BUS-107 Contemporary Business Law Ch. 21

The two kinds of defenses used against payment of negotiable instruments.

(1) universal (real) defenses and (2) personal defenses

Any person who transfers a negotiable instrument for consideration makes the following five transfer warranties to the transferee. If the transfer is by indorsement, the transferor also makes these warranties to any subsequent transferee [UCC 3-416(a)]:

1. The transferor has good title to the instrument or is authorized to obtain payment or acceptance on behalf of one who does have good title. 2. All signatures are genuine or authorized. 3. The instrument has not been materially altered. 4. No defenses of any party are good against the transferor. 5. The transferor has no knowledge of any insolvency proceeding against the maker, the acceptor, or the drawer of an unaccepted instrument. A transferee who took the instrument in good faith may recover damages for breach of transfer warranty from the warrantor equal to the loss suffered. The amount recovered cannot exceed the amount of the instrument plus expenses and interest [UCC 3-416(b)]. EXAMPLE: Jill signs a promissory note to pay $1,000 to Adam. Adam cleverly raises the note to $10,000 and negotiates the note to Nick. Nick indorses the note and negotiates it to Matthew. When Matthew presents the note to Jill for payment, she has to pay only the original amount of the note, $1,000. Matthew can collect the remainder of the note ($9,000) from Nick, based on a breach of the transfer warranty. If Nick is lucky, he can recover the $9,000 from Adam.

taking in good faith requirement

A UCC requirement that says a holder must take the instrument in good faith in order to qualify as an HDC.

taking without notice of defect requirement

A UCC requirement that says a person cannot qualify as an HDC if he or she has notice that the instrument is defective in certain ways. It can not be defective in any of the following ways: • It is overdue. • It has been dishonored. • It contains an unauthorized signature or has been altered. • There is a claim to it by another person. • There is a defense against it.

universal defense (real defense)

A defense that can be raised against both holders and HDC's to deny the payment of negotiable instruments. If a universal defense is proven, the holder or HDC cannot recover on the negotiable instrument. The most important universal defenses are: 1. Minority. A minor who does not misrepresent his or her age can disaffirm negotiable instruments.. 2. Extreme duress. If force or violence was used to issue or have issued a negotiable instrument, then it is unenforceable. 3. Mental Incapacity. A person adjudicated mentally incompetent cannot issue a negotiable instrument; the instrument is void from its inception. 4. Illegality. If an instrument arises out of an illegal transaction, it is unenforceable. 5. Discharge in Bankruptcy. Bankruptcy law allows for obligations to pay negotiable instruments to be discharged and therefore be unenforceable. 6. Fraud in the inception. If a person is deceived into signing a negotiable instrument, thinking that it is something else, it is unenforceable. 7. Forgery. The unauthorized signature of a maker, a drawer, or an indorser is wholly inoperative as that of the person whose name is signed. 8. Material Alteration. An instrument that has been fraudulently and materially altered cannot be enforced by an ordinary holder; HDCs can enforce such an instrument if the alteration is not apparent. EXAMPLE: A universal defense can be raised against an HDC in the following scenario: Assume that a state's law declares gambling to be illegal and gambling contracts to be void. Gordon wins $5,000 from Jerry in an illegal poker game. Jerry, who does not have cash to immediately cover his debt, signs a promissory note promising to pay Gordon this amount plus 10 percent interest in 30 days. Gordon negotiates this note to Dawn, an HDC. When Dawn presents the note to Jerry for payment, Jerry can raise the universal defense of illegality against the enforcement of the note by Dawn. Dawn's only recourse is against Gordon

personal defense

A defense that can be raised against enforcement of a negotiable instrument by an ordinary holder but not against an HDC. Thus, if a personal defense is proven, the holder cannot recover on the negotiable instrument. The most important personal defenses are: 1. Breach of Contract - If there is a breach of contract, the negotiable instrument may be deemed unenforceable by a holder but enforceable by an HDC. 2. Fraud in the inducement. Occurs when a wrongdoer makes a false statement to another person to lead that person to enter into a contract with the wrongdoer. Fraud in the inducement makes a negotiable instrument unenforceable by an ordinary holder but enforceable by an HDC. 3. Mental illness that makes a contract voidable instead of void (usually a nonadjudicated mental illness). If mental illness is found that makes a contract voidable rather than void, then the negotiable instrument is unenforceable by a holder but is enforceable by an HDC. 4. Illegality of a contract that makes the contract voidable instead of void. If a contract is found to be illegal but the illegality only makes the contract voidable rather than void, then the negotiable instrument is unenforceable by a holder but is enforceable by an HDC. 5. Ordinary duress or undue influence [UCC 3-305(a) (1)(ii)]. If a person is wrongfully influenced or threatened to enter into a negotiable instrument, it is unenforceable by a holder but is enforceable by an HDC. 6. Discharge of an instrument by payment or cancellation. If an instrument is discharged by payment or cancellation, it is unenforceable by a holder but is enforceable by an HDC. EXAMPLE: A personal defense cannot be raised against an HDC in the following scenario: Morton represents to potential investors that he will accept funds to drill for oil and that the investors will share in the profits from his venture. He plans to use any obtained funds for himself, however. Relying on Morton's statements, Mimi draws a $50,000 check payable to Morton. This constitutes fraud in the inducement. Morton negotiates the check to Tim, an HDC. Tim can enforce the check against Mimi because the personal defense of fraud in the inducement is not effective against Tim as an HDC. Mimi's only recourse is to recover against the wrongdoer (Morton), if he can be found.

holder in due course (HDC)

A holder who acquires a negotiable instrument for value; in good faith; and without notice that the instrument is overdue, that it has been dishonored, that any person has a defense against it or a claim to it, or that the instrument contains unauthorized signatures, alterations, or is so irregular or incomplete as to call into question its authenticity. Commercial paper held by an HDC is virtually as good as money because HDCs take an instrument free of all claims and most defenses that can be asserted by other parties. Several defenses, called universal defenses, can be raised against the payment of an instrument to the HDC. If payment is not made on a negotiable instrument when it is due, the holder can use the court system to enforce the instrument. HDC unique to the area of negotiable instruments.

shelter principle

A holder who does not qualify as a holder in due course in his or her own right becomes a holder in due course if he or she acquires the instrument through a holder in due course. EXAMPLE: Jason buys a used car from Debbie. He pays 10 percent down and signs a negotiable promissory note, promising to pay Debbie the remainder of the purchase price, with interest, in 36 equal monthly installments. At the time of sale, Debbie materially misrepresented the mileage of the automobile. Later, Debbie negotiates the note to Eric, who has no notice of the misrepresentation. Eric, an HDC, negotiates the note to Jaime. Assume that Jaime does not qualify as an HDC in her own right. She becomes an HDC, however, because she acquired the note through an HDC (Eric). Jaime can enforce the note against Jason.

accommodation party

A party who signs an instrument and lends his or her name (and credit) to another party to the instrument. An accommodation party who signs an instrument guaranteeing payment is primarily liable on the instrument. That is, the debtor can seek payment on the instrument directly from the accommodation maker without first seeking payment from the maker. EXAMPLE: Sonny, a college student, wants to purchase an automobile on credit from ABC Motors. He does not have a sufficient income or credit history to justify the extension of credit to him alone. Sonny asks his mother to cosign the note to ABC Motors, which she does. Sonny's mother is an accommodation maker and is primarily liable on the note.

agent

A person who has been authorized to sign a negotiable instrument on behalf of another person. The principal is bound by an authorized agent's signature [UCC 3-402(2)].

holder

A person who is in possession of a negotiable instrument that is drawn, issued, or indorsed to him or to his order, or to bearer, or in blank. A holder is subject to all the claims and defenses that can be asserted against the transferor.

taking where there is no evidence of forgery, alteration, or irregularity requirement

A requirement that says a holder cannot become an HDC to an instrument that is apparently forged or altered or is so otherwise irregular or incomplete as to call into question its authenticity. Clever and undetectable forgeries and alterations are not classified as obvious irregularities.

taking for value requirement

A requirement that says a holder must give value for a negotiable instrument in order to qualify as an HDC.

FTC HDC rule

A rule adopted by the Federal Trade Commission (FTC) that eliminates HDC status with regard to negotiable instruments that arise out of certain consumer credit transactions. EXAMPLE: Greg, a consumer, purchases a television on credit from Lou's Electronics. He signs a note, promising to pay the purchase price plus interest to Lou's Electronics in twelve equal monthly installments. Lou's Electronics immediately negotiates the note at a discount to City Bank for cash. City Bank is an HDC. The television is defective. Greg would like to stop paying for it, but under the UCC, Greg cannot assert the personal defense of the defectiveness of a product against City Bank, an HDC, from collecting on the note. Under the UCC, Greg's only recourse is to sue Lou's Electronics. However, this is often an unsatisfactory result because Greg has no leverage against Lou's Electronics, and bringing a court action is expensive and time-consuming. However, because the FTC HDC rule eliminates HDC status for negotiable instruments arising out of consumer transactions, Greg can assert the otherwise personal defense of the defectiveness of the product against enforcement of the promissory note by City Bank, an HDC.

fictitious payee rule

A rule that states that a drawer or maker is liable on a forged or unauthorized indorsement if the person signing as or on behalf of a drawer or maker intends the named payee to have no interest in the instrument or when the person identified as the payee is a fictitious person. Exception to forged indorsement general rule. EXAMPLE: Marcia is the treasurer of Weld Corporation. As treasurer, Marcia makes out and signs the payroll checks for the company. Marcia draws a payroll check payable to the order of her neighbor Harold Green, who does not work for the company. Marcia does not intend Harold to receive this money. She indorses Harold's name on the check and names herself as the indorsee. She cashes the check at a liquor store. Under the fictitious payee rule, Weld Corporation is liable because it was in a better position than the liquor store to have prevented the fraud.

imposter rule

A rule that states that if an imposter forges the indorsement of the named payee, the drawer or maker is liable on the instrument to any person who, in good faith, pays the instrument or takes it for value or for collection. Exception to forged indorsement general rule. EXAMPLE: Fred purchases goods by telephone from Cynthia. Fred has never met Cynthia. Beverly goes to Fred and pretends to be Cynthia. Fred draws a check payable to the order of Cynthia and gives the check to Beverly, believing her to be Cynthia. Beverly forges Cynthia's indorsement and cashes the check at a liquor store. Under the imposter rule, Fred is liable and the liquor store is not because Fred was in the best position to have prevented the forged indorsement.

unauthorized signature

A signature made by a purported agent without authority from the purported principal. The purported agent is liable to any person who in good faith pays the instrument or takes it for value [UCC 3-403(a)].

primary liability

Absolute liability to pay a negotiable instrument, subject to certain universal (real) defenses. Makers of promissory notes and certificates of deposit have primary liability for the instruments.

Discharge of Liability

Actions or events that relieve certain parties from liability on negotiable instruments. There are three methods of discharge: (1) payment of the instrument, (2) cancellation, and (3) impairment of the right of recourse. Generally, all parties to a negotiable instrument are discharged from liability if (1) the party primarily liable on the instrument pays it in full to the holder of the instrument or (2) a drawee in good faith pays an unaccepted draft or check in full to the holder. When a party other than a primary obligor (e.g., an indorser) pays a negotiable instrument, that party and all subsequent parties to the instrument are discharged from liability [UCC 3-602]. The holder of a negotiable instrument can discharge the liability of any party to the instrument by cancellation [UCC 3-604]. The instrument is not canceled if it is destroyed or mutilated by accident or by an unauthorized third party. The holder can bring suit to enforce the destroyed or mutilated instrument.

dishonored instrument

An instrument that is presented for payment and payment is refused. EXAMPLE: A person who takes a check that has been marked by the payer bank "payment refused—not sufficient funds" cannot qualify as an HDC.

transfer

Any passage of an instrument other than its issuance and presentment for payment.

presentment warranties

Implied warranties made by any person who presents a draft or check for payment or acceptance to a drawee or an acceptor who pays or accepts the instrument in good faith. 1. The presenter has good title to the instrument or is authorized to obtain payment or acceptance of the person who has good title. 2. The instrument has not been materially altered. 3. The presenter has no knowledge that the signature of the maker or drawer is unauthorized. A drawee who pays an instrument may recover damages for breach of presentment warranty from the warrantor. The amount that can be recovered is limited to the amount paid by the drawee less the amount the drawee received or is entitled to receive from the drawer because of the payment plus expenses and interest [UCC 3-147(b)]. EXAMPLE: Maureen draws a $1,000 check on City Bank "payable to the order of Paul." Paul cleverly raises the check to $10,000 and indorses and negotiates the check to Neal. Neal presents the check for payment to City Bank. As the presenter of the check, Neal makes the presentment warranties of UCC 3-417(a) to City Bank. City Bank pays the check as altered ($10,000) and debits Maureen's account. When Maureen discovers the alteration, she demands that the bank recredit her account, which the bank does. City Bank can recover against the presenter (Neal), based on breach of the presentment warranty that the instrument was not altered when it was presented. Neal can recover against the wrongdoer (Paul), based on breach of the transfer warranty that the instrument was not altered.

transfer warranties

Implied warranties made by any person who transfers a negotiable instrument for consideration to a transferee who took the instrument in good faith. Transferors can be held liable for breaching certain implied warranties when negotiating instruments.

signature liability (contract liability)

Liability in which a person cannot be held contractually liable on a negotiable instrument unless his or her signature appears on the instrument. Also called contract liability.

secondary liability

Liability on a negotiable instrument that is imposed on a party only when the party primarily liable on the instrument defaults and fails to pay the instrument when due. This liability is similar to that of a guarantor of a simple contract. EXAMPLEL: Elliot draws a check on his checking account at City Bank "payable to the order of Phyllis Jones." When Phyllis presents the check for payment, City Bank refuses to pay it even though there are sufficient funds in Elliot's account to pay Phyllis. Phyllis can collect the amount of the check from Elliot because Elliot—the drawer—is secondarily liable on the check when it is dishonored.

The location of the signature on an instrument generally determines the signer's capacity...whether they are makers of notes or certificates of deposit, drawers of drafts or checks, drawees who certify or accept checks or drafts, indorsers who indorse instruments, agents who sign on behalf of others, and accommodation parties.

Most indorsements appear on the back or reverse side of an instrument. Unless an instrument clearly indicates that such a signature is made in some other capacity (e.g., agents who properly sign the instrument), it is presumed to be that of the indorser. Every party that signs a negotiable instrument (except qualified indorsers) is either primarily or secondarily liable on the instrument. EXAMPLE: A signature in the lower-right corner of a check indicates that the signer is the drawer of the check. A signature in the lower-right corner of a promissory note indicates that the signer is the maker of the note. The signature of the drawee named in a draft on the face of the draft or another location on the draft indicates that the signer is an acceptor of the draft.

What are two examples when a drawee (bank) is primarily responsible on a draft (there usually is no primary liability on a draft)

On occasion, a drawee is requested to accept a draft or check. Acceptance of a draft occurs when the drawee writes the word accepted across the face of the draft. The acceptor is primarily liable on the instrument. A check is accepted when it is certified by a bank. A bank is primarily liable to pay a certified check. The issuer of a cashier's check is also primarily liable on the instrument.

forged indorsement

The forged signature of a payee or holder on a negotiable instrument. EXAMPLE: Andy draws a check payable to the order of Mallory. Leslie steals the check from Mallory, forges Mallory's indorsement, and cashes the check at a liquor store. The liquor store is liable. Andy, the drawer, is not. The liquor store can recover from Leslie, the forger (if she can be found).

How do you qualify as a holder in due course (HDC)

The person must be the holder of a negotiable instrument that was taken (1) for value; (2) in good faith; (3) without notice that it is overdue, dishonored, or encumbered in any way; and (4) bearing no apparent evidence of forgery, alterations, or irregularity [UCC 3-302].

unqualified indorsers

Those who are secondarily liable on negotiable instruments they indorse. EXAMPLE: Dara borrows $10,000 from Todd and signs a promissory note, promising to pay Todd this amount plus 10 percent interest in one year. Todd indorses the note and negotiates it to Frank. Frank indorses the note and negotiates it to Linda. Linda presents the note to Dara for payment when the note is due. Dara refuses to pay the note. Because Frank became secondarily liable on the note when he indorsed it to Linda, he must pay the amount of the note—$11,000—to Linda. Frank can then require Todd to pay the note to Frank because Todd (as payee) became secondarily liable on the note when he indorsed it to Frank. Todd can then enforce the note against Dara. Linda could have skipped over Frank and required the payee, Todd, to pay the note. In this instance, Frank would have been relieved of any further liability because he indorsed the instrument after the payee.

qualified indorsers

Those who disclaim liability and are not secondarily liable on instruments they endorse. (i.e., an indorser who indorses instruments "without recourse" or similar language that disclaims liability)

Good faith

means honesty in fact in the conduct or transaction concerned [UCC 1-201(19)]. EXAMPLE: If a holder acquires an instrument from a stranger under suspicious circumstances and at a deep discount, it could be inferred that the holder did not take the instrument in good faith. Note that the good faith test applies only to the holder. It does not apply to the transferor of an instrument. EXAMPLE: A thief steals a negotiable instrument and transfers it to Harry, who does not know that the instrument is stolen. Harry meets the good faith test and qualifies as an HDC.

Warranty liability

the liability of someone who receives payment on an instrument. It is imposed whether or not the transferor signed the instrument. There are two types of implied warranties: 1) transfer warranties and 2) presentment warranties. Transfer and presentment warranties shift the risk of loss to the party who was in the best position to prevent the loss. This party is usually the one who dealt face-to-face with the wrongdoer.

Value has been given under the UCC if the holder:

• Performs the agreed-upon promise • Acquires a security interest in or lien on the instrument • Takes the instrument in payment of or as security for an antecedent claim • Gives a negotiable instrument as payment • Gives an irrevocable obligation as payment EXAMPLE: Karen executes a note payable to Fred for $3,000 for goods she purchased from him. Fred transfers the note to Amy who pays $2,500 for the note. Amy has given value for the negotiable instrument and therefore meets this qualification for HDC status. EXAMPLE: Ted draws a check "payable to the order of Mary Smith" and delivers the check to Mary. Mary indorses it and gives it as a gift to her daughter. Mary's daughter cannot qualify as an HDC because she has not given value for it.