number and bank at which it

is maintained, and the vendor then issues a check drawn on the consumer’s account.

In this case, Sprint and Atlantic Mobile issued drafts on the account of Tasoulis to pay for telephone services The drafts contained the typed notation “verbally authorized by your depositor.” Bell and Atlantic Mobile deposited the drafts in their respective accounts at Fleet, and the drafts were ultimately paid by Interbank.

Thereafter, Tasoulis advised Interbank that he had never authorized Atlantic Mobile or Sprint to issue the drafts and cuted affidavits to that effect as to each draft Interbank then sued Fleet Bank to recover the amount of the drafts.

exe-Fleet took the position that the preauthorized checks should be treated like any other check and that in accordance with the UCC a depository bank such as Fleet could not be held liable for accepting a check on which the signature of the drawer

is forged, unless it knew the signature was forged (this will be discussed in Chapter 33, Liability) Interbank took the tion that a preauthorized check cannot be treated as an ordinary check and is not a negotiable instrument.

posi-Chapter Thirty-One Negotiable Instruments 813

Edmead, Judge

Section 3–104(a) of the UCC provides that for a writing to be a

negotiable instrument it must be signed by the maker or drawer.

Interbank argues that since the subject drafts are not signed by

the maker, but merely contain the notation “verbally authorized

by your depositor,” the drafts do not constitute negotiable

instruments.

UCC section 1–201(3) provides that “signed” includes any symbol executed or adopted by a party with a present intention

to authenticate a writing UCC section 3–401(2) provides that a

signature is made by any word or mark used in lieu of a written

signature.

In accordance with these sections of the UCC, if a drawer or maker intended the notation “verbally authorized by your de-

positor” to authenticate the checks and intended that the

nota-tion take the place of a written signature, then the check would

be a negotiable instrument.

Clearly, if Tasoulis had authorized Atlantic Mobile to issue the check with the notation “verbally authorized by your depos-

itor,” in place of his written signature, the check would qualify

as a negotiable instrument The only infirmity in the subject drafts is that Tasoulis did not authorize their issuance Thus, the notation “verbally authorized by your depositor,” which could constitute a signature under the UCC, is unauthorized The unauthorized use of a stamped printed signature constitutes a forgery So too here the notation “verbally authorized by your depositor,” which can constitute a signature under the UCC, when unauthorized, constitutes a forged signature Ac- cordingly, the preauthorized checks should be treated as any other check that contains a forged signature These preauthorized checks constitute negotiable instruments.

Summary judgment granted to Fleet.

Note: The case did not address the issue of whether Atlantic Mobile

and Sprint would be liable to Interbank if they did not have the proper authorization from Tasoulis It should also be noted that this case was decided under the pre-1990 version of Articles 3 and 4 as New York has not adopted the 1990 Revision of Articles 3 and 4 However, the same result would be expected if it had adopted the Revised Articles.

Unconditional Promise

or Order

Requirement of a Promise or Order If

an instrument is promissory in nature, such as a note or a

certificate of deposit, it must contain an unconditional

promise to pay or it cannot be negotiable Merely

acknowl-edging a debt is not sufficient [3–103(9)] For example,the statement “I owe you $100” does not constitute apromise to pay An IOU in this form is not a negotiableinstrument

If an instrument is an order to pay, such as a check or

a draft, it must contain an unconditional order A simplerequest to pay as a favor is not sufficient; however, a po-litely phrased demand, such as “please pay,” can meet thewww.downloadslide.com

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ap-gotiable instruments and be readily transferable Two of these

requirements contemplate paper-based transactions—the

requirement that promises to pay and orders to pay be “in

writing” (see 3–103) and be “signed” (see 3–104) For this

rea-son, at present, it would be difficult to “electrify” negotiable

instruments successfully.

In contrast, e-payments—more commonly substitutes

for traditional “check” payments—are neither in writing or

“signed” by affixing a signature in ink to a sheet of paper

In-stead, the transaction is documented electronically—such as

by sending an e-mail message or fax to a bank to direct them

to pay a third-party seller of goods or services (such as the

purchase of an online information product).

The buyer and seller using e-payments have many of the same concerns as buyers and sellers using traditional payments methods: they want to be certain that they are dealing with each other honestly and that it will not be easier for the seller to double-charge the buyer’s account or to get away with taking payment but not delivering the goods or services that the buyer seeks from the transaction; and they want to guard against unscrupulous persons hacking into their records and stealing from either the buyer or seller Because of legal uncer- tainty about which body of law—federal consumer protection laws designed to govern credit-card payments or “electronic funds transfers” or state-created laws such as Articles 3 and 4

of the Uniform Commercial Code—will govern the transaction, the majority of consumers have continued to use traditional, paper-based payments methods and credit cards that they un- derstand better than newer e-payments methods of payment For e-commerce to reach its fullest potential, more consumers will have to become comfortable with e-payments methods, in addition to better-known checks and credit cards.

requirement Checks commonly use the language “Pay

to the order of.” This satisfies the requirement that the

check contain an order to pay The order is the word “pay,”

not the word “order.” The word “order” has another

function—that of designating the instrument as payable

“to order” or “to bearer” for purposes of negotiability

Promise or Order Must Be

Uncondi-tional An instrument is not negotiable unless the

promise or order is unconditional For example, a note

that provides, “I promise to pay to the order of Karl

Adams $100 if he replaces the roof on my garage,” is not

negotiable because it is payable on a condition

To be negotiable, an instrument must be written so

that a person can tell from reading the instrument alone

what the obligations of the parties are If a note contains

the statement “Payment is subject to the terms of a

mort-gage dated November 20, 2010,” it is not negotiable To

determine the rights of the parties on the note, one would

have to examine another document—the mortgage

However, a reference to another document for a

state-ment of rights with respect to collateral, prepaystate-ment, or

acceleration does not destroy the negotiability of a note

[3–106(b)] For example, a note could contain this

state-ment: “This note is secured by a mortgage dated August

30, 2010” without affecting its negotiability In this

case, the mortgage does not affect rights and duties of

the parties to the note It would not be necessary to amine the mortgage document to determine the rights

ex-of the parties to the note; the parties need only examinethe note

The negotiability of an instrument is not affected by astatement of the consideration for which the instrumentwas given or by a statement of the transaction that gaverise to the instrument For example, a negotiable instru-ment may state that it was given in payment of lastmonth’s rent or that it was given in payment of the pur-chase price of goods The statement does not affect thenegotiability of the instrument

A check may reference the account to be debited out making the check conditional and thus nonnegotiable.For example, a check could contain the notation, “payrollaccount” or “petty cash.” Similarly, the account numberthat appears on personal checks does not make the instru-ment payable only out of a specific fund Under originalArticle 3, a check (other than a governmental check) thatstated that it was payable only out of a specific fund or ac-count was treated as a conditional order and thus was notnegotiable Revised Article 3 changed this rule so thatlimiting payment to a particular fund or source does notmake the promise or order conditional [3–106(b)].Revised Article 3 also addresses the negotiability oftraveler’s checks that commonly require, as a condition

with-to payment, a countersignature of a person whose

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specimen signature appears on the draft Under the

revi-sion, the condition does not prevent the instrument from

meeting the “unconditional promise or order”

require-ment [3–106(c)] However, if the person whose specimen

signature appears on the instrument fails to countersign

it, the failure to sign becomes a defense to the obligation

of the issuer to pay This concept will be discussed in the

following chapter

A conditional indorsement does not destroy the

nego-tiability of an otherwise negotiable instrument The Code

determines negotiability at issuance, so that

indorse-ments do not affect the underlying negotiability of the

instrument We discuss conditional indorsements in

Chapter 32, Negotiation and Holder in Due Course

Fixed Amount of Money

Fixed Amount The promise or order in an

instru-ment must be to pay a fixed amount of money, with or

without interest or other charges described in the

prom-ise or order The requirement of a “fixed amount” applies

only to principal; the amount of any interest payable is

that described in the instrument Interest may be stated in

an instrument as a fixed or variable amount of money or

it may be expressed as a fixed or variable rate or rates If

a variable rate of interest is prescribed, the amount of

interest is calculated by reference to the formula or index

referenced in the instrument For example, a note might

provide for interest at “three percent (3.00%) over

JPMorgan Chase Prime Rate to be adjusted monthly.” If

the description of interest in the instrument does not

allow the amount of interest to be ascertained, then

inter-est is payable at the judgment rate in effect at the place of

payment at the time interest first accrues [3–112] The

judgment rate is the rate of interest courts impose on

losing parties until they pay the winning parties

Under the original version of Article 3, a promise ororder had to be to pay a “sum certain.” Generally, to meet

this requirement, a person had to be able to compute

from the information in the instrument the amount

re-quired to discharge—or pay off—the instrument at any

given time Among other things, this caused problems

when applied to variable rate instruments that came into

common commercial usage in the United States after the

original Article 3 was drafted Some state courts held

that instruments providing for variable interest rates

as-certainable through reference to indexes outside the

instrument were not negotiable; other courts sought to

interpret the Code to accommodate this new commercial

practice As noted above, the negotiability of instruments

that provide for variable interest rates has now been solved in Revised Article 3

re-Payable in Money The amount specified in the

instrument must be payable in money Money is a

medium of exchange authorized or adopted by a tic or foreign government and includes a monetary unit

domes-of account established by an intergovernmental zation or by agreement between two or more nations[1–201(24)] Unless the instrument otherwise provides,

organi-an instrument that states the amount payable in foreignmoney may be paid in the foreign money or in an equiv-alent dollar amount [3–107] If the person obligated topay off an instrument can do something other than paymoney, the instrument is not negotiable For example, if

a note reads, “I promise to pay to the order of SarahSmith, at my option, $40 or five bushels of apples, JohnJones,” the note is not negotiable

Payable on Demand

or at a Definite Time

To be negotiable, the promise or order must be payable ther on demand or at a specified time in the future Thereason for this requirement is that the time when the in-strument is payable can be determined with some cer-tainty An instrument that is payable on the happening ofsome uncertain event is not negotiable Thus, a notepayable “when my son graduates from college” is not ne-gotiable, even though the son does graduate subsequently

ei-Payable on Demand A promise or order is

“payable on demand” if (1) it states that it is payable on

“demand” or “sight” (or otherwise at the will of theholder of the instrument) or (2) does not state any timefor payment [3–108(a)] For example, if the maker for-gets to state when a note is payable, it is payable imme-diately at the request of the holder of the note

An instrument may be antedated or postdated, andnormally an instrument payable on demand is notpayable before the date of the instrument [3–113(a)].However, revised Article 3 makes an important excep-tion for checks: a payor bank (a bank that is the drawee

of a draft) may pay a postdated check before the stated

date unless the drawer has notified the bank of postdating

pursuant to a procedure set out in the Code [3–113(a);4–401(c)] that is similar to the process involved in stop-ping payment on a check (See Chapter 34.)

Payable at a Definite Time A promise ororder is “payable at a definite time” if it is payable at awww.downloadslide.com

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816 Part Seven Commercial Paper

fixed date or dates or at a time or times readily

ascertain-able at the time the promise or order is issued [3–108(b)]

Thus, a note dated March 25, 2010, might be made

payable at a fixed time after a stated date, such as “30

days after date.”

Under the Code, an instrument that names a fixed

date or time for payment—without losing its negotiable

character—also may contain a clause permitting the time

for payment to be accelerated at the option of the maker

Similarly, an instrument may allow an extension of time

at the option of the holder or allow a maker or acceptor

to extend payment to a further definite time Or, the due

date of a note might be triggered by the happening of an

event, such as the filing of a petition in bankruptcy

against the maker The Code permits these clauses so

long as one can determine the time for payment with

cer-tainty [3–108]

A promise or order also is “payable at a definite time”

if it is payable on elapse of a definite period of time after

“sight” or “acceptance.” A draft payable at a specified

time—such as “15 days after sight”—is, in effect, payable

at a fixed time after the draft is presented to the drawee

for acceptance

If an instrument is undated, its “date” is the date it is

issued by the maker or drawer [3–113(b)]

Payable to Order or Bearer

Except for checks, to be negotiable an instrument must be

“payable to order or to bearer.” A note that provides, “I

promise to pay to the order of Sarah Smith” or “I promise

to pay to Sarah Smith or bearer” is negotiable However,

one that provides “I promise to pay to Sarah Smith” is

not The words “to the order of ” or “to bearer” show that

the drawer of a draft, or the maker of a note, intends to

issue a negotiable instrument The drawer or maker is not

restricting payment of the instrument to just Sarah Smith

but is willing to pay someone else designated by Sarah

Smith This is the essence of negotiability

In the original version of Article 3, an order in the

form of a check also had to be “payable to order or

bearer” to qualify as a negotiable instrument However,

the drafters of Revised Article 3 created an exception for

instruments that otherwise meet the requirements for a

negotiable instrument as well as the definition of a check

[3–104(c)] Under the revised article, a check that reads

“Pay John Doe” could qualify as a negotiable instrument

As a result, the Code treats checks, which are payment

instruments, as negotiable instruments whether or not

they contain the words “to the order of.” The drafters

ex-plained that most checks are preprinted with these words

but that occasionally the drawer may strike out the wordsbefore issuing the check and that a few check forms havebeen in use that do not contain these words In these in-stances, the drafters preferred not to limit the rights ofholders of such checks who may pay money or givecredit for a check without being aware that it is not in theconventional form for a negotiable instrument

A promise or order is considered to be payable “toorder” if it is payable (1) to the order of an identified per-son or (2) to an identified person or that person’s order[3–109(b)] Examples would include: “Pay to the order

of Sandy Smith” and “Pay to Sandy Smith or order.” Themost common forms of a promise or order being payable

to bearer use the words “pay to bearer,” “pay to the order

of bearer,” “pay to cash,” or “pay to the order of cash”[3–109(a)] A check sent with the payee line blank ispayable to bearer However, it is also considered an in-complete instrument, the rules concerning which will bediscussed in the following two chapters

The original payee of a draft or a note can transfer theright to receive payment to someone else By makingthe instrument payable “to the order of ” or “to bearer,”the drawer or maker is giving the payee the chance to ne-gotiate the instrument to another person and to cut offcertain defenses that the drawer or maker may haveagainst payment of the instrument

An instrument that is payable to the order of a specificperson is known as “order paper.” Order paper can be ne-gotiated or transferred only by indorsement An instru-ment payable “to bearer” or “to cash” is known as

“bearer paper”; it can be negotiated or transferred by livery of possession without indorsement [3–201(b)].The rules governing negotiation of instruments will bedetailed in the next chapter

de-An instrument can be made payable to two or morepayees For example, a check could be drawn payable “tothe order of John Jones and Henry Smith.” Then, bothJones and Smith have to be involved in negotiating it orenforcing its payment An instrument also can be madepayable to alternative persons—for example, “to theorder of Susan Clark or Betsy Brown.” In this case, eitherClark or Brown could negotiate it or enforce its payment[3–110(d)]

A number of recent cases have addressed the question

of whether checks should be interpreted as being payablejointly, or whether they are payable in the alternative.Some of those cases have addressed the use of the vir-gule ( / ) punctuation mark to separate the names of thepayees One recent case involved a check made payable

to “International Livestock/Purina Mills.” The court soned that a virgule is used to separate alternatives and

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rea-Pelican National Bank v Provident Bank of Maryland

849 A.2d 475 (Maryland Ct App 2004)

Hartford Mutual Insurance Company issued a check drawn on Allfirst Bank in the amount of $60,150.00 to payees as follows:

Andrew Michael Bogdan, Jr., Crystal Bodgan Oceanmark Bank FSB

ad-The check, indorsed only by the Bodgans and the adjuster, was presented for payment to Provident Bank, which cashed

it Michael Bodgan deposited the proceeds to a commercial account he held at Provident Bank When Oceanmark Bank was unable to obtain reimbursement from Provident Bank for negotiating the check without Oceanmark Bank’s indorsement, it brought suit against Provident Bank for conversion of the check by paying it without having obtained a required indorsement The trial court held that the check was ambiguous as to whether it was payable jointly and thus negotiable only with the indorsement of all of the payees Accordingly, the court held that it could be negotiated with the indorsement of any of the named payees Oceanmark Bank appealed.

Bell, Chief Judge

The issue in this case is whether a check made payable to

mul-tiple payees, listed in stacked formation on its face, without any

grammatical connector or punctuation, is ambiguous as to

whether it is negotiable only jointly, thus, requiring the

indorse-ment of all of the named payees, or alternatively, requiring the

indorsement of any one of the named payees.

Enacted as part of the 1996 revision to the Maryland form Commercial Code, Section 3–110(d) enunciates the rules

Uni-for determining, objectively, the intent of a drawer with respect

to an instrument made payable to multiple payees Therefore,

we must first examine Section 3–110(d) to determine whether

the stacked payee format in this case is an ambiguous multiple

payee designation as contemplated by the Maryland

Legisla-ture when it enacted the statute Section 3–110(d) provides:

(d) If an instrument is payable to two or more persons natively, it is payable to any of them and may be negotiated, discharged, or enforced by any or all of them in possession

alter-of the instrument If an instrument is payable to two or more persons not alternatively, it is payable to all of them and may be negotiated, discharged, or enforced only by all of

them If an instrument payable to two or more persons is ambiguous as to whether it is payable to the persons alternatively, the instrument is payable to the persons alternatively The Official Comment to that section provides further guid- ance regarding how to treat a check with multiple payees:

An instrument payable to X or Y is governed by the first sentence of subsection (d) An instrument payable to X and

Y is governed by the second sentence of subsection (d) If

an instrument is payable to X or Y, either is the payee and if either is in possession that person is the holder and the person entitled to enforce the instrument If an instrument

is payable to X and Y, neither X nor Y acting alone is the person to whom the instrument is payable The instrument is “payable to an identified person.” The “identified person” is X and Y acting jointly.

* * * The third sentence of subsection (d) is directed to cases in which it is not clear whether an instrument is payable to multiple payees alternatively In the case of ambiguity, persons dealing with the instrument should be able to rely on the indorsement of a single payee For example, an instrument

concluded that the check required only the indorsement

of either International Livestock or Purina Mills The

fol-lowing case, Pelican National Bank, involves a check

where the payees were listed in a stacked formation

with-out any grammatical connector or punctuation The courtconcluded that the check was ambiguous and applied thedefault rule that treated the document as if it was payable

in the alternative

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Galatia Community State Bank v Kindy 307 Ark 467 (Ark Sup Ct 1991)

Galatia Community State Bank honored a check it took for collection for $5,550, which was the amount imprinted by a writing machine in the center underlined section of the check commonly used for stating the amount in words The imprint looked like this:

check-Registered

No 497345 **5550 DOL’S 00 CTS

The impression made by the check-writing machine could be felt on the front and back of the check, and “**5550 DOL’S

00 CTS” was imprinted in red ink In the box on the right-hand side of the check commonly used for numbers, “6,550.00”

payable to X and/or Y is treated like an instrument payable

to X or Y.

Thus, Section 3–110(d), confirmed by the explanation in

the Official Comment, clearly and unambiguously enunciates

the default rule, that, unless checks payable to multiple payees

are specifically and clearly made payable jointly or in the

alter-native, they are ambiguous with respect to how they are to be

paid and, therefore, are payable alternatively Indeed, that is

precisely what the last sentence of the section states.

Applying Section 3–110(d) and this default rule to the facts

of this case produces a clear result The subject check was

drawn to the order of three payees, listed in stacked format,

with no grammatical connector, punctuation or symbol ing their relationship or how the check was intended to be paid Therefore, the check was neither clearly payable in the alternative, the payees not being connected by “or” or its equivalent, nor clearly payable jointly, the payees not being joined by

indicat-“and” or its equivalent It was, consequently, we hold, ous as to whether it is payable to the persons alternatively.” Accordingly, we further hold, it was proper for Provident Bank

“ambigu-to have negotiated the check without the indorsement of Oceanmark The indorsement of any one of the payees was sufficient.

Judgment for Provident Bank affirmed.

Special Terms

Additional Terms Generally, if an instrument is

to qualify as a negotiable instrument, the person

promis-ing or orderpromis-ing payment may not state undertakpromis-ings or

instructions in addition to the payment of money

[3–104(a)(3)] However, the instrument may include

clauses concerning (1) giving, maintaining, or protecting

collateral to secure payment; (2) an authorization to

con-fess judgment or to realize on or dispose of collateral;

and (3) waiving the benefit of any law intended for the

protection or benefit of any person obligated on the

instrument

Thus, a term authorizing the confession of judgment

on an instrument when it is due does not affect the

nego-tiability of the instrument A confession of judgment

clause authorizes the creditor to go into court if the

debtor defaults and, with the debtor’s acquiescence, to

have a judgment entered against the debtor However,

some states prohibit confessions of judgment

Banks and other businesses often use forms of

com-mercial paper that meet their particular needs These

forms may include certain other terms that do not affectthe negotiability of an instrument For example, a notemay designate a place of payment without affecting theinstrument’s negotiability Where the instrument does notspecify a place of payment, the Code sets out rules for as-certaining where payment is to be made [3–111]

Ambiguous Terms Occasionally, a person maywrite or receive a check on which the amount written infigures differs from the amount written in words Or anote may have conflicting terms or an ambiguous term.Where a conflict or an ambiguous term exists, there aregeneral rules of interpretation that are applied to resolvethe conflict or ambiguity: Typewritten terms prevail overprinted terms, handwritten terms prevail over printed andtypewritten terms, and where words and numbers con-flict, the words control the numbers [3–114]

The following Galatia Community State Bank v Kindy case involves a check on which there was a differ-

ence between the numbers on the check placed there

by a check-writing machine and the number written byhand

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appeared in handwriting The check was in partial payment of the purchase price of two engines that Eugene Kindy was ing from the payee on the check, Tony Hicks Kindy postdated the check by a month and deliberately placed two different amounts on the check because he thought the bank would check with him before paying it Kindy wanted to be sure that the engines had been delivered to Canada before he paid the $6,550 balance of the purchase price.

buy-After the check was deposited in the Galatia Bank and Hicks was given $5,550, an employee of the bank altered the “6”

by hand to read “5.” Because Kindy had stopped payment on the check, the drawee bank refused to pay it to Galatia Bank Galatia Bank then brought suit against Kindy as the drawer of the check One of the issues in the lawsuit was how the check should be constructed The trial court found that the rules on construction provided in the Code were not helpful because they were contradictory The trial court held in favor of Kindy, and Galatia Bank appealed.

Newbern, Justice

The trial court reviewed Code section 3–118(b) and (c) (1987)

which has since been superseded by section 3–114 (1991) but

which was in effect at the time in question in this case The

statute provided in relevant part:

3–118 Ambiguous terms and rules of construction The following rules apply to every instrument:

* * * (b) Handwritten terms control typewritten and printed terms, and typewritten control printed.

(c) Words control figures except that if the words are ambiguous figures control.

The frustration expressed by the trial court with respect to section 3–118 which stated the applicable rules of construction

for negotiable instruments is understandable.

The $5550.00 amount imprinted by the check-writing chine upon the line customarily used for words is expressed in

ma-figures and not in words One question is whether imprinted

numbers located where words are customarily placed on a

check control figures placed where figures are customarily

placed Another question is whether handwritten figures

con-trol printing.

We find both questions satisfactorily answered in St Paul

Fire & Marine Ins Co v Bank of Salem In that case, there

was a conflict between an amount imprinted by a

check-imprinting machine and numbers expressed in typewritten

figures The court recognized the imprinted amount was not

expressed in words but held “the purposes of the UCC are best

served by considering an amount imprinted by a

check-writing machine as ‘words’ for the purpose of resolving an

ambiguity between an amount and an amount entered upon

the line usually used to express the amount in figures.” The

court quoted from a pre-UCC case, United States Fidelity and

Guaranty Co v First National Bank of South Carolina (1964),

as follows:

A prime purpose, as we see it, of making a sum payable when expressed in words controlling over the sum payable expressed in figures is the very fact that words are much

more difficult to alter The perforated imprinting by a check-writing machine, while fully expressing the sum payable in figures, is even more difficult to successfully alter than a sum payable in written words.

Because a check-imprinting machine’s purpose is to protect against alterations, the amount shown on the imprint should control whether the number is in words or figures.

Turning to the question of whether typewriting controls

printing, the court in United States Fidelity and Guaranty Co.

stated:

As the section makes clear, in the event of an ambiguity tween printed terms and typewritten terms, the latter would control We do not consider the impression made by the check imprinter to be “printed terms” under this section.

be-A conflict between the two amounts on a check would be resolved by section 3–118 which states that words control figures Arguably, the amount imprinted by the check- writing machine upon the line customarily expressing the amount in words, is expressed in figures We think, however, that the purposes of the UCC are best served by considering an amount imprinted by a check-writing machine as “words” for the purpose of resolving an ambiguity between that amount and an amount entered upon the line usually used to express the amount in figures.

Although the court did not say specifically that it regarded the portion written by the check-writing machine as the equivalent of handwriting, that is the clear effect of the decision.

In United States v Hibernia National Bank, a typed

numer-ical amount was located in the place customarily used for words The amount conflicted with the amount located in the place customarily used for figures The court found the typed amount controlling despite the fact it was not expressed in words.

Judgment for Kindy reversed on other grounds.

Note: Although, as the court notes, this case was decided under the

original version of Article 3, the dilemma posed, and the conclusion reached by the court on the construction of the check, would likely be the same under Revised Article 3.

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Problems and Problem Cases

1. Is the following instrument a note, a check, or a draft?

Why? If it is not a check, how would you have to

change it to make it a check?

To: Arthur Adams January 1, 2010

TEN DAYS AFTER DATE PAY TO THE ORDER OF:

Bernie Brown THE SUM OF: Ten thousand and no/100 DOLLARS SIGNED: Carl Clark

2. Frank agrees to build a garage for Sarah for $15,000.Sarah offers either to sign a contract showing her ob-ligation to pay Frank $15,000 or to sign a negotiablepromissory note for $15,000 payable to the order of

Requirements for Negotiability

Must Be in Writing 1 The instrument may be handwritten, typed, or printed.

Must Be Signed by the

3 Agent or authorized representative may supply the “signature.”

Must Be Payable in Money 1 Obligation must be payable in a medium of exchange authorized or adopted by a

government or by an international organization or agreement between two or more nations.

2 Maker or drawer cannot have the option to pay in something other than money.

Must Be Payable on Demand

1 Bearer requirement is met if instrument is payable “to bearer” or “to cash.”

2 Order requirement is met if instrument is payable “to the order of ” a specified person or persons.

3 Exception from requirement is made for instruments meeting both the definition

of a check and all the other requirements for a negotiable instrument.

May Not State Any Other

Under-taking or Instruction by the Person

Promising or Ordering Payment

to Do AnyAct in Addition to the

Payment of Money

1 However, it may contain (a) an undertaking or power to give, maintain, or protect collateral to secure payment, (b) an authorization or power to the holder

to confess judgment or realize on or dispose of collateral, or (c) a waiver of the

benefit of any law intended for the advantage or protection of an obligor on the instrument.

Must Call for Payment

of a Fixed Amount of Money

1 Must be able to ascertain the principal from the face of the instrument.

2 May contain a clause providing for payment of interest or other charges such as collection or attorney’s fees.

Promise or Order Must

Be Unconditional

1 Entire obligation must be found in the instrument itself and not in another document or documents.

2 Payment cannot be conditioned on the occurrence of an event.

Must Contain a Promise

or Order to Pay

1 Promise must be more than acknowledgment of a debt.

2 Order requirement is met if the drawer issues an instruction to “pay.”

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Frank Would you advise Frank to ask for the contract

or the promissory note? Explain

3. Wiley, Tate & Irby, buyers and sellers of used cars,

sold several autos to Houston Auto Sales Houstonwrote out the order for payment on the outside of sev-eral envelopes He signed them and they were drawn

on his bank, Peoples Bank & Trust Co., to be paid onthe demand of Wiley, Tate & Irby Can the envelopesqualify as negotiable instruments?

4. A handwritten note provided as follows:

I, Robert Harrison, owe Peter Jacob $25,000 five thousand dollars) as of 3/27/10 for the following:

(twenty-(1) $15,000 for Caterpillar loader (2) $5,000 for a loan

(3) $5,000 for a tag-a-long trailer.

Would this instrument qualify as a negotiableinstrument?

5. Holly Hill Acres, Ltd., executed a promissory note

and mortgage and delivered them to Rogers The notecontained the following stipulation:

This note with interest is secured by a mortgage on real estate of even herewith, made by the maker hereof in favor of the said payee, and shall be construed and enforced according to the laws of the State of Florida The terms of said mortgage are by this reference made a part hereof.

Is the note a negotiable instrument?

6. Strickland ordered a swimming pool from Kafko

Manufacturing and gave it a check for the purchaseprice that included the following words in the space

following the word memo: “for pool kit to be

deliv-ered.” Is the check negotiable?

7. Holliday made out a promissory note to Anderson,

leaving the date of payment of the note blank son filled in the words “on demand” in the blankwithout Holliday’s knowledge Does this alter therights or obligations of the parties?

Ander-8. Darryl Young presented five photocopied checks to

the Lynnwood Check-X-Change on five differentdays between June 13 and June 21 Lynwood cashedthe first four checks presented The fifth check, whichwas presented on a Saturday, was drawn on a differentaccount from the first four checks and was payable onthe following Monday Lynnwood’s practice was to

cash checks on Saturday that are dated the followingMonday Young was convicted of five counts of for-gery On appeal, Young argued that the postdatedcheck was not a legal instrument for purposes of theforgery statute The crime of forgery requires an in-strument that, if genuine, may have legal effect or bethe foundation of legal liability Young argued that thepostdated check did not meet this requirement “be-cause the time for payment had not arrived and thusthe check could not have created any legal liability onthe part of any person at that time.” If a check is post-dated, can it qualify as a negotiable instrument andcreate legal liability?

9. Emmett McDonald, acting as the personal tive of the estate of Marion Cahill, wrote a checkpayable to himself, individually, on the estate check-ing account in the Commercial Bank & Trust Com-pany The instrument contained an obvious variancebetween the numbers and the written words that indi-cated the amount of the check It said: “Pay to theorder of Emmett E McDonald $10075.00 Ten hun-dred seventy five Dollars.” The bank paid the

representa-$10,075 sum stated by the numerals to McDonald,who absconded with the funds Yates, the successorrepresentative, sued the bank on behalf of the estate torecover the $9,000 difference between that amountand the $1,075 that was written out Did the bank paythe correct amount on the check?

Accessing Information from Your Bank

Use the Internet to locate the Web site for the bank or cial institution where you maintain a checking account From the Web site ascertain the following information: (1) what is the monthly fee (if any) for maintaining the type of checking account you maintain? (2) does the institution charge a fee for each check you use or if you exceed a certain number of transactions per month? (3) what rate of interest does the institution pay on a $10,000, five-year certificate of deposit (CD)? and (4) what rate of interest does the institution charge

finan-on secured persfinan-onal loans such as a loan for the purchase of

a new car?

Online Research

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Rachel Allen purchases a used Honda from Friendly Fred’s Used Cars, paying $1,500 down and signing

a promissory note in which she promises to pay $2,000 to Fred or to his order 12 months from the date

of the note with interest at 8.5 percent Fred assures Rachel that the car is in good condition and hasnever been involved in an accident Fred indorses (signs) his name on the back of the promissory note anddiscounts (assigns) the note to Factors, Inc Subsequently, Rachel discovers that, contrary to Fred’s assurance, theHonda had in fact been involved in an accident that caused a front-end alignment problem When Factors noti-fies her of the assignment to it of the note and asks for payment on the due date, Rachel wants to assert a defense

of failure of consideration or breach of contract (warranty) against full payment of the note

Among the legal issues raised in this scenario are:

• When Fred transferred the promissory note to Factors after signing his name to the back of it, what rightsdid Factors obtain?

• Will Rachel be able to assert a defense of failure of consideration or breach of contract against full payment

of the note to Factors?

• If the promissory note contained the clause required by the Federal Trade Commission in consumer notes orinstallment sales contracts, would it change Rachel’s rights?

chapter 32

NEGOTIATION AND HOLDER

IN DUE COURSE

THE PRECEDING CHAPTER DISCUSSED the nature

and benefits of negotiable instruments It also outlined

the requirements an instrument must meet to qualify as a

negotiable instrument and thus possess the qualities that

allow it to be accepted as a substitute for money

This chapter focuses on negotiation—the process by

which rights to a negotiable instrument pass from one

person to another Commonly, this involves an

indorse-ment and transfer of the instruindorse-ment This chapter also

develops the requirements that a transferee of a

nego-tiable instrument must meet to qualify as a holder in due

course and thus attain special rights under negotiable

in-struments law These rights, which put a holder in due

course in an enhanced position compared to an assignee

of a contract, are discussed in some detail

In this chapter, you also will consider whether it

would be ethical to incur a gambling debt, to issue a

check or other negotiable instrument in satisfaction of

the debt, and then assert the defense of illegality against

payment of the instrument

Negotiation

Nature of Negotiation Under Revised Article 3,

negotiation is the transfer of possession (whether

volun-tary or involunvolun-tary) of a negotiable instrument by aperson (other than the issuer) to another person who be-

comes its holder [3–201] A person is a holder if she is

in possession of an instrument (1) that is payable tobearer or (2) made payable to an identified person andshe is that identified person [1–201(20)].1

For example, when an employer gives an employee,Susan Adams, a paycheck payable “to the order of SusanAdams,” she is the holder of the check because she is inpossession of an instrument payable to an identified per-son (Susan Adams) and she is that person When she in-dorses (writes her name) on the back of the check and

1 The numbers in brackets refer to sections of the Uniform Commercial Code (UCC), which is reproduced in the appendix.

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exchanges it for cash and merchandise at Ace Grocery,

she has negotiated the check to the grocery store and the

store is now the holder because it is in possession by

transfer of a check and unless she specifies the grocery

store by name, the check now is payable to bearer

Simi-larly, if Susan Adams indorsed the check “Pay to the

Order of Ace Grocery, Susan Adams” and transferred it

to the grocery store, it would be a holder through the

ne-gotiation of the order check to it The grocery store

would be in possession of an instrument payable to an

identified person (Ace Grocery) and is the person

identi-fied in the check

In certain circumstances, Revised Article 3 allows aperson to become a holder by negotiation even though

the transfer of possession is involuntary For example, if

a negotiable instrument is payable to bearer and is stolen

by Tom Thief or found by Fred Finder, Thief or Finder

becomes the holder when he obtains possession The

in-voluntary transfer of possession of a bearer instrument

results in a negotiation to Thief or Finder

Formal Requirements for Negotiation

The formal requirements for negotiation are very simple

If an instrument is payable to the order of a specific

payee, it is called order paper and it can be negotiated

by transfer of possession of the instrument after

indorse-ment by the person specified [3–201(b)]

For example, if Rachel’s father gives her a checkpayable “to the order of Rachel Stern,” then Rachel can

negotiate the check by indorsing her name on the back of

the check and giving it to the person to whom she wants

to transfer it Note that the check is order paper, not

be-cause the word order appears on the check but rather

because it named a specific payee, Rachel Stern

If an instrument is payable “to bearer” or “to cash,” it

is called bearer paper and negotiating it is even simpler.

An instrument payable to bearer may be negotiated by

transfer of possession alone [3–201(b)] Thus, if

some-one gives you a check that is made payable “to the order

of cash,” you can negotiate it simply by giving it to the

person to whom you wish to transfer it No indorsement

is necessary to negotiate an instrument payable to bearer

However, the person who takes the instrument may ask

for an indorsement for her protection By indorsing the

check, you agree to be liable for its payment to that

per-son if it is not paid by the drawee bank when it is

pre-sented for payment This liability will be discussed in

Chapter 33, Liability of Parties

Nature of Indorsement An indorsement is

made by adding the signature of the holder of the

instru-ment to the instruinstru-ment, usually on the back of it, either

alone or with other words Indorsement is defined to

mean “a signature (other than that of a maker, drawer oracceptor) that alone or accompanied by other words, ismade on an instrument for purpose of (i) negotiating theinstrument, (ii) restricting payment of the instrument, or(iii) incurring indorser’s liability on the instrument”[3–204(a)] The negotiation and restriction of paymentaspects of indorsements will be discussed below; in-dorser’s liability will be covered in the next chapter.The signature constituting an indorsement can be sup-plied or written either by the holder or by someone who isauthorized to sign on behalf of the holder For example, acheck payable to “H&H Meat Market” might be indorsed

“H&H Meat Market by Jane Frank, President,” if Jane isauthorized to do this on behalf of the market

Wrong or Misspelled Name When ing an instrument, the holder should spell his name in thesame way as it appears on the instrument If the holder’sname is misspelled or wrong, then legally the indorse-ment can be made either in his name or in the name that

indors-is on the instrument However, any person who pays theinstrument or otherwise gives value for it may require theindorser to sign both names [3–204(d)]

Suppose Joan Ash is issued a check payable to theorder of “Joanne Ashe.” She may indorse the check as ei-ther “Joan Ash” or “Joanne Ashe.” However, if she takesthe check to a bank to cash, the bank may require her tosign both “Joanne Ashe” and “Joan Ash.”

Checks Deposited without ment Occasionally, when a customer deposits a check

Indorse-to her account with a bank, she may forget Indorse-to indorse thecheck It is common practice for depositary banks toreceive unindorsed checks under what are known as

“lock-box” arrangements with customers who receive ahigh volume of checks Normally, a check payable to theorder of an identified person would require the indorse-ment of that person in order for a negotiation to thedepositary bank to take place and for it to become aholder Under the original Article 3, the depositary bank,

in most cases, had the right to supply the customer’sindorsement Instead of actually signing the customer’sname to the check as the indorsement, the bank mightjust stamp on it that it was deposited by the customer orcredited to her account Banks did not have the right toput the customer’s indorsement on a check that the cus-tomer has deposited if the check specifically required thepayee’s signature Insurance and government checkscommonly require the payee’s signature

Chapter Thirty-Two Negotiation and Holder in Due Course 823

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The revision to Article 3 and the conforming

amend-ments to Articles 1 and 4 address the situation where a

check is deposited in a depositary bank without

indorse-ment differently The depositary bank becomes a holder

of an item delivered to it for collection, whether or not it

is indorsed by the customer, if the customer at the time of

delivery qualified as a holder [4–205] Concomitantly,

the depositary bank warrants to other collecting banks,

the payor bank (drawee), and the drawer that it paid the

amount of the item to the customer or deposited the

amount to the customer’s account

Transfer of Order Instrument Except for

the special provisions concerning depositary banks, if

an order instrument is transferred without indorsement,

the instrument has not been negotiated and the

trans-feree cannot qualify as a holder For example, Sue

Brown gives a check payable “to the order of Susan

Brown” to a drugstore in payment for some cosmetics.Until Sue indorses the check, she has not “negotiated” itand the druggist could not qualify as a “holder” of thecheck

Transfer of an instrument, whether or not the transfer

is a negotiation, vests in the transferee, such as the store, any right of Sue, the transferor, to enforce theinstrument However, the transferee cannot obtain therights of a holder in due course (discussed later in thischapter) if he is engaged in any fraud or illegality affect-ing the instrument Unless otherwise agreed, if an instru-ment is transferred for value but without a requiredindorsement, the transferee has the right to obtain theunqualified indorsement of the transferor; however,the “negotiation” takes place only when the transferorapplies her indorsement [3–203(c)]

drug-The Town of Freeport case, which follows, illustrates

these principles

Town of Freeport v Ring 727 A.2d 901 (Maine Sup Jud Ct 1999)

Thornton Ring was the owner of real property located on Main Street in Freeport, Maine In August 1994, the Town sent Ring

a letter noting that his 1993–1994 real estate taxes were unpaid and notified him of the Town’s intent to file a lien on the property if payment was not received within 30 days The taxes remained unpaid and a tax lien was filed on the property On January 26, 1996, because a portion of the taxes still remained unpaid, the Town sent a Notice of Impending Foreclosure

of the Tax Lien Certificate to Ring by certified mail, advising him that the tax lien would be deemed to be foreclosed on February 27, 1996 Ring subsequently was in default for his 1994–1995 taxes and similar notices were sent.

In January 1997, Ring delivered to the Town a check in the amount of $11,347.09 The check was issued by Advest, Inc., and made payable to the order of Thornton D Ring The back of the check was inscribed as follows:

Payable to Town of Freeport

Property Taxes

2 Main St[.]

The check was accompanied by a letter, signed by Ring and dated January 20, 1997, which reads, “I have paid $11,347.09

of real estate taxes and request the appropriate action to redeem the corresponding property.” On February 3, 1997, Ring received a letter from the Town which explained that the Town was returning the check because the 1994 tax lien on the property had matured in 1996.

The Town filed suit seeking a declaratory judgment that it had good title to the Main Street property One of the issues was whether the delivery of the check by Ring constituted payment of his outstanding taxes.

Clifford, Justice

With respect to a check that is made payable to the order of a

specific person, negotiation occurs, and the person receiving

the check becomes a holder of a negotiable instrument, if

pos-session of the check is transferred and the check is indorsed by

the transferor An indorsement is a signature of someone other

than the maker, or some other designation identifying the

in-dorser, that is made on an instrument for the purpose of

negoti-ating the instrument Kelly v Central Bank & Trust Co (writing

on back of check which reads “For deposit only” to an account

other than the payee’s and without payee’s signature is not an effective indorsement) If negotiation occurs and the holder qualifies as a holder in due course, the holder can demand payment of the instrument subject only to real defenses.

The check Ring sent to the Town was issued by Advest, Inc., payable to the order of Thornton D Ring Because it was payable to Ring’s order, the check could only be negotiated by Ring through indorsement and transfer of possession Ring’s signature, however, does not appear on the back of the check The words that do appear on the back of the check—“Payable

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Effects of an Indorsement There are three

functions to an indorsement First, an indorsement is

necessary in order for the negotiation of an instrument

that is payable to the order of a specified person Thus, if

a check is payable “to the order of James Lee,” James

must indorse the check before it can be negotiated

Sec-ond, the form of the indorsement that the indorser uses

also affects future attempts to negotiate the instrument

For example, if James indorses it “Pay to the order of

Sarah Hill,” Sarah must indorse it before it can be

nego-tiated further

Third, an indorsement generally makes a person liable

on the instrument By indorsing an instrument, a person

incurs an obligation to pay the instrument if the person

primarily liable on it (for example, the maker of a note)

does not pay it We discuss the contractual liability of

indorsers in Chapter 33 In this chapter, we discuss the

effect of an indorsement on further negotiation of an

instrument

Kinds of Indorsements There are three basickinds of indorsements: (1) special, (2) blank, and (3) re-strictive In addition, an indorsement may be “qualified.”

Special Indorsement A special indorsement contains

the signature of the indorser along with words indicating

to whom, or to whose order, the instrument is payable.For example, if a check is drawn “Pay to the Order ofMarcia Morse” and Marcia indorses it “Pay to the Order

of Sam Smith, Marcia Morse,” or “Pay to Sam Smith,Marcia Morse,” it has been indorsed with a special in-dorsement An instrument that is indorsed with a specialindorsement remains “order paper.” It can be negotiatedonly with the indorsement of the person specified[3–205(a)] In this example, Sam Smith must indorse thecheck before he can negotiate it to someone else

Blank Indorsement If an indorser merely signs hisname and does not specify to whom the instrument is

payable, he has indorsed the instrument in blank For

example, if a check drawn “Pay to the Order of Natalie

to Town of Freeport[/]Property Taxes[/]2 Main St[.]”—do not

identify Ring The words only indicate to whom the instrument

should have been payable had the check been properly

in-dorsed Thus, the writing is an incomplete attempt to create a

special indorsement A special indorsement is an indorsement

that identifies a person to whom the indorser is making the

check payable.

The statement included within the letter accompanying the check does not serve as a valid indorsement either In determin-

ing whether an instrument is properly indorsed, any papers

affixed to the instrument are considered part of the instrument.

See section 3–204(1) This language specifically references

only “affixed” documents Courts interpreting this language

have concluded that a signature on a separate, unattached piece

of paper is not an indorsement of the instrument Ring does not

dispute that there is no evidence on record to suggest that the

letter was physically attached to the check.

Relying on sections 3–203(3) and 3–203(2), Ring also contends that even in the absence of an indorsement, the

check should have been accepted as payment of his

outstand-ing taxes because the Town (1) had a statutory right to

de-mand an indorsement of the check, or (2) was entitled to

enforce the instrument without the indorsement Section

3–203(3) provides that “if an instrument is transferred for

value and the transferee does not become a holder because of

lack of indorsement by the transferor, the transferee has a specifically enforceable right to the unqualified indorsement

of the transferor .” Section 3–203(2) provides “Transfer of

an instrument, whether or not the transfer is a negotiation, vests in the transferee any right of the transferor to enforce the instrument.”

Even if the Town could demand an indorsement pursuant to section 3–203(3), negotiation does not occur until the indorsement is made See section 3–203(3) Thus, at the time the check was received, the Town had a right to demand an indorsement, but could not go to the bank to demand payment of the check Pursuant to section 3–203(2), the bank also had the right

to enforce the instrument as the transferee of an instrument from a holder That right, however, could be enforced only through a judicial proceeding Such contingent rights to receive payment are not sufficient to redeem property subject to

a municipal tax lien Checks are meant to be the functional equivalent of cash when they are properly issued and negotiated If the Town has to institute a judicial proceeding to receive the cash equivalent of the check, the check has not served its purpose The unindorsed check presented to the Town is not the type of payment the redemption option of the tax lien statute contemplates.

Judgment for Town affirmed.

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Lehigh Presbytery v Merchants Bancorp Inc.

17 UCC Rep 2d 163 (Penn Super Ct 1991)

Mary Ann Hunsberger was hired by the Lehigh Presbytery as a secretary/bookkeeper In this capacity, she was responsible for opening the Presbytery’s mail, affixing a rubber-stamp indorsement to checks received by the Presbytery, and depositing the checks into the Presbytery’s account at Merchants Bancorp, Inc Over a period of more than five years, Hunsberger deposited into her own account 153 of these checks Each check was indorsed: “For Deposit Only To The Credit of Presbytery

of Lehigh, Ernest Hutcheson, Treas.” The bank credited the checks to Hunsberger’s account, despite the rubber stamp tive indorsement, because it relied solely on the account number handwritten on the deposit slips submitted by Hunsberger with the checks at the time of deposit Hunsberger obtained the deposit slips in the lobby of the bank, wrote the proper account title, “Lehigh Presbytery,” but inserted her own account number rather than the account number of her employer.

restric-Owens” is indorsed “Natalie restric-Owens” by Natalie, Natalie

has indorsed it in blank An instrument indorsed in blank

is payable to the bearer (person in possession of it) and

from that act is “bearer paper.” As such, the bearer

nego-tiates it by transfer alone and no further indorsement is

necessary for negotiation [3–205(b)]

If Natalie indorsed the check in blank and gave it to

Kevin Foley, Kevin would have the right to convert the

blank indorsement into a special indorsement [3–205(c)]

He could do this by writing the words “Pay to the Order

of Kevin Foley” above Natalie’s indorsement Then

Kevin would have to indorse the check before it could be

further negotiated

If Kevin took the check indorsed in blank to a bank and

presented it for payment or for collection, the bank

nor-mally would ask him to indorse the check It asks not

because it needs his indorsement for the check to be

nego-tiated to it; the check indorsed in blank can be negonego-tiated

merely by delivering it to the bank cashier Rather, the

bank asks for his indorsement because it wants to make

him liable on the check if it is not paid when the bank

sends it to the drawee bank for payment Chapter 33,

Lia-bility of Parties, discusses the liaLia-bility of indorsers

Restrictive Indorsement A restrictive indorsement

is one that specifies the purpose of the indorsement or

specifies the use to be made of the instrument Among

the more common restrictive indorsements are:

1 Indorsements for deposit For example, “For Deposit

Only” or “For Deposit to My Account at First

Na-tional Bank.”

2 Indorsements for collection, which are commonly put

on by banks involved in the collection process For

example, “Pay any bank, banker, or trust company” or

“For collection only.”

3 Indorsements indicating that the indorsement is for

the benefit of someone other than the person to whom

it is payable For example, “Pay to Arthur Attorney inTrust for Mark Minor.”

Generally, the person who takes an instrument with arestrictive indorsement must pay or apply any money orother value he gives for the instrument consistently withthe indorsement In the case of a check indorsed “fordeposit” or “for collection,” any person other than abank who purchases the check is considered to have

converted the check unless (1) the indorser received the

amount paid for it or (2) the bank applied the amount ofthe check consistently with the indorsement (e.g., de-posited it to the indorser’s account) Similarly, a deposi-tary bank (a bank that takes an item for collection) orpayor bank (the drawee bank) that takes an instrumentfor deposit or for immediate payment over the counterthat has been indorsed “for deposit” or “for collection”will be liable for conversion unless the indorser receivedthe amount paid for the instrument or the proceeds or thebank applied the amount consistently with the indorse-ment [3–206(c)].2

By way of illustration, assume that Robert Franks hasindorsed his paycheck “For Deposit to My Account

No 4068933 at First Bank.” While on his way to the bank

he loses the check, and Fred Finder finds it If Finder tries

to cash the check at a check-cashing service, the servicemust ensure that any value it gives for the check either isdeposited to Franks’s account at First Bank or is received

by Franks If it gives the money to Finder, it will be liable

to Franks for converting his check This principle is

illus-trated in Lehigh Presbytery, which involves a bank that

failed to apply value given for checks consistently withrestrictive indorsements on the checks

2 Otherwise, a payor bank as well as an intermediary bank may disregard the indorsement and is not liable if the proceeds of the instrument are not received by the indorser or applied consistently with the indorsement [3–206(c)(4)].

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When Lehigh Presbytery discovered the diversionary scheme, it sued the bank to recover the funds credited to berger’s account The primary issue in the case was whether the bank was bound to follow the restrictive indorsements on the

Huns-153 checks that it instead had deposited to the personal account of Hunsberger The trial court ruled in favor of the bank and Lehigh Presbytery appealed.

McEwen, Judge

UCC Section 3–205 provides:

An indorsement is restrictive which either:

(3) includes the words “for collection,” “for deposit,” “pay any bank,” or like terms signifying a purpose of deposit or collection; or

.

It is undisputed that the indorsement stamped on each check by

Ms Hunsberger is a restrictive indorsement within the

pay or apply any value given by him for or on the security of the instrument consistently with the indorsement and to the extent he does he becomes a holder for value.

Thus, the UCC mandates application of the value of the checks consistently with the indorsement, that is, for deposit to Lehigh Presbytery’s account.

Courts considering the significance of a restrictive ment have consistently concluded that the UCC imposes an un- waivable obligation upon the bank to follow the indorsement New York State’s highest court has held that “[t]he presence of

indorse-a restriction imposes upon the depositindorse-ary bindorse-ank indorse-an obligindorse-ation not to accept that item other than in accord with the restriction.

By disregarding the restriction, it not only subjects itself to bility for any losses resulting from its actions, but it also passes

lia-up what may be the best opportunity to prevent the fraud.”

Judgment reversed in favor of Lehigh Presbytery.

Note: Although this case was decided under the original version of

Article 3, the same result would be expected under Revised Article 3.

Some indorsements indicate payment to the indorsee

as an agent, trustee, or fiduciary A person who takes an

instrument containing such an indorsement from the

in-dorsee may pay the proceeds to the inin-dorsee without

regard to whether the indorsee violates a fiduciary duty

to the indorser unless he is on notice of any breach of

fiduciary duty that the indorser may be committing

[3–206(d)] A person would have such notice if he took

the instrument in any transaction that benefited the

in-dorsee personally [3–307] Suppose a person takes a

check indorsed to “Arthur Attorney in Trust for Mark

Minor.” The money given for the check should be put in

Mark Minor’s trust account A person would not be

justi-fied in taking the check in exchange for a television set

that he knew Attorney was acquiring for his own—rather

than Minor’s—use

There are two other kinds of indorsements that theoriginal Article 3 treated as restrictive indorsements but

that the revised Article 3 no longer considers as

restric-tive indorsements They are:

1 Indorsements purporting to prohibit further

negotia-tion For example, “Pay to Carl Clark Only.”

2 Conditional indorsements, which indicate that they

are effective only if the payee satisfies a certain dition For example, “Pay to Bernard Builder Only if

con-He Completes Construction on My House by ber 1, 2010.”

Novem-Under Revised Article 3, any indorsement that purports

to limit payment to a particular person, or to prohibit ther transfer or negotiation of the instrument, is not effec-tive to prevent further transfer or negotiation [3–206(a)].Thus, if a note is indorsed “Pay to Carl Clark Only” andgiven to Clark, he may negotiate the note to subsequentholders who may ignore the restriction on the indorsement.Indorsements that state a condition to the right of theindorsee to receive payment do not affect the right of theindorsee to enforce the instrument Any person who paysthe instrument or takes it for value or for collection maydisregard the condition Moreover, the rights and liabili-ties of the person are not affected by whether the condi-tion has been fulfilled [3–206(b)]

fur-Qualified Indorsement A qualified indorsement is

one where the indorser disclaims her liability to make thewww.downloadslide.com

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Convention on International Bills

of Exchange and International Promissory Notes

In 1988 the Convention on International Bills of Exchange

and International Promissory Notes was adopted by the

United Nations The Convention is applicable to drafts and

notes but not to checks Under the Convention, a bill of

exchange is an order to pay money while a promissory note is

a promise to pay money To be covered, they must have the

attributes of negotiability They also must be international in

nature in that at least two of the places where their operations

occur—such as the address of the drawer or promissory, the

address of the payee, or the place of payment—must be in

dif-ferent countries The Convention also requires that the parties

must affirmatively elect to be covered by the Convention by

placing a specified legend on the instrument.

In drafting the Convention, the drafters had to try to accommodate or harmonize differences between civil and common law countries concerning negotiable instruments A major difference between the two systems is how they deal with forged indorsements Under the common law and UCC Articles 3 and 4, a forged indorsement is not effective to negotiate an instrument to the indorsee while under the civil law it is Under the civil law, the indorsee takes title to the instrument and acquires the rights of a holder, and payment

to the indorsee discharges makers and drawers As discussed

in this and the following chapter, under the UCC, an indorsee taking an instrument with a forged indorsement does not gain these rights and a maker or drawer is not discharged by making payment to that indorsee The resolution of these differences in the Convention is too complex to discuss in this textbook.

The Global Business Environment

instrument good if the maker or drawer defaults on it

Words such as “Without Recourse” are used to qualify an

indorsement They can be used with either a blank

in-dorsement or a special inin-dorsement and thus make it a

qualified blank indorsement or a qualified special

in-dorsement The use of a qualified indorsement does not

change the negotiable nature of the instrument Its effect

is to eliminate the contractual liability of the particular

indorser Chapter 33, Liability of Parties, will discuss

this liability in detail

Rescission of Indorsement Negotiation is

effective to transfer an instrument even if the negotiation

is (1) made by a minor, a corporation exceeding its

powers, or any other person without contractual

capac-ity; (2) obtained by fraud, duress, or mistake of any kind;

(3) made in breach of duty; or (4) part of an illegal

trans-action A negotiation made under the preceding

circum-stances is subject to rescission before the instrument has

been negotiated to a transferee who can qualify as a

holder in due course or a person paying the instrument in

good faith and without knowledge of the factual basis for

rescission or other remedy [3–202] The situation in such

instances is analogous to a sale of goods where the sale

has been induced by fraud or misrepresentation In such

a case, the seller may rescind the sale and recover the

goods, provided that the seller acts before the goods are

resold to a bona fide purchaser for value

Holder in Due Course

A person who qualifies as a holder in due course of a gotiable instrument gets special rights Normally, thetransferee of an instrument—like the assignee of acontract—gets only those rights in the instrument thatare held by the person from whom he got the instrument.But a holder in due course can get better rights A holder

ne-in due course takes a negotiable ne-instrument free of all

personal defenses, claims to the instrument, and claims in recoupment either of the obligor or of a third

party A holder in due course does not take free of the

real defenses, which go to the validity of the instrument

or of claims that develop after he becomes a holder Wedevelop the differences between “personal” and “realdefenses” in more detail later in this chapter and also ex-plain claims to the instrument and claims in recoupment.The following example illustrates the advantage that aholder in due course of a negotiable instrument mayhave

Assume that Carl Carpenter contracts with HelenHawkins to build her a garage for $18,500, payable on Oc-tober 1 when he expects to complete the garage Assumefurther that Carpenter assigns his right to the $18,500 toFirst National Bank in order to obtain money for materi-als If the bank tries to collect the money from Hawkins onOctober 1 but Carpenter has not finished building thegarage, then Hawkins may assert the fact that the garage is

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CONCEPT REVIEW

Indorsements (Assume a check is payable “To The Order of Mark Smith.”)

Blank Mark Smith 1 Satisfies the indorsement requirement for the negotiation of order paper.

2 The instrument becomes bearer paper and can be negotiated by delivery alone.

3 The indorser becomes obligated on the instrument (See Chapter 33, Liability of Parties.)

Special Pay to the Order

of Joan Brown, Mark Smith

1 Satisfies the indorsement requirement for the negotiation of order paper.

2 The instrument remains order paper and Joan Brown’s indorsement is required for further negotiation.

3 The indorser becomes obligated on the instrument (See Chapter 33.)

Restrictive For deposit only to my

account in First American Bank, Mark Smith

1 Satisfies the indorsement requirement for the negotiation of order paper.

2 The person who pays value for the instrument is obligated to pay it consistent with the indorsement (i.e., to pay it into Mark Smith’s account

at First American Bank).

3 The indorser becomes obligated on the instrument (See Chapter 33.)

Qualified Mark Smith (without

recourse)

1 Satisfies the indorsement requirement for negotiation of order paper.

2 Eliminates the indorser’s obligation (See Chapter 33.)

not complete as a defense to paying the bank As assignee

of a simple contract, the bank has only those rights that its

assignor, Carpenter, has and is subject to all claims and

defenses that Hawkins has against Carpenter

Now assume that instead of simply signing a contractwith Hawkins, Carpenter had Homeowner give him a

negotiable promissory note in the amount of $18,500

payable to the order of Carpenter on October 1 and that

Carpenter then negotiated the note to the bank If the bank

is able to qualify as a holder in due course, it may collect

the $18,500 from Hawkins on October 1 even though she

might have a personal defense against payment of the note

because Carpenter had not completed the work on the

garage Hawkins cannot assert that personal defense

against a holder in due course She would have to pay the

note to the bank and then independently seek to recover

from Carpenter for breach of their agreement The bank’s

improved position is due to its status as a holder in due

course of a negotiable instrument If the instrument in

question was not negotiable, or if the bank could not

qual-ify as a holder in due course, then it would be in the same

position as the assignee of a simple contract and would be

subject to Homeowner’s personal defense

We turn now to a discussion of the requirements thatmust be met for the possessor of a negotiable instrument

to qualify as a holder in due course

General Requirements In order to become a

holder in due course, a person who takes a negotiable

instrument must be a holder, and take the instrument:

1 For value.

2 In good faith.

3 Without notice that is overdue or has been dishonored

or that there is any uncured default with respect topayment of another instrument issued as part of thesame series

4 Without notice that the instrument contains an

unau-thorized signature or has been altered.

5 Without notice of any claim of a property or

posses-sory interest in it.

6 Without notice that any party has any defense against

it or claim in recoupment to it (3–302[a][2]).

In addition, revised Article 3 requires “that the ment when issued or negotiated to the holder does not

instru-bear such apparent evidence of forgery or alteration or is not otherwise so irregular or incomplete as to call into

question its authenticity” [3–302(a)(1)]

If a person who takes a negotiable instrument doesnot meet these requirements, he is not a holder in duecourse Then the person is in the same position as anassignee of a contract

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Golden Years Nursing Home, Inc v Gabbard

682 N.E 2d 731 (Obio Ct App 1996)

From 1972 until 1991, Nancy Gabbard, the office manager for the Golden Years Nursing Home, received at the nursing home Social Security checks drawn on the United States Treasury and made payable either to individual patients or to “Golden Years Nursing Home for [an individual patient].” From 1986 until 1991, Gabbard engaged in an embezzling scheme whereby she would have certain patients indorse their own checks in blank; that is, each patient would sign his own name on the back

of the check placing no restrictions on the manner in which the check could subsequently be negotiated Gabbard would then cash the checks and either keep the cash or deposit the funds into her personal bank account.

In 1992, after Gabbard’s scheme was discovered, Golden Years brought suit against Gabbard and also against the Star Bank Corporation where the checks had been cashed The patients had in other documents assigned their interests in the checks to Golden Years, and the claim against the bank alleged that it had converted Golden Years’ property by cashing checks with forged indorsements One of the issues in the lawsuit was whether the checks had been properly negotiated to Star Bank The trial court granted summary judgment to Golden Years, finding that the bank was not a holder in due course because the checks contained “forged indorsements.” Star Bank appealed.

Holder To be a holder of a negotiable instrument, a

person must have possession of an instrument that is

ei-ther payable to “bearer” or that is payable to him For

ex-ample, if Teresa Gonzales is given a check by her

grand-mother that is made payable “to the order of Teresa

Gonzales,” Teresa is a holder of the check because it is

made out to her If Teresa indorses the check “Pay to the

order of Ames Hardware, Teresa Gonzales” and gives it

to Ames Hardware in payment for some merchandise,

then Ames Hardware is the holder of the check Ames

Hardware is a holder because it is in possession of a

check that is indorsed to its order If Ames Hardware

in-dorses the check “Ames Hardware” and deposits it in its

account at First National Bank, the bank becomes the

holder The bank is in possession of an instrument that is

indorsed in blank and thus is payable to bearer

It is important that all indorsements on the instrument

at the time it is payable to the order of someone are

authorized indorsements With limited exceptions

(dis-cussed later), a forged indorsement is not an effective

indorsement and prevents a person from becoming aholder

To be a holder, a person must have a complete chain

of authorized indorsements Suppose the Internal enue Service mails to Robert Washington an income taxrefund check payable to him Tom Turner steals thecheck from Washington’s mailbox, signs (indorses)

Rev-“Robert Washington” on the back of the check, andcashes it at a shoe store The shoe store is not a holder ofthe check because its transferor, Turner, was not a holderand because it needs Washington’s signature to have agood chain of authorized indorsements Robert Wash-ington has to indorse the check in order for there to be avalid chain of indorsements Turner’s signature is not ef-fective for this purpose because Washington did not au-thorize him to sign Washington’s name to the check[1–201(20); 3–403(a); 3–416(a)(2)]

The Golden Years Nursing Home case illustrates that

a party in possession of a check indorsed in blank is aholder of the instrument

Per Curiam

The Star Bank argues that the genuine indorsement of the

indi-vidual payee designated on face of an instrument cannot

consti-tute an unauthorized signature or a forged indorsement Under

the circumstances presented in this case, we agree.

Under the Ohio Uniform Commercial Code, the term

“unauthorized signature” “includes both a forgery and a

signa-ture made by an agent exceeding his actual or apparent

author-ity,” i.e., it occurs in the context of an agency relationship.

Golden Years does not argue that the patients forged their own

signatures as that term is commonly understood Rather, it

con-tends that the signatures constitute unauthorized indorsements

and, thus, were also forged indorsements because “for purposes

of a [section 3–419] conversion action, a forged indorsement and an unauthorized indorsement are synonymous.” In addition, Golden Years does not argue that the patients were agents

of the nursing home who signed the checks without actual or apparent authority Rather, Golden Years contends that because the patients had assigned their beneficial interest in the checks

to Golden Years, any signature other than Golden Years’ rate stamp was “unauthorized.”

corpo-We note that Golden Years use of the term “unauthorized signature” does not fall within the scope of the UCC definition

of that term, i.e., “made without actual, implied or apparent

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authority.” More important, assuming that the patients had

assigned their interest in the checks to Golden Years, any

sepa-rate agreement between the patient-payees and Golden Years

would not affect the negotiability of patients’ checks bearing

the patients’ genuine indorsements.

UCC section 3–119(2) provides that a “separate agreement does not affect the negotiability of an instrument.” Negotiabil-

ity “is always to be determined by what appears on the face of

the instrument alone .” A separate writing may affect the

terms of an instrument but the Official Comment makes clear

that the inquiry is controlled by what the instrument itself states

or reflects, not, what the collateral agreement says.

If an instrument is payable to order it is negotiated by ery with any necessary indorsement (UCC 3–202) “However,

deliv-once a payee indorses the check in blank, it becomes bearer

paper which can be ‘negotiated by delivery alone’ ” (UCC

3–204) “Negotiation is the transfer of an instrument in such

form that the transferee becomes a holder” (UCC 3–202).

Thus, in this case, Gabbard became a holder of the checks

when the checks, indorsed in blank by the patient-payees, were

delivered to her When Star Bank accepted the checks that were

indorsed with the genuine signatures of the payees, the checks bore no indication that they had been assigned to Golden Years Star Bank cashed the checks in good faith without notice of any defenses and thus became a holder in due course.

This analysis does not change even if Gabbard presented the checks to the payees for their indorsement with the intent to embezzle the funds eventually:

Assuming that the stolen bearer instrument does not bear a restrictive indorsement, the thief will himself be a holder and whether or not he is a holder, he can constitute his transferee a holder simply by transfer If his transferee then cashes the check and so gives value in good faith and without notice of any defense, that transferee will be a holder in due course under 3–302, free of all claims to the instrument

on the part of any person and free of all defenses to it.

Judgment for Star Bank.

Note: Ohio’s adoption of Revised Articles 3 and 4 was not effective

until Aug 19, 1994, after the events that gave rise to this action ever, the same result would be expected under Revised Articles 3 and 4.

How-Chapter Thirty-Two Negotiation and Holder in Due Course 831

Value To qualify as a holder in due course of a

nego-tiable instrument, a person must give value for it Value

is not identical to simple consideration Under the

provi-sions of the Revised Article 3, a holder takes for value if

(1) the agreed-upon promise of performance has been

performed—for example, if the instrument was given in

exchange for a promise to deliver a refrigerator and the

refrigerator has been delivered; (2) he acquires a security

interest in, or a lien on, the instrument; (3) he takes the

instrument in payment of, or as security for, an

an-tecedent claim; (4) he gives a negotiable instrument for

it; or (5) he makes an irrevocable commitment to a third

person [3–303] Thus, a person who gets a check as a gift

or merely makes an executory promise in return for a

check has not given value for it and cannot qualify as

a holder in due course

A bank or any person who discounts an instrument in

the regular course of trade has given value for it In this

context the discount essentially is a means for increasing

the return or the rate of interest on the instrument

Like-wise, if a loan is made and an instrument is pledged as

security for the repayment of the loan, the secured party

has given value for the instrument to the amount of the

loan If Axe, who owes Bell a past-due debt, indorses and

delivers to Bell, in payment of the debt or as security for

its repayment, an instrument issued to Axe, Bell has

given value for the instrument If a bank allows a tomer to draw against a check deposited for collection, ithas given value to the extent of the credit drawn against

cus-If the promise of performance that is the tion for an instrument has been partially performed, theholder may assert rights as a holder in due course ofthe instrument only to the fraction of the amountpayable under the instrument equal to the partial per-formance divided by the value of the promised perform-ance [3–302(d)] For example, Arthur Wells agrees topurchase a note payable to the order of Helda Parks Thenote is for the sum of $5,000 Wells pays Parks $1,000 onthe negotiation of the note to him and agrees to pay thebalance of $4,000 in 10 days Initially, Wells is a holder

considera-in due course for one-fifth of the amount of the note If

he later pays the $4,000 due he may become a holder indue course for the full amount

Good Faith To qualify as a holder in due course of

a negotiable instrument, a person must take it in good

faith, which means that the person obtained it honestly

and in the observance of reasonable commercial dards of fair dealing [3–103(a)(4)] If a person obtains acheck by trickery or with knowledge that it has beenstolen, the person has not obtained the check in good faithand cannot be a holder in due course A person who payswww.downloadslide.com

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stan-too little for an instrument, perhaps because she suspects

that something may be wrong with the way it was

obtained, may have trouble meeting the good faith test

Suppose a finance company works closely with a

door-to-door sales company that engages in shoddy practices If

the finance company buys the consumers’ notes from the

sales company, it will not be able to meet the good faith

test and qualify as a holder in due course of the notes

Overdue or Dishonored In order to qualify as

a holder in due course, a person must take a negotiable

instrument before he has notice that it either is overdue

or has been dishonored The reason for this is that one

should perform obligations when they are due If a

nego-tiable instrument is not paid when it is due, the Code

considers the person taking it to be on notice that there

may be defenses to the payment of it

Overdue Instruments If a negotiable instrument is

payable on demand, it is overdue (1) the day after demand

for payment has been made in a proper manner and form;

(2) 90 days after its date if it is a check; and (3) if it is an

instrument other than a check, when it has been

outstand-ing for an unreasonably long period of time in light of the

nature of the instrument and trade practice [3–304(a)]

Thus, a check becomes stale after 90 days For other kinds

of instruments, one must consider trade practices and the

facts of the particular case In a farming community, the

normal period for loans to farmers may be six months A

demand note might be outstanding for six or seven

months before it is considered overdue On the other hand,

a demand note issued in an industrial city where the

nor-mal period of such loans is 30 to 60 days would be

consid-ered overdue in a much shorter period of time

If a negotiable instrument due on a certain date is not

paid by that date, normally then it will be overdue at the

beginning of the next day after the due date For example,

if a promissory note dated January 1 is payable “30 days

after date,” it is due on January 31 If it is not paid by

January 31, it is overdue beginning on February 1

As to instruments payable at a definite time, Revised

Article 3 sets out the following rules: (1) if the principal

is not payable in installments and the due date has not

been accelerated, the instrument is overdue on the day

after the due date; (2) if the principal is due in

install-ments and a due date has not been accelerated, the

instru-ment is overdue upon default for nonpayinstru-ment of an

installment and remains overdue until the default is

cured; (3) if a due date for the principal has been

accel-erated, the instrument is overdue on the day after the

ac-celerated due date; and (4) unless the due date of the

principal has been accelerated, an instrument does not

become overdue if there is a default in payment of est but no default in payment of principal [3–304(b)]

inter-Dishonored Instruments To be a holder in due course,

a person not only must take a negotiable instrument fore he has notice that it is overdue but also must take itbefore it has been dishonored A negotiable instrument

be-has been dishonored when the holder be-has presented it for

payment (or acceptance) and payment (or acceptance)has been refused

For example, Susan writes a check on her account atFirst National Bank that is payable “to the order of SvenSorensen.” Sven takes the check to First National Bank tocash it but the bank refuses to pay it because Susan has in-sufficient funds in her account to cover it The check hasbeen dishonored If Sven then takes Susan’s check

to Harry’s Hardware and uses it to pay for some paint,Harry’s cannot be a holder in due course of the check if it

is on notice that the check has been dishonored Harry’swould have such notice if First National had stamped thecheck “Payment Refused NSF” (not sufficient funds).Similarly, suppose Carol Carson signs a 30-day notepayable to Ace Appliance for $500 and gives it to Ace aspayment for a stereo set When Ace asks Carol for pay-ment, she refuses to pay because the stereo does not workproperly If Ace negotiates the note to First NationalBank, First National cannot be a holder in due course if

it knows about Carol’s refusal to pay

Notice of Unauthorized Signature or Alteration A holder who has notice that an instru-ment contains an unauthorized signature or has beenaltered cannot qualify as a holder in due course of theinstrument For example, Frank makes out a check in theamount of $5 payable to George Grocer and gives it tohis daughter, Jane, to take to the grocery store to pur-chase some groceries The groceries Frank wants cost

$20 and Jane changes the check to read $25, giving it toGrocer in exchange for the groceries and $5 in cash.Grocer cannot qualify as a holder in due course if he seesJane make the alteration to the check or otherwise is onnotice of it [See 3–302(a)(1).]

Notice of Claims If a person taking a negotiable

instrument is on notice of an adverse claim to the

instru-ment by someone else (for example, that a third person isthe rightful owner of the instrument) or that someoneearlier sought to rescind a prior negotiation of the instru-ment, the current holder cannot qualify as a holder in duecourse For example, a U.S Treasury check is payable toSusan Samuels Samuels loses the check and it is found

by Robert Burns Burns takes the check to a hardware

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Firstar Bank, N.A v First Service Title Agency, Inc.

54 UCC Rep.2d 701 (Ct App Ohio 2004)

On January 22, 2002, as a result of a real estate transaction, First Service Title Agency issued three checks drawn on its account with Key Bank The first check was for $850 and was payable to the order of “Richard G Knostman, Atty and Mark

F Foster, Atty and Resa Kermani & Badri Kermani.” The second check was for $36,295.80 and was made payable to “JD Properties and Resa Kermani & Badri Kermani.” The third check was for $4,010 and payable to “Knab Mortgage.”

store, signs “Susan Samuels” on the back of the check in

the view of a clerk, and seeks to use it in payment of

mer-chandise The hardware store cannot be a holder in due

course because it is on notice of a potential claim to the

instrument by Susan Samuels

Notice of Breach of Fiduciary Duty One situation in

which the Code considers a person to be on notice of a

claim is if she is taking a negotiable instrument from a

fiduciary, such as a trustee If a negotiable instrument is

payable to a person as a trustee or an attorney for

some-one, then any attempt by that person to negotiate it for his

own behalf or for his use (or benefit) or to deposit it in an

account other than that of the fiduciary puts the person

on notice that the beneficiary of the trust may have a

claim [3–307]

For example, a check is drawn “Pay to the order ofArthur Adams, Trustee for Mary Minor.” Adams takes the

check to Credit Union, indorses his name to it, and uses it

to pay off the balance on a loan Adams had from Credit

Union Credit Union cannot be a holder in due course

because it should know that the negotiation of the check

is in violation of the fiduciary duty Adams owes to Mary

Minor Ace should know this because Adams is

negotiat-ing the check for his own benefit, not Mary’s

Notice of Defenses and Claims in Recoupment To

qualify as a holder in due course, a person must also acquire

a negotiable instrument without notice that any party to it

has any defenses or claims in recoupment Potential

de-fenses include infancy, duress, fraud, and failure of

consid-eration Thus, if a person knows that a signature on the

instrument was obtained by fraud, misrepresentation, or

duress, the person cannot be a holder in due course

A claim in recoupment is a claim of the person

obli-gated on the instrument against the original payee of the

instrument The claim must arise from the transaction

that gave rise to the instrument An example of a claim in

recoupment would be as follows: Buyer purchases a used

automobile from Dealer for $8,000, giving the dealer a

note for $8,000 payable in one year Because the

automo-bile is not as warranted, Buyer has a breach of warranty

claim that could be asserted against Dealer as

counter-claim or “counter-claim in recoupment” to offset the amountowing on the note

Irregular and Incomplete Instruments

A person cannot be a holder in due course of a negotiableinstrument if, when she takes it, the instrument is irregu-lar or some important or material term is blank If the ne-gotiable instrument contains a facial irregularity, such as

an obvious alteration in the amount, then it is considered

to be irregular paper If you take an irregular

instru-ment, you are considered to be on notice of any possibledefenses to it For example, Kevin writes a check for

“one dollar” payable to Karen Karen inserts the word

“hundred” in the amount, changes the figure “$1” to

“$100,” and gives the check to a druggist in exchange for

a purchase of goods If the alterations in the amountshould be obvious to the druggist, perhaps because thereare erasures, different handwritings, or different inks,then the druggist cannot be a holder in due course Shewould have taken irregular paper and would be on noticethat there might be defenses to it These defenses includeKevin’s defense that he is liable for only $1 because that

is the amount for which he made the check

Similarly, if someone receives a check that has beensigned but the space where the amount of the check is to bewritten is blank, then the person cannot be a holder in duecourse of that check The fact that a material term is blank

means that the instrument is incomplete and should put the

person on notice that the drawer may have a defense to ment of it To be material, the omitted term must be one thataffects the legal obligation of the parties to the negotiableinstrument Material terms include the amount of the in-strument and the name of the payee If a negotiable instru-ment is unauthorizedly completed after the obligor signed

pay-it but before a person acquires pay-it, the person can qualify as

a holder in due course if she had no notice about the thorized completion A person has notice if she knows orshould know of the unauthorized completion

unau-In the case that follows, Firstar Bank, N.A v First Service Title Agency, Inc., the court concluded that a

bank could not qualify as a holder in due course of threeinstruments because it took them with obvious irregular-ities that called their authenticity into question

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First Service Title subsequently learned that the underlying real estate transaction had been fraudulent Consequently, on January 23, 2002, it put stop payment orders on all three checks and refunded the monies it had received in the transaction First Service Title notified the parties and the payees of the stop payment orders.

On the same day that First Service Title Agency placed the stop payment orders on the checks, Randall Davis, who had various accounts at Firstar Bank, presented all three checks to Firstar Bank Firstar Bank paid the checks to Davis even though Davis was not a party to any of the checks, the checks contained multiple indorsements that appeared to be in the same handwriting, and they all were marked “for deposit only.”

Key Bank subsequently returned the checks to Firstar Bank with the notation “Payment stopped.” Firstar Bank then filed suit against First Services Title Agency and Davis One of the issues in the suit against First Services Title Agency was whether Firstar Bank was a holder in due course of the three checks.

Per Curiam

A holder becomes a holder in due course if the holder takes the

instrument (1) for value; (2) in good faith; (3) and without notice

of any claims or defenses otherwise available to the person

obli-gated on the instrument or of various defects in the instrument.

A person has notice of a fact when (1) the person has actual

knowledge of it; (2) the person has received a notice or

notifica-tion of it; or (3) from all the facts and circumstances known to

the person at the time in question, the person has reason to know

that it exists Additionally, an instrument when issued or

negoti-ated to the holder, cannot bear any evidence of forgery or

alteration that is so apparent or cannot otherwise be so irregular

or incomplete as to call into question its authenticity.

The trial court held that Firstar was not a holder in due course because “it failed to exercise ordinary care having knowledge that the checks were forged or otherwise deficient.” The checks in question bore evidence of forgery and were so irregular on their face as to call into question their authenticity and to give notice to a reasonably prudent person exercising ordinary care of defects in the checks.

Judgment affirmed in favor of First Service Title Agency, Inc.

Shelter Rule The transferee of an instrument—

whether or not the transfer is a negotiation—obtains

those rights that the transferor had, including (1) the

transferor’s right to enforce the instrument and (2) any

right as a holder in due course [3–203(b)] This means

that any person who can trace his title to an instrument

back to a holder in due course receives rights like those

of a holder in due course even if he cannot meet the

re-quirements himself This is known as the shelter rule in

Article 3 For example, Archer makes a note payable to

Bryant Bryant negotiates the note to Carlyle, who

quali-fies as a holder in due course Carlyle then negotiates the

note to Darby, who cannot qualify as a holder in due course

because she knows the note is overdue Because Darby can

trace her title back to a holder in due course (Carlyle),

Darby has rights like a holder in due course when she

seeks payment of the note from Archer

There is, however, a limitation on the shelter rule A

transferee who has himself been a party to any fraud or

il-legality affecting the instrument cannot improve his

posi-tion by taking, directly or indirectly, from a later holder in

due course [3–203(b)] For example, Archer, through

fraudulent representations, induced Bryant to execute a

negotiable note payable to Archer and then negotiated the

instrument to Carlyle, who took as a holder in due course

If Archer thereafter took the note for value from Carlyle,Archer could not acquire Carlyle’s rights as a holder indue course Archer was a party to the fraud that inducedthe note, and, accordingly, cannot improve his position bynegotiating the instrument and then reacquiring it

Rights of a Holder

in Due Course

Claims and Defenses Generally RevisedArticle 3 establishes four categories of claims anddefenses They are:

1 Real defenses—which go to the validity of the

instrument

2 Personal defenses—which generally arise out of the

transaction that gave rise to the instrument

3 Claims to an instrument—which generally concern

property or possessory rights in an instrument or itsproceeds

4 Claims in recoupment—which also arise out of the

transaction that gave rise to the instrument

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CONCEPT REVIEW

Requirements for a Holder in Due Course

1 Must be a holder. A holder is a person in possession of an instrument payable to bearer or payable

to an identified person and he is that person.

a To the extent the agreed-on consideration has been paid or performed.

b To the extent a security interest or lien has been obtained in the negotiable

instrument.

c By taking the negotiable instrument in payment of—or as security for—an

antecedent claim.

d By giving a negotiable instrument for it.

e By making an irrevocable commitment to a third person.

3 Must take in good faith. Good faith means honesty in fact and the observance of reasonable commercial

standards of fair dealing.

4 Must take without notice that the instrument is overdue.

An instrument payable on demand is overdue the day after demand for payment has been duly made.

A check is overdue 90 days after its date.

If it is an instrument other than a check and payable on demand, then it is overdue when it has been outstanding for an unreasonably long period of time in light of nature of the instrument and trade practice.

If it is an instrument due on a certain date, then it is overdue at the beginning of the next day after the due date.

5 Must take without notice that the instrument has been dishonored.

An instrument has been dishonored when the holder has presented it for payment (or acceptance) and payment (or acceptance) has been refused.

6 Must take without notice of any

uncured default with respect to

payment of another instrument issued as part of the same series.

If there is a series of notes, holder must take without notice that there is an uncured default as to any other notes in the series.

7 Must take without notice that

the instrument contains an

unauthorized signature or has

10 Must take without notice of a

claim in recoupment to it.

A claim in recoupment is a claim of the obligor on the instrument against the original payee that arises from the transaction that gave rise to the instrument.

8 Must take without notice of any

claim of a property or

posses-sory interest in it.

Claims of property or possessory interest include:

a Claim by someone that she is the rightful owner of the instrument.

b Person seeking to rescind a prior negotiation of the instrument.

c Claim by a beneficiary that a fiduciary negotiated the instrument for his own

benefit.

11 The instrument must not bear

apparent evidence of forgery or alteration or be irregular or incomplete.

The instrument must not contain obvious reasons to question its authenticity.

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General Credit Corp v New York Linen Co., Inc.

46 UCC Rep.2d 1055 (New York Civ Ct., Kings County 2002)

On February 25, 2001, New York Linen Co., a party rental company, agreed to purchase approximately 550 chairs from Elite Products, a company owned by Meir Schmeltzer A deposit was given for the chairs and upon their delivery, a final check dated February 27, 2001, was issued for $13,300 After a final count of the chairs was made, New York Linen discovered that

These defenses and claims are discussed in some detail

below

Importance of Being a Holder in Due

Course In the preceding chapter, we explained that

one advantage of negotiable instruments over other kinds

of contracts is that they are accepted as substitutes for

money People are willing to accept them as substitutes for

money because, generally, they can take them free of

claims or defenses to payment between the original parties

to the instrument On the other hand, a person who takes

an assignment of a simple contract gets only the same

rights as the person had who assigned the contract

There are two qualifications to the ability of a person

who acquires a negotiable instrument to be free of claims

or defenses between the original parties First, the person

in possession of a negotiable instrument must be a

person entitled to enforce the instrument as well as a

holder in due course (or must be a holder who has the

rights of a holder in due course through the shelter rule)

If the person is neither, then she is subject to all claims or

defenses to payment that any party to it has Second, the

only claims or defenses that the holder in due course has

to worry about are so-called real defenses—those that

af-fect the validity of the instrument—or claims that arose

after she became a holder For example, if the maker or

drawer did not have legal capacity because she was a

minor, the maker or drawer has a real defense The holder

in due course does not have to worry about other

de-fenses and claims that do not go to the validity of the

instrument—the so-called personal defenses

Real Defenses There are some claims and

de-fenses to payment of an instrument that go to the validity

of the instrument These claims and defenses are known

as real defenses They can be used as reasons against

payment of a negotiable instrument to any holder,

includ-ing a holder in due course (or a person who has the rights

of a holder in due course) Real defenses include:

1 Minority or infancy that under state law makes the

in-strument void or voidable For example, if Mark

Miller, age 17, signs a promissory note as maker, he

can use his lack of capacity to contract as a defense

against paying it even to a holder in due course

2 Incapacity that under state law makes the instrument

void For example, if a person has been declared tally incompetent by a court, then the person has areal defense if state law declares all contracts enteredinto by the person after the adjudication of incompe-tency to be void

men-3 Duress that voids or nullifies the obligation of a party

liable to pay the instrument For example, if Haroldpoints a gun at his grandmother and forces her to ex-ecute a promissory note, the grandmother can useduress as a defense against paying it even to a holder

in due course

4 Illegality that under state law renders the obligation

void For example, in some states, checks and notesgiven in payment of gambling debts are void

5 Fraud in the essence (or fraud in the factum) This

oc-curs where a person signs a negotiable instrumentwithout knowing or having a reasonable opportunity

to know that it is a negotiable instrument or of itsessential terms For example, Amy Jones is an illiter-ate person who lives alone She signs a document that

is actually a promissory note but is told that it is agrant of permission for a television set to be left in herhouse on a trial basis Amy has a real defense againstpayment of the note even to a holder in due course.Fraud in the essence is distinguished from fraud inthe inducement, discussed below, which is only apersonal defense

6 Discharge in bankruptcy For example, if the maker

of a promissory note has had the debt discharged in abankruptcy proceeding, she no longer is liable on itand has a real defense against payment [3–305(a)(1)].Real defenses can be asserted even against a holder indue course of a negotiable instrument because it is moredesirable to protect people who have signed negotiableinstruments in these situations than it is to protect per-sons who have taken negotiable instruments in the ordi-nary course of business

In the case that follows, General Credit Corp v New York Linen, the court held that a holder in due course of

a check was not subject to the personal defense of failure

of consideration that the drawer of the check had againstthe payee of the check

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Baily-Schiffman, Judge

Pursuant to UCC section 3–302 [pre-1990 version inasmuch as

New York has not yet adopted Revised Article 3] General

Credit is a holder in due course since it took the instrument for

value and claims to have all the rights of a holder in due course.

General Credit seeks to force New York Linen to pay on the

check.

Pursuant to Article 3 of the Uniform Commercial Code, a holder in due course has significant rights vis-à-vis the nego-

tiable instrument being held A holder of an instrument

be-comes the holder in due course if the instrument is taken for

value, in good faith, and without notice of defect or defense

(UCC section 3–302) An indorsed check, as in this case, is a

negotiable instrument as defined in this section of the UCC In

this case, pursuant to the applicable sections of Article 3

(sec-tions 3–303 and 3–304), General Credit was a good faith

pur-chaser without notice As a holder in due course, General

Credit is protected by section 3–305, taking the check free of

all defenses and claims, except those enumerated by the

sec-tion Thus, any defense New York Linen had which related to its

purchase of the chairs was not a defense against General Credit.

New York Linen contends that it would not have drafted a second check if it had known that Elite had already been paid

by General Credit While to the casual observer, the potential double payment by New York Linen may seem an unfair result,

it is specifically mandated by the Uniform Commercial Code New York Linen has offered no legal defense to General Credit’s claim as a holder in due course pursuant to Article 3 of the UCC By tradition the defenses from which a holder in due course takes free are called “personal defenses” and they include failure for lack of consideration, which is New York Linen’s defense in this case.

Summary judgment granted in favor of General Credit on its claim against New York Linen.

Note: While this case was decided under the pre-1990 version of

Article 3 because New York is the one state that has not yet adopted Revised Article 3, the same result would result from application of Revised Article 3 to the facts of this case.

the delivery was not complete New York Linen then contacted its bank and asked that the bank stop payment of the check A second check, dated February 28, 2001, for $11,275, was drafted and delivered to New York Linen the next day This check reflected the adjusted amount due for the chairs that had actually been delivered.

Unbeknownst to New York Linen, the original check for $13,300 was sold by Meir Schmeltzer to General Credit Corp., a company in the business of purchasing instruments from payees in exchange for immediate cash When New York Linen’s bank refused to pay the check to General Credit because of the stop-payment order that had been placed on it, General Credit Corp brought suit against New York Linen to collect on the check.

In addition to the real defenses discussed above, thereare several other reasons why a person otherwise liable

to pay an instrument would have a defense against

pay-ment that would be effective even against a holder in due

course They include:

1 Forgery For example, if a maker’s signature has been

put on the instrument without his authorization and

without his negligence, the maker has a defense against

payment of the note

2 Alteration of a completed instrument This is a partial

defense against a holder in due course (or a person having

the rights of a holder in due course) and a complete

de-fense against a nonholder in due course A holder in due

course can enforce an altered instrument against the maker

or drawer according to its original tenor (terms)

3 Discharge If a person takes an instrument with

knowl-edge that the obligation of any party obligated on the

in-strument has been discharged, the person takes subject to

the discharge even if the person is a holder in due course

Personal Defenses Personal defenses are legal

reasons for avoiding or reducing liability of a person who

is liable on a negotiable instrument Generally, personaldefenses arise out of the transaction in which the nego-tiable instrument was issued and are based on negotiableinstruments law or contract law A holder in due course

of a negotiable instrument (or one who can claim therights of one) is not subject to any personal defenses orclaims that may exist between the original parties to theinstrument Personal defenses include:

1 Lack or failure of consideration For example, a

promissory note for $100 was given to someone withoutintent to make a gift and without receiving anything inreturn [3–303(b)]

2 Breach of contract, including breach of warranty.

For example, a check was given in payment for repairs to

an automobile but the repair work was defective

3 Fraud in the inducement of any underlying contract.

For example, an art dealer sells a lithograph to Cheryl,www.downloadslide.com

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Ethics in Action

Asserting the Defense of Illegality against Payment of a Gambling Debt

Assume that in the course of a vacation you drop by the casino

in the hotel where you were staying You decide to play a few

hands of blackjack After winning your first few hands, you

then go on a sustained losing streak Believing your luck is

about to change, you keep going until you have lost $10,000,

much more than you intended or could readily afford At the end of the evening, you write the casino a check Later in the hotel bar, you tell your sad tale to a fellow drinker who is a local lawyer and who informs you that a state law makes gambling obligations void Would it be ethical for you to stop payment on the check and then assert the defense of illegality against the holder of the check?

telling her that it is a Picasso, and takes Cheryl’s check

for $500 in payment The art dealer knows that the

litho-graph is not a genuine Picasso but a forgery Cheryl has

been induced to make the purchase and to give her check

by the art dealer’s fraudulent representation Because of

this fraud, Cheryl has a personal defense against having

to honor her check to the art dealer

4 Incapacity to the extent that state law makes the

ob-ligation voidable, as opposed to void For example,

where state law makes the contract of a person of limited

mental capacity but who has not been adjudicated

in-competent voidable, the person has a personal defense to

payment

5 Illegality that makes a contract voidable, as opposed

to void For example, where the payee of a check given

for certain professional services was required to have a

license from the state but did not have one

6 Duress, to the extent it is not so severe as to make the

obligation void but rather only voidable For example, if

the instrument was signed under a threat to prosecute the

maker’s son if it was not signed, the maker might have a

personal defense

7 Unauthorized completion or alteration of the

instru-ment For example, the instrument was completed in an

unauthorized manner, or was altered after it left the

maker’s or drawer’s possession

8 Nonissuance of the instrument, conditional issuance,

and issuance for a special purpose For example, the

per-son in possession of the instrument obtained it by theft or

by finding it, rather than through an intentional delivery

of the instrument to him [3–105(b)]

9 Failure to countersign a traveler’s check [3–106(c)].

10 Modification of the obligation by a separate

agree-ment [3–117].

11 Payment that violates a restrictive indorsement

[3–206(f)]

12 Breach of warranty when a draft is accepted

(dis-cussed in following chapter) [3–417(b)]

The following example illustrates the limited extent towhich a maker or drawer can use personal defenses as areason for not paying a negotiable instrument he signed.Suppose Tucker Trucking bought a used truck from Hon-est Harry’s and gave Harry a 60-day promissory note for

$32,750 in payment for the truck Honest Harry’s anteed” the truck to be in “good working condition,” but

“guar-in fact the truck had a cracked eng“guar-ine block If Harry tries

to collect the $32,750 from Tucker Trucking, TuckerTrucking could claim breach of warranty as a reason fornot paying Harry the full $32,750 because Harry is not aholder in due course However, if Harry negotiated thenote to First National Bank and the bank was a holder indue course, the situation would be changed If the banktried to collect the $32,750 from Tucker Trucking, TuckerTrucking would have to pay the bank Tucker Truckingcannot use its defense or claim of breach of warranty as areason for not paying the bank, which qualified as aholder in due course It is a personal defense TuckerTrucking must pay the bank the $32,750 and then pursueits breach of warranty claim against Harry

The rule that a holder in due course takes a negotiableinstrument free of any personal defenses or claims to it hasbeen modified to some extent, particularly in relation tocertain instruments given by consumers These modifica-tions will be discussed in the next section of this chapter

Claims to the Instrument For purposes of

Re-visedArticle 3, the term claims to an instrument can include:

1 A claim to ownership of the instrument by one who

asserts that he is the owner and was wrongfully prived of possession

de-2 A claim of a lien on the instrument.

3 A claim for rescission of an indorsement.

A holder in due course takes free of claims that arose fore he became a holder but is subject to those arising

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when or after she becomes a holder in due course For

example, if a holder impairs the collateral given for an

obligation, he may be creating a defense for an obligor

Claims in Recoupment A claim in

recoup-ment is not actually a defense to an instrurecoup-ment but rather

an offset to liability For example, Ann Adams purchases

a new automobile from Dealership, giving it a note for

the balance of the purchase price beyond her down

pay-ment After accepting delivery, she discovers a breach of

warranty that the dealer fails to remedy If Dealer has

sold the note to a bank that subsequently seeks payment

on the note from Adams, she has a claim in recoupment

for breach of warranty If the bank is a holder in due

course, the claim in recoupment cannot be asserted

against it However, if the bank is not a holder in due

course, then Adams can assert the claim in recoupment

to reduce the amount owing on the instrument at the time

the action is brought against her on the note Her claim

could serve only to reduce the amount owing and not as

a basis for a net recovery from the bank However, if

Dealer was the person bringing an action to collect the

note, Adams could assert the breach of warranty claim as

a counterclaim and potentially might recover from

Dealer any difference between the claim and the

dam-ages due for breach of warranty

The obligor may assert a claim up to the amount of theinstrument if the holder is the original payee but cannot

assert claims in recoupment against a holder in due

course In addition, the obligor may assert a claim against

a transferee who does not qualify as a holder in due

course, but only to reduce the amount owing on the

instru-ment at the time it brought the claim in recoupinstru-ment

Changes in the Holder in Due

Course Rule for Consumer

Credit Transactions

Consumer Disadvantages The rule that a

holder in due course of a negotiable instrument is not

subject to personal defenses between the original parties

to it makes negotiable instruments a readily accepted

substitute for money This rule can also result in serious

disadvantages to consumers Consumers sometimes buy

goods or services on credit and give the seller a

nego-tiable instrument such as a promissory note They often

do this without knowing the consequences of their

sign-ing a negotiable instrument If the goods or services are

defective or not delivered, the consumer would like to

withhold payment of the note until the seller corrects the

problem or makes the delivery Where the note is still

held by the seller, the consumer can do this because anydefenses of breach of warranty or nonperformance aregood against the seller

However, the seller may have negotiated the note at adiscount to a third party such as a bank If the bank qual-ifies as a holder in due course, the consumer must paythe note in full to the bank The consumer’s personaldefenses are not valid against a holder in due course Theconsumer must pay the holder in due course and then try

to get her money back from the seller This may be cult if the seller cannot be found or will not accept re-sponsibility The consumer would be in a much strongerposition if she could just withhold payment, even againstthe bank, until the goods or services are delivered or theperformance is corrected

diffi-State Consumer Protection Legislation

Some state legislatures and courts have limited theholder in due course rule, particularly as it affects con-sumers State legislation limiting the doctrine typicallyamended state laws dealing with consumer credit trans-actions For example, some state laws prohibit a sellerfrom taking a negotiable instrument other than a checkfrom a consumer in payment for consumer goods andservices Other states require promissory notes given byconsumers in payment for goods and services to carry

the words consumer paper Holders of instruments with

the legend “consumer paper” are not eligible to beholders in due course3 [3–106(d)]

Federal Trade Commission tion The Federal Trade Commission (FTC) has prom-ulgated a regulation designed to protect consumersagainst operation of the holder in due course rule TheFTC rule applies to persons who sell to consumers oncredit and have the consumer sign a note or an install-ment sale contract or arrange third-party financing of thepurchase The seller must ensure that the note or the con-tract contains the following clause:

Regula-NOTICE: ANY HOLDER OF THIS CONSUMER CREDIT CONTRACT IS SUBJECT TO ALL CLAIMS AND DEFENSES WHICH THE DEBTOR COULD ASSERT AGAINST THE SELLER OF THE GOODS

OR SERVICES OBTAINED PURSUANT HERETO OR

3 Revised Article 3 expressly deals with these state variations in section 3–106(d) and Official Comments 3 to 3–106 and Comments 3

to 3–305 Section 3–106(d) permits instruments containing legends or statements required by statutory or administrative law that preserve the obligator’s right to assert claims or defenses against subsequent holders as within Article 3 except that no holder can be a holder in due course.

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CONCEPT REVIEW

Claims and Defenses against Payment of Negotiable Instruments

Real Defense 1 Minority that under state law makes the contract void or voidable.

Valid against all holders, including 2 Other lack of capacity that makes the contract void.

holders in due course and holders 3 Duress that makes the contract void.

who have the rights of holders in 4 Illegality that makes the contract void.

6 Discharge in bankruptcy.

Personal Defense 1 Lack or failure of consideration.

Valid against plain holders of 2 Breach of contract (including breach of warranty).

instruments—but not against holders 3 Fraud in the inducement.

in due course or holders who have 4 Lack of capacity that makes the contract voidable (except minority).

the rights of in due course holders 5 Illegality that makes the contract voidable.

through the shelter rule 6 Duress that makes the contract voidable.

7 Unauthorized completion of an incomplete instrument, or material alteration of the instrument.

8 Nonissuance of the instrument.

9 Failure to countersign a traveler’s check.

10 Modification of the obligation by a separate agreement.

11 Payment that violates a restrictive indorsement.

12 Breach of warranty when a draft is accepted.

Claim to an Instrument 1 Claim of ownership by someone who claims to be the owner and that he

was wrongfully deprived of possession.

2 Claim of a lien on the instrument.

3 Claim for rescission of an indorsement.

Claims in Recoupment 1 Breach of warranty in the sale of goods for which the instrument was issued.

WITH THE PROCEEDS HEREOF RECOVERY

HERE-UNDER BY THE DEBTOR SHALL NOT EXCEED

AMOUNTS PAID BY THE DEBTOR HEREUNDER.

The effect of the notice is to make a potential holder of

the note or contract subject to all claims and defenses of

the consumer This is illustrated in Music Acceptance

Corp., which follows

In the hypothetical case set out at the start of this

chap-ter, Rachel buys a used car and gives the seller a

nego-tiable promissory note in which she promises to pay the

balance in 12 months The seller then negotiates the

prom-issory note to a third party When Rachel discovers that,

contrary to the seller’s assurances, the car had previously

been involved in an accident, Rachel would like to assert a

defense of failure of consideration or breach of contract

(warranty) against payment You know that normally, if

the person to whom the note was assigned can qualify as a

holder in due course, then the maker of a note will not be

able to assert those particular defenses against paymentbecause they are considered to be “personal defenses,”and a holder in due course of an instrument takes the in-strument free of such defenses against payment However,the introductory hypothetical goes on to pose the question

of whether it would make a difference if the promissorynote contained the clause required by the Federal TradeCommission in consumer notes You are now in a position

to know that it would make a difference in Rachel’s rightsand that she would be able to assert such defenses againstpayment of the note to the current holder, even if he couldqualify as holder in due course If the note or contract doesnot include the clause required by the FTC rule, the con-sumer does not gain any rights that he would not otherwisehave under state law, and a subsequent holder may qualify

as a holder in due course However, the FTC does have theright to seek a fine of as much as $10,000 against the sellerwho failed to include the clause

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Music Acceptance Corp v Lofing 39 Cal Rptr 159 (Cal Ct App 1995)

Dan Lofing purchased a Steinway grand piano from Sherman Clay & Co., Steinway & Sons’ Sacramento dealer, and received financing through Sherman Clay’s finance company, Music Acceptance Corporation (MAC) The consumer note for

$19,650.94 prepared by MAC and signed by Lofing included the following in boldface type:

NOTICE ANY HOLDER OF THIS CONSUMER CREDIT CONTRACT IS SUBJECT TO ALL CLAIMS AND DEFENSES WHICH THE DEBTOR COULD ASSERT AGAINST THE SELLER OF GOODS OR SERVICES OBTAINED PUR- SUANT HEREIN OR WITH THE PROCEEDS HEREOF RECOVERY HEREUNDER SHALL NOT EXCEED AMOUNTS PAID BY THE DEBTOR HEREUNDER.

Lofing received a warranty from Steinway that provided the company “will promptly repair or replace without charge any part of this piano which is found to have a defect in material or workmanship within five years” from the date of sale.

Lofing became disenchanted with the piano after experiencing a variety of problems with it There was a significant deterioration in the action and tonal quality of the piano which the Sherman Clay piano technician was unable to remedy despite lengthy and repeated efforts A Steinway representative who was called in to inspect the piano concluded that it was

in “terrible condition” and expressed surprise that it had ever left the factory He concluded that the piano would have to be completely rebuilt at the factory.

Because the piano was impossible to play and was ruining his technique, Lofing stopped making payments on the piano.

To mitigate his damages, Lofing sold the piano for $7,000 and purchased a Kawai piano from another dealer He brought suit against Sherman Clay, Steinway, and MAC for, among other things, breach of warranty One of the issues in the litiga- tion was whether the Notice in the note allowed him to assert the breach of warranty as a grounds for not continuing to pay off the note to MAC.

Sparks, Associate Justice

The FTC adopted a rule which makes it an unfair or deceptive

act or practice for a seller to take or receive a consumer credit

application which does not contain the following provision in

large boldface type:

NOTICE ANY HOLDER OF THIS CONSUMER CREDIT CON- TRACT IS SUBJECT TO ALL CLAIMS AND DE- FENSES WHICH THE DEBTOR COULD ASSERT AGAINST THE SELLER OF GOODS OR SERVICES OBTAINED PURSUANT HEREIN OR WITH THE PRO- CEEDS HEREOF RECOVERY HEREUNDER SHALL NOT EXCEED AMOUNTS PAID BY THE DEBTOR HEREUNDER.

This notice is identical to that included in Lofing’s sales contract.

The FTC enacted this rule because it believed it was “an fair practice for a seller to employ procedures in the course of

un-arranging the financing of a consumer deal which separate[d]

the buyer’s duty to pay for goods or services from the seller’s

reciprocal duty to perform as promised.” The FTC explained:

“Our primary concern has been the distribution or

alloca-tion of costs occasioned by seller misconduct in credit sale

transactions These costs arise from breaches of contract,

breaches of warranty, misrepresentation, and even fraud The current commercial system which enables sellers and creditors

to divorce a consumer’s obligation to pay for goods and ices from the seller’s obligation to perform as promised, allo- cates all of these costs to the consumer/buyer.”

serv-In its “Guidelines on Trade Regulation Rule Concerning Preservation of Consumers’ Claims and Defenses,” the FTC explained further:

[The] dramatic increase in consumer credit over the past thirty years has caused certain problems Evolving doc- trines and principles of contract law have not kept pace with changing social needs One such legal doctrine which has worked to deprive consumers of the protection needed in credit sales is the so-called “holder in due course doctrine.” Under this doctrine, the obligation to pay for goods or services is not conditioned upon the seller’s corresponding duty

to keep his promises.

Typically, the circumstances are as follows: A consumer relying in good faith on what the seller has represented to be

a product’s characteristics, service warranty, etc., makes a purchase on credit terms The consumer then finds the product unsatisfactory; it fails to measure up to the claims made on its behalf by the seller, or the seller refuses to provide promised maintenance The consumer, therefore, seeks relief from his debt obligations only to find that no relief is possible His debt obligation, he is told, is not to the seller

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Figure 1 The Transfer of Commercial Paper

Ne gotiated to

Assigned to

Nonnegotiable commercial paper

Assignee

Negotiable commercial paper

Holder with due course status

Holder without due course status Negotiated to

Assignment ONLY

Nonconsumer credit transaction

Consumer credit transaction

Real defenses only

Real and personal defenses

Source: “Charting the Way through the Transfer of Commercial Paper,” Janell Kurtz and Wayne Wells, Journal of Legal Studies Education

13 (1995), p 191.

but to a third party whose claim to payment is legally

unre-lated to any promise made about the product.

The seller may, prior to the sale, have arranged to have the

debt instrument held by someone other than himself; he may

have sold the debt instrument at a discount after the purchase.

From the consumer’s point of view, the timing and means

by which the transfer was effected are irrelevant He has been

left without ready recourse He must pay the full amount of

his obligation He has a product that yields less than its

prom-ised value And he has been robbed of the only realistic

lever-age he possessed that might have forced the seller to provide

satisfaction—his power to withhold payment.

As one court noted, before this rule was adopted “[t]he

reciprocal duties of the buyer and seller which were mutually

dependent under ordinary contract law became independent

of one another Thus, the buyer’s duty to pay the creditor was

not excused upon the seller’s failure to perform In abrogating

the holder in due course rule in consumer credit transactions,

the FTC preserved the consumer’s claims and defenses

against the creditor-assignee The FTC rule was therefore

designed to reallocate the cost of seller misconduct to the

creditor The commission felt the creditor was in a better

po-sition to absorb the loss or recover the cost from the guilty

party—the seller.”

MAC contends the FTC rule is inapplicable here MAC

cites comments in the FTC guidelines discussing possible

lim-itations on the rule Specifically, the FTC points out that

because the regulation’s definition of “Financing a Sale” pressly refers to the Truth-in-Lending Act, it “thus incorpo- rate[s] the limitations contained in these laws As a result, even with respect to transactions involving a sale of consumer goods

ex-or services, a purchase involving an expenditure of mex-ore than

$25,000 is not affected by the Rule.” MAC argues that since the cash price of the piano, including sales tax, was $25,650.94, the transaction is exempt from these requirements.

MAC’s argument is unavailing as it is based on the line’s unfortunate use of the phrase “expenditure of more than

guide-$25,000.” As Lofing points out, the exemption referred to in the Truth-in-Lending Act does not speak of expenditures of more than $25,000, but of transactions in which the “total amount financed exceeds $25,000.” Here, because Lofing traded in his piano, the total amount financed was $19,650.94, well below the exemption level.

More importantly, it is irrelevant whether the FTC rule plies Even if such a notice was not required to be given, the fact remains that it was: Lofing’s contract included the precise language mandated by the FTC rule Put simply, Lofing is in the same position whether we apply the FTC rule or the language of his particular contract The jury’s finding that Sherman Clay breached its warranties mandates that the judgment in favor of MAC and against Lofing be reversed.

ap-Judgment in favor of Lofing.

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Problems and Problem Cases

1. From 1999 through 2003 Christina Cidoni,

individu-ally and as president of Spectrum Settlement Group,Inc., maintained bank accounts at the Bay Shorebranch of NSBC Bank USA (NSBC) On August 30,

2003, Cidoni appeared at a real estate closing for thepurchase and sale of residential property as an inde-pendent title closer At the closing, a check drawn onthe Fleet Bank Boston account of Laura Hamel, theattorney handling the closing, and payable to “ABNAmro Mortgage” was issued in the amount of

$207,530.14 The check was intended to satisfy theexisting mortgage of the sellers of the residentialproperty One of Spectrum’s responsibilities was tosee that the check was delivered to a representative ofABN Amro Mortgage Instead, Cidoni indorsed thecheck on the back “for deposit” and deposited it intoSpectrum’s account at NSBC Was the check negoti-ated to the bank?

2. A bank cashed the checks of its customer, Dental

Supply, Inc., presented to the bank by an employee ofDental Supply named Wilson The checks were in-dorsed in blank with a rubber stamp of Dental Supply,Inc Wilson had been stealing the checks by takingcash rather than depositing them to Dental Supply,Inc.’s account What could Dental Supply have done

to avoid this situation?

3. Reliable Janitorial Service, Inc., maintained a bank

account with AmSouth Bank Rosa Pennington wasemployed by Reliable as a bookkeeper/office man-ager She deposited checks made payable to Reliablebut did not have authority to write checks on Reli-able’s account Beginning in January, Pennington ob-tained counter deposit slips from AmSouth She wrote

on the deposit slips that the depositor was “ReliableJanitorial Services, Inc.,” but in the space for the ac-count number, Pennington wrote the account numberfor her own personal account with AmSouth Shestamped the checks that were made payable to “Reli-able Janitorial Service, Inc.” with the indorsement

“For Deposit Only, Reliable Carpet Cleaning, Inc.”

Over an 11-month period, Pennington was able to posit 169 checks so indorsed AmSouth credited thedeposits to Pennington, not Reliable Penningtonspent all the funds that she diverted to her account

de-When Reliable discovered the fraud, it brought suitagainst AmSouth for conversion and sought to haveits account credited with the improperly paid checks

Was AmSouth Bank liable to Reliable for the value of

the restrictively indorsed checks that it paid tently with the indorsement?

inconsis-4. Reggie Bluiett worked at the Silver Slipper GamblingHall and Saloon She received her weekly paycheckmade out to her from the Silver Slipper She indorsedthe check in blank and left it on her dresser at home.Fred Watkins broke into Bluiett’s house and stole thecheck Watkins took the check to the local auto store,where he bought two tires at a cost of $71.21 He ob-tained the balance of the check in cash Could the autostore qualify as a holder in due course?

5. While cleaning out his self-storage locker in Largo,Florida, in late January 2001, Kim Griffith found acertificate of deposit issued by Mellon Bank, N.A., ofPittsburgh, Pennsylvania, on July 3, 1975, for theamount of $530,000 The certificate was entitled “Ne-gotiable Certificate of Deposit, No I-48346” andstated as follows:

This certifies that there has been deposited with this Bank the sum of FIVE HUNDRED AND THIRTY THOUSAND AND 00/100 * * DOLLARS $530,000* which will be paid to bearer on August 4, 1975 with interest at the rate of 5.75% per annum on presentation of this certificate at any office of this Bank in Pennsylva- nia This deposit is not subject to check, draft, or any form of withdrawal prior to the above maturity date.

Griffith and his wife found the certificate in one ofseveral books stored in their storage locker as he andhis wife were shaking out all of the books in thelocker Griffith purchased the books in the lockerfrom some unnamed person and was unable to recallhow much he had paid for them On its face, the cer-tificate of deposit had not been marked paid On Au-gust 15, 2002, Griffith presented the certificate forpayment in person at a Mellon Bank office in Penn-sylvania Mellon refused to honor the certificate ofdeposit, and Griffith brought suit against Mellonseeking payment of the certificate, seeking to recover

$2.5 million dollars in principal and interest Amongthe issues in the case were whether Griffith was aholder in due course or a person entitled to enforcethe instrument

Pennsylvania law provides that:

After the lapse of twenty years, all debts not within the orbit of the Statue of Limitations are presumed to have been paid Until the passage of twenty years it

is the burden of the debtor to prove payment; after the passage of twenty years, it is the burden of the creditor

to prove non-payment and for the satisfaction of such

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burden the evidence must be clear and convincing and

must consist of proof other than the specialty itself.

Griffith presented evidence that the certificate had

not been marked paid and it was the policy of Mellon

Bank to mark certificates paid or to destroy them

when they are redeemed Was Griffith a holder in due

course or a person otherwise entitled to enforce the

certificate of deposit?

6. Charles Alcombrack was appointed guardian for his

son, Chad Alcombrack, who was seven years old and

the beneficiary of his grandfather’s life insurance

policy The insurance company issued a check for

$30,588.39 made payable to “Charles Alcombrack,

Guardian of the Estate of Chad Stephen Alcombrack,

a Minor.” The attorney for the son’s estate directed the

father to take the check, along with the letters of

guardianship issued to the father, to the bank and

open up a guardianship savings and checking

ac-count Instead, the father took the check, without the

letters of guardianship, to the Olympic Bank and

opened a personal checking and a personal savings

account Despite the fact that the check was payable

to the father in his guardianship capacity, the bank

al-lowed the father to place the entire amount in his

newly opened personal accounts The father used all

but $320.60 of the trust money for his personal

bene-fit A new guardian, J David Smith, was appointed

for Chad Smith brought suit against the Olympic

Bank, on Chad’s behalf, to recover the amount of the

check Was the bank a holder in due course of the

check?

7. On December 11, 1990, two American Express money

orders in the amounts of $550 and $650, respectively,

which were payable to Stacey Anne Dillabough, were

presented to Chuckie Enterprise, Inc (Chuckie’s), a

check-cashing operation in Philadelphia The money

orders were duly indorsed, and photo identifications

were provided by the payee, whereupon Chuckie’s

paid the face amounts minus a 2 percent fee

Dill-abough was a previous customer of Chuckie’s and

was recognized as such by the president of Chuckie’s,

Charles Giunta, who handled the transaction The two

money orders had been stolen from the premises of an

American Express agent When stolen, the money

or-ders were signed with the preprinted signature of the

chairman of American Express but were blank as to

payee, date, sender, and amount When presented to

Chuckie’s, however, they had been completed by

persons unknown Dillabough’s role is not clear fromthe case She could have been an accomplice of thethief, the thief, or even someone who bought itfrom the thief, but the court does not say, and it is notcritical to the issue here

The money orders were passed through the usualbanking channels and were presented for payment atUnited Bank of Grand Junction, Colorado AmericanExpress, having noted on its “fraud log” that themoney orders were stolen, returned the money ordersmarked “Reported Lost or Stolen Do Not Redeposit.”American Express refused to pay the amounts of themoney orders

Triffin, a commercial discounter, purchased thedishonored money orders for cash from Chuckie’s andtook an assignment of all of Chuckie’s rights, claims,and interests in the money orders Triffin brought suitagainst Dillabough and American Express, demand-ing payment of the stolen money orders Judgmentwas entered against Dillabough by default Whereblank money orders were stolen and completed with-out authorization prior to their negotiation, can thetransferee enforce the instruments as completed if hequalifies as a holder in due course?

8. Panlick, the owner of an apartment building, enteredinto a written contract with Bucci, a paving contractor,whereby Bucci was to install asphalt paving on theparking lot of the building When Bucci finished thejob, Panlick gave Bucci a check for $6,500 and apromissory note for $7,593 with interest at 10 percentdue six months from its date When the note camedue, Panlick refused to pay it Bucci brought suit tocollect the note, and Panlick claimed that there hadbeen a failure of consideration because the asphaltwas defectively installed Can Panlick assert this de-fense against Bucci?

9. Ralph Herrmann wrote a check for $10,000 payable

to Ormsby House, a hotel-casino in Carson City,Nevada, and exchanged it for three counterchecks hehad written earlier that evening to acquire gamingchips Ormsby House was unable to collect the pro-ceeds from the check because Herrmann had insuffi-cient funds in his account The debt evidenced by thecheck was assigned to Sea Air Support, Inc., d/b/aAutomated Accounts Associates, for collection SeaAir was also unsuccessful in its attempts to collectand filed a lawsuit against Herrmann to recover on thedishonored check Nevada law then provided that all

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