Negotiable Instruments

Commercial Paper

WHAT IS COMMERCIAL PAPER?

• Unconditional written orders or promises to pay money

• Demand instrument(A substitute for money)

A negotiable instrument must:• Be in writing• Be signed by the maker or drawer• Be an unconditional promise or order to pay• State a fixed amount of money• Not require any undertaking in addition to the

payment of money• Be payable on demand or at a definite time• Be payable “to order” or “to bearer”

Why are banks debtors of their checking account depositors?

The Bank – Customer Relationship

Creditor – Debtor Relationship• Created when a customer deposits money

into the bank.

• The customer is the creditor and the bank is the debtor (owes the money).

The Bank – Customer Relationship (continued)

Principal – Agent Relationship• Created if the:

– deposit is a check that the bank must collect for the customer or the

– customer writes a check against his or her account

• The customer is the principal and the bank is the agent.

TYPES OF COMMERCIAL PAPER

• Drafts

• Checks– Honor and dishonor– Stop-payment orders– Precautions and care

• Promissory notes

• Certificates of deposit

Draft• A draft is a three-party instrument that is

an unconditional written order by one party that orders the second party to pay money to a third party.– Drawer of a draft

– Drawee of a draft

– Payee of a draft

Check• A distinct form of draft drawn on a financial

institution and payable on demand.

– Drawer of a check

– Drawee of a check

– Payee of a check

Parties to a Check• Drawer

- Customer who maintains the checking account and writes checks against the account

• Drawee

- Bank on which the check is drawn

• Payee

- Party to whom the check is written

Duties of Bank and Customer

• Customer must examine bank statements and promptly notify bank of unauthorized payments– Liable for failure to perform duties

• Bank owes duty of ordinary care in presenting and sending checks for collection– Liable for losses caused by its negligence

Promissory Notes• A two-party negotiable instrument that is

an unconditional written promise by one party to pay money to another party.– Maker of a note– Payee of a note

• Types of notes:– Time note– Demand note– Installment notes

Promissory Notes (continued)

• Collateral required– Some notes require posting security– May be automobiles, homes, buildings,

securities, or other property– If maker fails to repay note as due, lender can

foreclose and take collateral as payment

Certificates of Deposit (CD)• A two-party negotiable instrument

• Special form of note created when a depositor deposits money at a financial institution– Institution promises to pay back the amount of

the deposit plus an agreed-upon rate of interest at set time.

Primary Liability• Makers of promissory notes and

certificates of deposit have primary liability for the instrument.

• Maker unconditionally promises to pay the amount stipulated in the note when due.

• Makers are absolutely liable to pay the instrument, subject only to certain real defenses.

Secondary Liability• Drawers of checks and drafts and

unqualified indorsers of negotiable instruments have secondary liability on the instrument.

• This liability is similar to that of a guarantor of a simple contract.

• It arises when the party primarily liable on the instrument defaults and fails to pay the instrument.

Secondary Liability (continued)

• Unqualified indorsers have secondary liability.• Qualified indorsers have no secondary liability.

– They have expressly disclaimed liability.

• Secondary liability arises from an instrument being:– Properly presented– Dishonored.– Notice being timely given to person who is

secondarily liable.

SPECIALIZED TYPES OF COMMERCIAL PAPER

• Certified checks

• Teller’s check

• Cashier’s check

• Money orders

• Traveler’s checks

Special Types of Checks• Certified Checks

– Bank agrees to accept check when presented– Pays out of funds set aside in special account– Drawer is discharged from liability on check

• Cashier’s Checks– Two party check– Bank is both drawer and drawee– Holder is payee

• Traveler’s Checks– Issued without named payee– Requires purchaser’s signature at issuance and upon

use

WHAT MAKES AN INSTRUMENT NEGOTIABLE?

• In writing and signed by the maker or drawer

• Unconditional promise or order

• Payable in a sum certain in money

• Payable on demand or at a definite time

• Payable to bearer or to someone’s order

• Negotiable instruments serve the following functions:– Substitute for money– Credit device– Record-keeping device

• Most purchases by businesses and many individuals are made by negotiable instruments instead of cash.

Additional Clauses• Prepayment clause

– Allows maker to pay amount before due date

• Acceleration clause– Payee or holder may accelerate payment of

principal

• Extension clause– Allows date of maturity to be extended

Nonnegotiable Contract

• A promise or order to pay that does not meet the requirements of a negotiable instrument.

• It is not subject to the provisions of UCC Article 3.

• A nonnegotiable contract can be enforced under normal contract law.

HOW IS COMMERCIAL PAPER TRANSFERRED?

• Indorsement

• Indorser

• Indorsee

• Holder

Transfers

• Negotiable instruments can be transferred to subsequent parties by negotiation.– Done by placing endorsement on instrument

ENDORSEMENTS AND THEIR FUNCTIONS

• Blank endorsements

• Special endorsements

• Qualified endorsements

• Restrictive endorsements

• Accommodation parties

Accommodation Party• A party who signs an instrument and lends his or

her name (and credit) to another party to the instrument.

• The accommodation party is obliged to pay the instrument in the capacity in which he or she signs.– Accommodation Maker – primarily liable– Accommodation Indorser – secondarily liable

• Liability of accommodation party:– Guarantee of payment– Guarantee of collection

BLANK INDORSEMENTS

SPECIAL INDORSEMENTS

HOW IS COMMERCIAL PAPER DISCHARGED?

• By payment

• By cancellation

• By alteration

• By impairment of collateral

• As a contract

Impairment of the Right of Recourse• Certain parties (holders, indorsers,

accommodation parties) are discharged from liability on an instrument if the holder:1.Releases an obligor from liability, or

2.Surrenders collateral without the consent of the parties who would benefit by it

COLLECTION OF COMMERCIAL PAPER OBLIGATIONS

• Holder in due course

• Qualifications of an HDC– Take in good faith and give value– Without knowledge of defense or dishonor

Holder Versus Holder In Due Course

Holder• A person who is in

possession of a negotiable instrument that is drawn, issued, or indorsed to him or his order, or to bearer, or in blank.

Holder in Due Course (HDC)

• A person who takes a negotiable instrument for value, in good faith, and without notice that it is defective or is overdue.

• If the requirements of Article 3 are met, a transferee who qualifies as a holder in due course takes the instrument free of many defenses that can be asserted against the original payee.

• In addition, the document is considered an ordinary contract that is subject to contract law.

WHAT ARE THE LIMITED (Personal) DEFENSES?

• Breach of contract or failure of consideration• Fraud in the inducement• Temporary incapacity to contract—excluding

minority• Ordinary duress• Prior payment or cancellation• Conditional delivery or non-delivery• Unauthorized completion• Theft

Personal DefensesPersonal Defenses Effect

1. Breach of contract2. Fraud in the inducement3. Mental illness that makes a

contract voidable instead of void4. Illegality of a contract that makes

the contract voidable instead of void

5. Ordinary duress or undue influence

6. Discharge of an instrument by payment or cancellation

Personal defenses cannot be raised against a holder in due course

WHAT ARE THE UNIVERSAL DEFENSES?

• Permanent incapacity to contract and minority• Illegality• Forgery or lack of authority• Alteration• Fraud in the execution of the paper or as to the

essential terms• Duress depriving control• Claims and defenses stemming from a

consumer transaction

Universal Defenses

Universal Defenses Effect

1. Minority2. Extreme duress3. Mental incapacity4. Illegality5. Discharge in bankruptcy6. Fraud in the inception7. Forgery8. Material alteration

Real defenses can be raised against a holder in due course

Signature Liability• A person cannot be held contractually

liable on a negotiable instrument unless his or her signature appears on the instrument.

• The signatures on a negotiable instrument identify those who are obligated to pay it.

• If it is unclear who the signer is, parol evidence can identify the signer.

Commercial Wire Transfers

• Fast– Transfers usually completed within one day

• Inexpensive

Questions?

Next Week: Chapters 38 & 39