Commercial Law

Negotiable Instruments

Introduction Article 3 governs negotiable instruments. Negotiable Instruments are safe substitute for cash

that are freely transferable. If an instrument is in a special form, i.e. negotiable, Transferred in a special way, i.e., negotiated To a person who takes the instrument for

Value In good faith and Without notice of any defenses to or claims on the

instrument, i.e., a holder in due course or “HDC.” The person will be able to enforce the instrument

subject to very few defenses.

Negotiable Instruments

Basically two kinds of Article 3 instruments Note Draft

Notes

A note is two-party negotiable instrument A written signed promise (undertaking) By one party (the maker) To pay to another party (the payee or bearer) [See U.C.C. §§ 3-103(a)(9), 3-104(e)]

Promissory NoteI, Max Maker, promise to pay to the order of Peter Payee one hundred dollars ($100).

/s/ Max Maker

Drafts

A draft, also known as “bill of exchange,” is a three-party negotiable instrument

A written and signed instruction by one person (the drawer)

To another person (the drawee) demanding that the drawee pay money

To still a third person (the payee or bearer)

Drafts

Example

Drew Drawer 101123 Pierce Rd 11/20/06Anytown, USA

Pay to the order Paula Payee $100One Hundred and 00/100-------------------- dollars

Second Bank of Anytown (drawee)

memo /s/ Drew Drawer

Checks

A specific type of draft, namely one drawn on a bank and payable on demand.

An instrument will be deemed a check if it meets these requirements, even if the instrument is described on its face by another term, (a money order). [UCC §3-104(f)]

Negotiability

A negotiable instrument means a written and signed:

Unconditional Promise or order To pay a fixed amount of money (with or without

interest or other charges described in the promise or order) Is payable to order or to bearer (at the time it is issued or first

comes into possession of a holder) Is payable on demand or at a definite time and Does not state any unauthorized undertaking or instruction (by

the person promising or ordering payment) [UCC §§ 3-103, 3-104]

The Negotiation Process

Negotiation is a transfer of possession of an instrument, whether voluntary or involuntary, by a person other than the issuer to a person who thereby becomes its holder [UCC §3-201(a)].

A holder is a person in possession of the instrument if the instrument is payable to bearer; if the instrument is payable to an identified person, that person is the holder as soon as she gets possession [UCC §1-201(21)].

Bearer Instruments

A negotiable instrument that is issued as bearer paper or subsequently converted into bearer paper (e.g. by blank indorsement) is negotiated simply by transferring possession of the instrument. Once the transferee has possession, she technically qualifies as a “holder.” [UCC §3-201(b)].

Ex. Drawer writes a check payable to “Cash” which makes the check a bearer instrument. If drawer transfers the check to Grocer, Grocer become a holder.

Order Instruments

Negotiation to Specific Payee An instrument that is payable to an identified person is

negotiated by transferring possession of the instrument along with the indorsement of the identified person. [UCC § §3-201(b), 3-205 (a)]

Dan Drawer writes a check payable to Paula Payee. Upon receiving the check, Paula qualifies as a “holder.” If Paula subsequently wishes to negotiate the check, she must indorse it and deliver possession to her transferee, who will then also qualify as a “holder.”

Location of Indorsement

Must be written on the instrument. Usually placed on back of instrument, but

may be placed on front or on a paper affixed to the instrument (an allonge) [UCC §3-204(a)]

Effect of Transferring Order Instrument without Indorsement May be effective to transfer possession, but

does not constitute a negotiation until the indorsement is made [UCC §3-203(c)]

Rights of Transferee without indorsement Needs to obtain indorsement or does not have

status of “holder,” and certainly cannot qualify as an HDC.

Cannot negotiate the instrument Suit to compel Indorsement Suit to Enforce Indorsement

Types of Indorsements

Special One that names a particular person as

indorsee (pay Joan Smith). The indorsee must sign in order for the instrument to be further negotiated. [UCC §3-205(a)]

Blank A signature that is not accompanied by the

naming of a specific indorsee. Blank indorsements create bearer paper, which

may then be negotiated by delivery alone

Holders in Due Course

Determining whether a person is an HDC is a two-step process

First, determine if the person is a “holder”

Second, determine if the person holds in “due course.”

Holder

Under UCC §1-201(21) the transferee must Have possession and The instrument must be payable either to

bearer or to the person in possession [UCC §1-201(21)]

The instrument must be free of forgeries of those names necessary to the chain of title (the payee and any special indorsees).

Due Course The UCC provides that the HDC is a holder

who takes the instrument: (i) for value; (ii) in good faith; and (iii) without notice that:

The instrument is overdue or has been dishonored

The instrument contains an unauthorized signature or has been altered

A claim to the instrument exists Any party has a defense or claim in recoupment

(a claim that reduces the amount payable on the instrument)

HDC: Value [UCC §3-303]

Types of value: Performance of the agreed consideration Acquisition by the holder of a lien or a SI in

the instrument other than a lien obtained by judicial proceeding

Taking the instrument as payment of or security for an preexisting debt

Trading a negotiable instrument for another instrument

HDC: Good Faith [UCC §3-103(a)(6)] Honesty in Fact-is subjective (what actor

actually believed), “pure heart, empty head” test. Not a reasonable person standard.

Reasonable Commercial Standards of Fair Dealing- is objective (the actor must proceed fairly in light of the facts and commercial standards) Note that the standard is different from ordinary care.

Notice to Purchaser

Actual knowledge (a subjective standard) Reason to know (an objective standard)

[UCC §1-202]

HDC: Shelter Rule Transferee Acquires Transferor’s rights [UCC

§3-203] Transferee takes “shelter” in the status of her

transferor This rule allows any transferee to “step into the

shoes” of the HDC who formerly held the instrument and to obtain the right of an HDC A promissory note is held by M, who qualifies as an HDC.

M makes a gift of the note to her daughter D. Because D did not give value for the note, she obviously would not otherwise qualify as an HDC, but because her mother had the status, D succeeds to the rights of an HDC too.

Protects the Free Negotiability of Negotiable Instruments