Negotiable Instruments

“A negotiable bill or note is a courier without luggage.”

John B. Gibson,Overton v. Tyler, 1846

System for transferring paper funds easily Types of commercial paper

◦ Negotiable◦ Non-negotiable

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

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

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

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

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

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

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

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

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

The instrument is overdue The instrument is dishonored The instrument is altered, forged, or

incomplete The holder has notice of certain claims or

disputes

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

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

Signature liability: Liability of someone who has signs an instrument

Warranty liability: Liability of someone who receives payment on an instrument

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

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

Drawee◦ Certified check: A check the issuer’s bank has

signed, indicating its acceptance of the check◦ Acceptor: Bank (drawee) that accepts a check

(draft), thereby becoming primarily liable on it◦ Cashier’s check: Check drawn on the bank itself

Promise that the bank will pay out of its own funds

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

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

The wrongdoer is always liable The drawee bank is liable if it pays a check

on which the drawer’s 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

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

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

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 drawer’s

signature is forged Anyone who presents a promissory note for

payment warrants that he is a holder of the instrument

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

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

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