Copyright 2007 Negotiable Instrument Page 1 of 8 by Learning House, Inc

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1 Copyright 2007 Negotiable Instrument Page 1 of 8

2 Business Law Negotiable Instruments Introduction This lesson will discuss the importance of the Uniform Commercial Code when dealing with commercial transactions and commercial paper. Commercial paper can be defined as any written promise or order to pay a sum of money. Drafts, checks, and promissory notes are typical examples. Commercial paper can be transferred more readily than ordinary contract rights, and persons who acquire it are normally subject to less risk than the assignee of a contractual right. This lesson will focus on these areas and delve into their importance within the business community. Negotiability and Transferability Uniform Commercial Code The historical development of our country s Uniform Commercial Code is quite interesting. Beginning in 1895, each state adopted the Uniform Negotiable Instruments Law, or N.I.L. The N.I.L. was drafted and promulgated by the National Conference of Commissioners on Uniform Law in In 1929, The Bank Collection Code was enacted. This Act was similar to the Uniform Negotiable Instruments Law, though it dealt specifically with bank collections procedures. Unfortunately, it was less successful than the Uniform Negotiable Instruments Law and was only adopted by 19 states. In 1942, the National Conference of Commissioners on Uniform State Laws and the American Law Institute began drafting the Uniform Commercial Code. The U.C.C. was designed to replace many of the existing uniform acts governing commercial transactions. After going through many drafts to reach its present form, the U.C.C was adopted by every state except Louisiana; moreover, even Louisiana adopted U.C.C. Article 3 on Commercial Paper (an updated version of the N.I.L.) and Article 4 on Bank Deposits and Collections (an updated version of the Bank Collections Code of 1929). In 1990, Articles 3 and 4 of the U.C.C. were rewritten and revised. These revisions cleared up many of the problems that existed with the original version and also permitted banks to move from a paper-based system to electronic banking. Copyright 2007 Negotiable Instrument Page 2 of 8

3 Negotiable Instruments What are negotiable instruments? Simply put, a negotiable instrument is a special type of commercial paper. The basic difference between a negotiable instrument and an ordinary contract is that negotiable instruments must have a specific form. Remember that commercial paper is relatively worthless as a substitute for money unless it is freely transferable. The Requirement of Negotiability Section 3-104(1) of the U.C.C. specifies the requirements of negotiability. A negotiable instrument must: 1. Be in writing 2. Be signed by the maker or the drawer 3. Be an unconditional promise or order 4. Contain a specific sum of money 5. Be payable on demand or at a definite time 6. Be payable to order or to bearer 7. Exclude any other promises, order, obligation, or power 8. Identify the drawee specifically if the instrument is a third party instrument. i) A Writing Negotiable instruments must be in written form. Clearly, an oral promise can create the danger of fraud or make it difficult to assign liability. Negotiable instruments must possess the quality of certainty that only formal written expression can give. ii) Signed by the Maker or Drawer For the instrument to be negotiable, it must be signed by the maker if it is a note or by the drawer if it is a draft or check (U.C.C., 3-104(1)(a)). Great latitude exists in determining what constitutes a signature. Section 3-401(2) of the U.C.C. states: A signature is made by the use of name, including any trade or assumed name, upon an instrument or by any word or mark used in lieu of a written signature. What this means is that initials, an X, or a thumb print will suffice; a trade name or a rubber stamp bearing a person s name when used by that person or an authorized agent constitutes a signature iii) Unconditional Promise or Order The terms of a promise or order have to be included in the writing on the face of a negotiable instrument and must not be conditioned upon the happening or failure to happen of some collateral agreement (U.C.C., 3-105(2)(a)). Copyright 2007 Negotiable Instrument Page 3 of 8

4 (1) Promise or Order In order for an instrument to be negotiable, it must contain an express order or promise to pay. A mere acknowledgement of the debt, which might logically imply a promise, is not sufficient under the Uniform Commercial Code because the promise must be an affirmative undertaking. (2) Unconditional A negotiable instrument s utility as a substitute for money or as a credit device would be dramatically reduced if it had conditional promises attached to it. To avoid such problems, the U.C.C. provides that only unconditional promises and orders can be negotiable (U.C.C., 3-104(1)(b)). iv) Specific Sum or Sum Certain Negotiable instruments must state the amount to be paid in a certain sum of money. This requirement promotes clarity and certainty in determining the value of the instrument (U.C.C., Sec (1)(b)). (1) Sum Certain The term sum certain means an amount that is ascertainable from the instrument itself without reference to an outside source (U.C.C., 3-104(1)(b)). v) Payable on Demand or at a Definite Time Section 3-104(1)(c) of the Uniform Commercial Code requires that a negotiable instrument be payable on demand or at a definite time. In order to ascertain the value of a negotiable instrument, it is necessary to know when the maker can be compelled to pay. It is also necessary to know when the obligations of secondary parties (i.e., drawers, endorsers, and guarantors) will rise, as well as the time during which the instrument will be valid before it expires by operation of law. Lastly, with an interest-bearing instrument, it is necessary to know the exact interval during which the interest will accrue in order to determine the present value of the instrument. vi) Payable to Order or to Bearer A negotiable instrument must clearly indicate that the maker or drawer intends the instrument to be fully transferable to someone other than the person to whom it was originally issued. Section 3-104(1)(d) states that the instrument must be payable to order or to bearer. These are the quintessential words of negotiability. (1) Order Instrument Section 3-110(1) of the U.C.C. states that an order instrument can be payable: a. To the maker or the drawer b. To the drawee or the payee who is not a maker, drawer, or drawee Copyright 2007 Negotiable Instrument Page 4 of 8

5 c. To two or more payees together d. To the representative of an estate, trust, or fund, or e. To a partnership or unincorporated association. (2) Bearer Instrument Section of the U.C.C. defines a bearer instrument as one that does not designate a specific payee. The term bearer means the person in possession of the instrument that is payable to bearer or endorsed in blank. For example, any instrument containing the following terms is a bearer instrument: a. Payable to the Order of Bearer b. Payable to Tom Smith or Bearer c. Payable to Bearer d. Pay Cash e. Pay to the Order of Cash Keep in mind that an instrument that is payable only to one person, for example, Payable to Tom Smith, is not payable to bearer. (3) Comparing Order Instruments and Bearer Instruments For further clarification purposes, look at these three types of negotiable instruments. (a) A check payable in cash is a bearer instrument (U.C.C., 3-111(c)). (b) A note payable to the order of Melinda Smith, which has to be indorsed and signed by Melinda Smith, is a bearer instrument because it is an instrument indorsed in blank. A blank endorsement is made by merely signing the back of the instrument (U.C.C., (2)). (c) A note payable to bearer and indorsed Pay to the order of Tom Smith, signed by Melinda Smith is an order instrument because the endorsement names the person to whom the instrument is being made payable (U.C.C., (1)). Omissions That Do Not Affect Negotiability The Uniform Commercial Code supports commercial commerce and protects the sanctity of the instrument even if certain omissions exist. Section lists the following terms and omissions that do not affect negotiability: 1) The omission of a statement of any consideration. 2) The omission of the place where the instrument is drawn or payable. 3) The promise or power to maintain or protect collateral or to give additional collateral. Copyright 2007 Negotiable Instrument Page 5 of 8

6 4) The term in a draft indicating that the payee, by indorsing or cashing the draft, acknowledges full satisfaction of the obligation of the drawer. Transferability Commercial paper must be freely transferable. Once a negotiable instrument circulates beyond the original parties, the commercial laws of principles of negotiation come into play (U.C.C., 3-102(1)(a)). The method of transfer that is used to pass the negotiable instrument from person to person determines the rights and duties that are passed. It should be noted, that once issued, a negotiable instrument can be transferred by assignment or by negotiation. 1. Assignment A transfer by assignment to an assignee gives the assignee only those rights that the assignor possesses at the time of transfer. Assignment is a transfer of rights under a contract. 2. Negotiation Negotiation is the transfer of an instrument that results in the transferee becoming the holder (U.C.C., 3-202(1)). Under U.C.C., a transfer by negotiation creates a holder who receives the rights of previous possessor (U.C.C., 3-202(1)). Unlike assignment, a transfer by negotiation can make it possible for a holder to receive more rights in the instrument than the prior possessor. A holder who receives greater rights is known as a holder in due course (U.C.C., 3-305). Rights and Liabilities of Parties The body of rules contained in Article 3 of the U.C.C. governs a party s right to payment of a check, draft, note, or certificate of deposit. The third party is characterized as either an ordinary holder or a holder in due course. For discussion purposes, this lecture will focus on holders in due course with negotiable instruments that have been negotiated. Now, let s examine what a holder is versus a holder in due course. Holder A holder is a person who has possession of a negotiable instrument that is drawn, issued, or indorsed to the person or that person s order, or to bearer, or in blank (U.C.C., Sec (20)). The holder is entitled to receive payment of the instrument. Either an original party or a third party can qualify as a holder. The manner in which possession of a negotiable instrument is acquired will determine whether or not a person qualifies as a holder (U.C.C., 3-202). A holder of a negotiable instrument has the power to negotiate it to another party. The holder has the right to demand payment of the instrument in his/her own name. Similarly, Copyright 2007 Negotiable Instrument Page 6 of 8

7 a holder can also cancel or discharge the obligation on an instrument whether or not he/she is the original owner (U.C.C., 3-301). Holder in Due Course A holder in due course (H.D.C.) is a special status transferee of a negotiable instrument who, by meeting certain requirements, takes the instrument free of most defenses or adverse claims to it. Stated another way, an H.D.C. can normally acquire a higher level of immunity to defenses against payment on the instrument of claims of ownership to the instrument by other parties (U.C.C., 3-301(1)). Requirement for Holder in Due Course Status The basic requirements for attaining H.D.C. status are set forth in the U.C.C., Sec An H.D.C. must first be a holder of a negotiable instrument. Then, the holder must take the instrument: 1) For value 2) In good faith, and 3) With notice. i. Value An H.D.C. must have given value for the paper (U.C.C., 3-303). A person who receives an instrument as a gift or who inherits it has not met the requirement of value. In these situations, the person becomes an ordinary holder and does not possess the rights of HDC (U.C.C., 3-201(1)). ii. Good Faith The second requirement of H.D.C. status is good faith (U.C.C., (1)(b)). The requirement of good faith means that the purchaser/holder acts honestly in the process of acquiring the instrument. Good faith is defined (U.C.C., Sec.1-201(19)) as honesty in fact in the conduct or transaction concerned. Remember, the good faith requirement only applies to the purchaser. It is immaterial whether the transferor acted in good faith. iii. Notice The third requirement for H.D.C. status involves notice (U.C.C., 3-304). A person will not be afforded H.D.C. protection if he/she acquires an instrument knowing, or having reason to know, that it is defective in any one of the following ways: Copyright 2007 Negotiable Instrument Page 7 of 8

8 a) It is overdue b) It has been dishonored c) There are defenses against it d) There is another claim to it (U.C.C., (1)(c)). Copyright 2007 Negotiable Instrument Page 8 of 8