Liability

• Signature liability – liability of someone who has signed a document.

• Warranty liability -- liability of someone who has received payment.

Contract vs. Instrument• Negotiable instruments are issued to

fulfill a contract. • The instruments create a second

contract to pay the debt created by the first agreement.

• Once an instrument is accepted in payment for a debt, the debt is suspended until the instrument is paid or dishonored.

Enforcing an Instrument• In a signature liability, to whom is the

signer liable?– To the holder of the instrument.– To anyone to whom the shelter rule

applies (non-holder with the rights of a holder).

– A holder who has lost the instrument.

Primary vs. Secondary Liability• Someone with primary liability must pay

unless he has a valid defense.• Someone with 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 Payment Process• Presentment – holder demands

payment.• Dishonor – if payment is not received

when due or demanded, the instrument is considered dishonored.

• Notice of Dishonor – notice is given to the party with secondary liability when the instrument is dishonored.

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.

• Indorsers are secondarily liable.– See next slide for more detail.

Signature Liability -- Indorsers • Indorsers are not liable if:– they write the words “without recourse”

next to their signature on the instrument, – a bank certifies the check, – the check is presented for payment more

than 30 days after the indorsement, or – the check is dishonored and the indorser

is not notified within 30 days.

Accommodation Party• An accommodation party (sometimes

called a co-signer or guarantor) is someone who adds her signature to an instrument in a capacity other than issuer, acceptor or indorser, in order to be liable for the instrument.

• An accommodation party has the same liability to the holder as the person for whom she signed.

Agent• To avoid personal liability when signing an

instrument, an agent must: – indicate that she is signing as an agent and – give the name of the principal.

• The principal is liable if the agent signs correctly, the agent signs just her own name, or the agent signs only the name of the principal.

Rules of Warranty Liability• The culprit 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 culprit is ultimately liable to anyone else who pays value for it.

Transfer Warranties• When someone transfers an

instrument, she warrants that:– She is the holder of the instrument,– All signatures are authentic and

authorized,– The instrument has not been altered,– No defense can be asserted against her,

and– As far as she knows the issuer is solvent.

Signature Liability vs.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.

• Under signature liability rules, the holder of a dishonored instrument cannot make a claim until the indorser or drawer is notified of the dishonor; under transfer warranties, the holder does not need to wait to make the claim.

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, and– She has no reason to believe the drawer’s signature is

forged.• Anyone who presents a promissory note for

payment warrants only that he is a holder of the instrument.

Other Liability Rules• Conversion Liability – Conversion means that (1) someone has stolen

an instrument or (2) a bank has paid a check that has a forged indorsement.

• Imposter Rule– If someone issues an instrument to an

imposter, then any indorsement in the name of the payee is valid as long as the person (a bank, say) who pays the instrument does not know of the fraud.

Other Liability Rules (cont’d)

• Fictitious Payee Rule– If an instrument is issued to a person who does

not exist, any 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, any indorsement in the name of the payee is valid as long as the payer does not know of the fraud.

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 (impostor rule, fictitious payee rule and employee indorsement rule).

• Anyone careless in allowing a forged or altered instrument to be created is also liable.

Crimes• Bouncing a check

– Writing a check on an account with insufficient funds is illegal, but usually only has a monetary penalty if the funds are deposited quickly.

• Check Kiting – An illegal scheme where checks are passed between overdrawn

accounts at two banks, earning interest at one bank before reversing the process to “repay” the other account.

• Forgery – Creating a fake document or passing on a known fake

document is illegal.

Discharge• Discharge means that liability on an instrument

terminates.By Payment By AgreementBy Cancellation By CertificationBy Alteration

• Discharge of an indorser or accommodation party– Article 3 provides that virtually any change in an

instrument that harms an indorser or accommodation party also discharges them unless they consent to the change.

“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.”