Negotiable Instruments

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Chapter 14

• Negotiable Instruments

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Quote of the Day

• A negotiable bill or note is a courier without
  luggage.
• John B. Gibson,
• Overton v. Tyler, 1846

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Commercial Paper

• System for transferring paper funds easily
• Types of commercial paper
• Negotiable
• Non-negotiable

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Types of Negotiable Instruments

• Note (promissory note) is a promise that you
  will pay money
• Two people involved
• Maker Issuer of a promissory note
• Payee Someone who is owed money under the terms
  of an instrument

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Types of Negotiable Instruments

• Draft Order directing someone else to pay money
  for you
• Check Most common form of a draft
• Order telling a bank to pay money
• Three people involved
• Drawer Person who issues a draft
• Drawee One ordered by the drawer to pay money to
  the payee
• Payee
• Issuer All purpose term that means both maker
  and drawer

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Fundamental Rule of Commercial Paper

• Possessor of commercial paper has an
  unconditional right to be paid, so long as
• Paper is negotiable
• It has been negotiated to the possessor
• Possessor is a holder in due course
• Issuer cannot claim a valid defense

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Difference between Negotiable and Non-negotiable
Commercial Paper
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Requirements for Negotiability

• The instrument must
• Be in writing
• Be signed by the maker or drawer
• Contain an unconditional promise or order to pay
• State a definite amount of money
• Be payable on demand or at a definite time
• Be payable to order or to bearer

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Interpretation of Ambiguities

• When terms contradict, three rules apply
• Words take precedence over numbers
• Handwritten terms prevail over typewritten terms
• Typed terms prevail over printed terms

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Negotiation

• Means that an instrument has been transferred to
  the holder by someone other than the issuer
• To be negotiated, order paper must first be
  indorsed and then delivered to the transferee
• Bearer paper must simply be delivered to the
  transferee
• No indorsement is required

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Negotiation

• Order paper Instrument that includes the words
  pay to the order of or their equivalent
• Bearer paper Note is a bearer paper if it is
  made out to bearer or it is not made out to any
  specific person
• Can be redeemed by any holder in due course
• Indorsement Signature of a payee

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Holder in Due Course

• Has an automatic right to receive payment for a
  negotiable instrument
• Requirements for holder in due course
• Is a holder who has given value for the
  instrument, in good faith
• Without notice of outstanding claims or other
  defects

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Holder in Due Course

• Requirements for holder in due course
• Holder For order paper, anyone in possession of
  the instrument if it is payable to or indorsed to
  her
• For bearer paper, anyone in possession
• Value Holder has already done something in
  exchange for the instrument
• Good faith
• Two tests to determine
• Subjective test
• Objective test

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Notice of Outstanding Claims or Other Defects

• The instrument is overdue
• The instrument is dishonored
• The instrument is altered, forged, or incomplete
• The holder has notice of certain claims or
  disputes

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Defenses against a Holder in Due Course

• Issuer of a negotiable instrument is not required
  to pay if
• Signature on the instrument was forged
• After signing, debts were discharged in
  bankruptcy
• Amount was altered after he signed it
• Signed under duress, mentally incapacitated, or
  part of illegal transaction
• Tricked into signing the instrument

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Consumer Exception

• Federal Trade Commission has special rules for
  consumer credit contracts
• Consumer credit contract Consumer borrows money
  from a lender to
• Purchase goods and services from a seller who is
  affiliated with the lender

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Liability for Negotiable Instruments

• Signature liability Liability of someone who has
  signs an instrument
• Warranty liability Liability of someone who
  receives payment on an instrument

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Primary versus Secondary Liability

• Primary liability Unconditionally liable
• Must pay unless he has a valid defense
• Secondary liability Must pay only if the person
  with primary liability does not pay
• The holder of an instrument must first try to get
  payment from
• The party with primary liability before making
  demands against a party with secondary liability

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Signature Liability

• The maker is primarily liable
• The drawer of a check has secondary liability
• The bank (drawee) is not liable to
• The holder and owes no damages to the holder for
  refusing to pay the check

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Signature Liability

• Drawee
• Certified check A check the issuers bank has
  signed, indicating its acceptance of the check
• Acceptor Bank (drawee) that accepts a check
  (draft), thereby becoming primarily liable on it
• Cashiers check Check drawn on the bank itself
• Promise that the bank will pay out of its own
  funds

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Signature Liability

• Indorser Anyone, other than an issuer or
  acceptor, who signs an instrument
• Secondary liable
• Indorsers are not liable if
• They write the words without recourse next to
  their signature on the instrument
• Bank certifies the check
• Check is presented for payment more than 30 days
  after the indorsement
• Check is dishonored and the indorser is not
  notified within 30 days

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Accommodation Party

• Someone, other than an issuer, acceptor, or
  indorser
• Who adds her signature to an instrument for the
  purpose of being liable on it
• Accommodated party Someone who receives a
  benefit from an accommodation party
• An accommodation party has the same liability to
  the holder as the person for whom he signed

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Rules of Warranty Liability

• The wrongdoer is always liable
• The drawee bank is liable if it pays a check on
  which the drawers name is forged
• The bank can recover from the payee only if the
  payee had reason to suspect the forgery
• In any other case of wrongdoing, a person who
  first acquires an instrument from a wrongdoer is
  ultimately liable to anyone else who pays value
  for it

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Transfer Warranties

• When someone transfers an instrument, she
  warrants that
• She is the holder of the instrument
• All signatures are authentic and authorized
• Instrument has not been altered
• No defense can be asserted against her
• As far as she knows the issuer is solvent

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Comparison of Signature Liability and Transfer
Warranties

• A forged signature is invalid and creates no
  signature liability for the person whose name was
  signed
• The recipient of a forged item may recover under
  transfer warranties
• Signature liability rules do not apply to the
  transfer of bearer paper since no indorsement is
  required
• Transfer warranties apply

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Presentment Warranties

• Apply to someone who demands payment for an
  instrument from the maker, drawee, or anyone else
  liable
• Presenter warrants that
• She is a holder
• The check has not been altered
• She has no reason to believe the drawers
  signature is forged
• Anyone who presents a promissory note for payment
  warrants that he is a holder of the instrument

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Other Liability Rules

• Conversion liability
• Conversion Means that
• Someone has stolen an instrument
• Bank has paid a check that has a forged
  indorsement
• Impostor rule
• If someone issues an instrument to an imposter
• Any indorsement in the name of the payee is valid
  as long as the person who pays the instrument
  does not know of the fraud

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Other Liability Rules

• Fictitious payee rule
• If an instrument is issued to a person who does
  not exist
• Indorsement in the name of the payee is valid as
  long as the payer does not know of the fraud
• Employee indorsement rule
• If an employee with responsibility for issuing
  instruments forges an instrument
• Indorsement in the name of the payee is valid as
  long as the payer does not know of the fraud

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Negligence

• Anyone negligent in creating or paying an
  unauthorized instrument is liable to an innocent
  third party
• Anyone careless in paying an unauthorized
  instrument is liable
• Despite the three rules
• Anyone careless in allowing a forged or altered
  instrument to be created is also liable
• Whether or not he has violated one of the three
  rules

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It is never wise to play an important game
without understanding the rules. The rules of
negotiable instruments are complex, but important
because this game is played by virtually
everyone.