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LAW BUSINESS17e

for

John D. Ashcroft, J.D.Distinguished Professor of Law and Government

Regent University Member of the Missouri and District of Columbia Bar

Janet E. Ashcroft, J.D.Member of the Missouri and District of Columbia Bar

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Law for Business, Seventeenth EditionJohn D. Ashcroft and Janet E. Ashcroft

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274 Part 5 Negotiable Instruments

CHAPTER

24Liabilities of Parties and Holders in Due Course

he Uniform Commercial Code (UCC) imposes liability on parties to negotiable instruments depending on the nature of the paper; the role of the party as maker, acceptor, indorser, or transferor; and the satisfaction

of certain requirements of conduct by the holder of the instrument. Two basic categories of liability incidental to negotiable instruments include (1) the liability created by what is written on the face of the paper (contractual liability), and (2) the liability for certain warranties regarding the instrument.

L E A R N I N G O B J E C T I V E S

1 Summarize the rules for primary and secondary liability.

2 Explain the procedures for an agent to use when executing a negotiable instrument.

3 Define holder in due course and holder through a holder in due course.

4 Discuss the special rules for holders of consumer paper.

P R E V I E W C A S E

First National Bank of Chicago sent a form/notice to Muhamad Mustafa that his certificate of deposit (CD) was maturing. The bank received the form apparently signed by Mustafa with instructions to close the CD account. First mailed a cashier’s check for $158,000 payable to Mustafa at his address. Michael Mustafa, Muhamad’s nephew who shared

his address, deposited the check in his account at MidAmerica Federal Savings Bank. The check was indorsed by Michael and also bore the purported signature of Muhamad. Michael lost all the money gambling at a riverboat casino. When Muhamad later tried to redeem the CD, First issued a replace-ment check and sued MidAmerica for breach of warranty. What warranties does a bank that accepts and pays a check make? Why does the bank make these warranties?

he Uniform negotiable insthe party as m

of certain requiremencategories of liability

T


Chapter 24 Liabilities of Parties and Holders in Due Course 275

Liability for the Face of the PaperParties whose signatures do not appear on negotiable instruments are not nor-mally liable for their payment. A signature can be any name, including a trade or assumed name, and may be handwritten, typed, or printed. It can even be a word or logo in place of an actual signature. For those whose signatures do appear, two types of contractual liability exist regarding the order or promise written on the face of the instrument: primary liability and secondary liability.

Primary LiabilityA person with primary liability may be called on to carry out the specific terms indicated on the paper. Of course, the paper must be due, but the holder of a negotiable instrument need meet no other conditions prior to the demand being made on one primarily liable. The two parties who ordinarily have the potential of primary liability on negotiable instruments include makers of notes and accep-tors of drafts.

The maker of a note is primarily liable and may be called on for payment. The maker has intended this by the unconditional promise to pay. Such a prom-ise to pay contrasts sharply with the terms used by drawers of drafts who order drawees to pay.

The drawer of a draft does not expect to be called on for payment; the drawer expects that payment will be made by the drawee. However, it would be unrea-sonable to expect that the drawee could be made liable by a mere order of another party, the drawer. Understandably then, the drawee of a draft who has not signed the instrument has no liability on it. Only when a drawee accepts a draft by writ-ing “accepted” and signing it does the drawee have liability on the instrument. By acceptance the drawee in effect says, “I promise to pay . . .” This acceptance ren-ders the drawee primarily liable just as the maker of a note is primarily liable.

Secondary LiabilityIndorsers and drawers are the parties whose liability on negotiable instruments is ordinarily secondary.

When the conditions of secondary liability have been met, a holder may require payment by any of the indorsers who have not limited their liability by the type of indorsement used or by the drawer. Except for drawers of checks or banks that have accepted a draft, who do not need notice of dishonor, three con-ditions must be met for a party to be held secondarily liable:

1. The instrument must be properly presented for payment.

2. The instrument must be dishonored.

3. Notice of the dishonor must be given to the party who is to be held second-arily liable.

Presentment. Presentment is the demand for acceptance or payment made on the maker, acceptor, drawee, or other payor of commercial paper. In order for indorsers to remain secondarily liable, the instrument must be properly presented. This means that the instrument should be presented to the correct person, in a proper and timely manner.

Presentment of instruments that state a specified date for payment should be made on that date. Other instruments must be presented for payment within a

LO 1Primary and secondary liability

Primary LiabilityLiability without conditions for commercial paper that is due

Secondary LiabilityLiability for a negotiable instrument that has been presented, dishonored, and notice of dishonor given

PresentmentDemand for acceptance or payment



reasonable time after a party becomes liable on the instrument. The nature of the instrument, existing commercial usage, and the partial facts of the case determine what length of time is reasonable. The UCC specifies that for drawers on uncerti-fied checks, a presentment within thirty days after the date of the check or the date it was issued, whichever is later, is presumed to be reasonable. As to indors-ers, the UCC specifies that presentment within seven days of the indorsement is presumed to be reasonable.

If presentment is delayed, drawers and makers of the instruments payable at a bank may no longer have funds in the bank to cover the instruments if the bank fails. If the bank failure occurs and the holder has delayed presentment for more than thirty days, drawers may be excused from liability on the basis that no proper presentment was made. To be so excused, the drawers must make a written assignment of their rights against the bank, to the extent of the funds lost, to the holders of the paper.

To reflect the fact that many banking transactions can be and are conducted by means of electronic devices, the UCC provides that presentment can be made electronically. The actual instrument need not be physically presented. Presentment takes place when a presentment notice is received. With electronic presentment, the banks involved have to have an agreement providing for pre-sentment by electronic means. This agreement will specify what happens to the actual instrument—which bank holds it or if it follows the presentment notice to the drawee bank.

Proper presentment is not a condition to secondary liability on a note when the maker has died or has been declared insolvent. A draft does not require presentment if the drawee or acceptor has died or gone into insolvency pro-ceedings. Commercial paper may contain terms specifying that the indorsers and the drawer agree to waive their rights to the condition of presentment. Furthermore, the holder is excused from the requirement of presentment if, after diligent effort, the drawee of a draft or the maker of a note cannot be located.

Finally, if the secondary party knows that the draft or note will not be paid or has no reason to believe that the paper will be honored, presentment is excused.

Dishonor. The UCC states that dishonor occurs when a presentment is made and a due acceptance or payment is refused or cannot be obtained within the prescribed time. This occurs when, for example, a bank returns a check to the holder stamped “insufficient funds” or “account closed.” Return of a check lack-ing a proper indorsement does not constitute dishonor.

Notice of Dishonor. A holder desiring to press secondary liability on an indorser or certain drawers must inform that party of the dishonor. Notice of dishonor must be conveyed promptly to these parties who are secondarily liable. The UCC requires that a bank give notice of dishonor to those it wishes to hold liable by midnight of the next banking day following the day on which it receives notice of dishonor. All other holders must give notice within thirty days following the day on which notice of dishonor is received. In order to avoid unduly bur-dening holders, the UCC provides that notice may be given by any commercially reasonable means. If by mail, proof of mailing conclusively satisfies the require-ment that notice be given.

When a check is deposited into a bank account, the check can be from that bank or any other bank. When the drawee is a different bank, it needs to be returned to that bank for payment from the drawer’s account. There is a system of clearinghouses that transfers checks from the banks in which they

DishonorPresentment made, but acceptance or payment not made



are deposited—depositary banks—to the drawee banks, called payor banks. Each bank in the clearinghouse system must give notice of dishonor in the pre-scribed time—by midnight of the next banking day following the day on which the check is received.

Generally, notice of dishonor does not need to be in any special form. However, if the dishonored instrument is drawn or payable outside the United States, notice of dishonor may be certified by a public official authorized to do so. This certificate of dishonor is known as protest.

Delay or failure to give notice of dishonor is excused in most cases where timely presentment would not have been required. Basically, this occurs when notice has been waived; when notice was attempted with due diligence but was unsuccessful; or if the party to be notified had no reason to believe that the instrument would be honored, for example, because of death or insolvency.

ProtestCertification of notice of dishonor by authorized official

Facts: Attorney Stephen Catron entered into a loan arrangement with Citizens Union Bank by exe-cuting a promissory note and pledging 375 shares of Ohio County Bancshares, Inc., as collateral. The note stated: “I waive the right to receive notice of any waiver or delay or presentment, demand, protest, or dishonor.” Catron’s payments were fre-quently late. Over one year, Citizens charged Catron late payment penalties twelve times for payments outside the ten-day grace period. Citizens also found out that shortly after pledging the shares of Ohio County Bancshares to it, Catron applied for a new stock certificate in his name on the ground

he had lost the certificate. When it sued Catron to accelerate the note, he alleged the waiver of notice provision was unconscionable and against public policy.

Outcome: The court stated the law provided that notice of dishonor could be excused if the party against whom enforcement of an instrument was sought had waived such notice and Catron had waived notice.

—Catron v. Citizens Union Bank, 229 S.W.3d 54 (Ky. App.)

C O U R T C A S E

GuarantorsIndorsers can escalate their liability to primary status by indorsing an instrument “Payment guaranteed.” These words indicate that the indorser agrees to pay the instrument if it is not paid when due. The holder does not need to seek payment from anyone else first.

If the transferor indorses the instrument with the words “Collection guar-anteed,” secondary liability is preserved. However, the contingencies that must be met by the holder in order to hold this type of guarantor liable change from presentment, dishonor, and notice of dishonor to obtaining against the maker or acceptor a judgment that cannot be satisfied.

People usually act as guarantors in order to increase the security of commer-cial paper. Frequently, if someone liable has a poor credit rating, the instrument could not be negotiated without having an additional party sign as a guarantor of the instrument.



Unauthorized SignaturesNormally, an unauthorized signature does not bind the person whose name is used. The signature is a forgery. However, there are two exceptions: (1) when the person whose name is signed ratifies the signature and (2) when the negligence of the person whose name is signed has contributed to the forgery.

When the forged signature is an indorsement, the loss usually falls on the first person to take the instrument after the forgery. That is one reason why banks ask for identification and even thumbprints before cashing a check for someone. Courts make the assumption that the person who deals with the forger is in the best position to prevent the loss.

There are exceptions to this rule usually involving dishonest employees. One occurs when someone signs an instrument on behalf of the maker or drawer, but intends the payee to have no interest in the instrument. For example, suppose Fazone, an employee of Gilbert Chemical, makes out Gilbert’s checks to suppliers but does not intend the suppliers to receive the checks. Fazone then indorses and deposits the checks in his own account. Fazone is embezzling from Gilbert, but the unauthorized indorsements are effective.

An additional exception occurs when an employer entrusts an employee with responsibility with respect to an instrument and the employee makes a fraudulent indorsement on the instrument in the name of the payee. As long as the person who takes the instrument does so in good faith, the indorsement is effective as the indorsement of the person to whom the instrument is payable. Responsibility with respect to an instrument means the authority, for example, to sign or indorse instruments, to control disposition of instruments in the name of the employer, or to prepare or process instruments for issuance in the name of the employer.

Facts: Stephen Schor, accountant and finan-cial advisor for Andre Romanelli, Inc., suggested Romanelli open an account at J. P. Morgan Chase Bank, N.A., to obtain a lower interest rate on a line of credit. Romanelli’s principal signed an account application, corporate resolution, and signature card for Romanelli and gave it to Schor. However, he did not cross out the unused signature boxes on the card as directed by the instructions. Schor later told Romanelli’s officers he could not get a bet-ter interest rate, so they told him not to open the account. Schor secretly signed a blank line on the signature card and opened an account for Romanelli at Chase. He changed the mailing address to his office address. He later suggested the officers write checks payable to themselves that he would use to

pay taxes to convince a lender they had sufficient assets to support a line of credit. The officers wrote checks totaling $4.5 million payable to themselves from a list Schor prepared and gave them to him. He indorsed the checks, deposited them in the account at Chase, and then withdrew the funds for his personal use. Romanelli sued Chase.

Outcome: The court held that since Schor was authorized to indorse the checks payable to the officers and issue checks payable to tax collectors, the bank properly cashed the checks.

—Andre Romanelli, Inc. v. Citibank, N.A., 874 N.Y.S.2d 14 (N.Y. A.D.)

C O U R T C A S E



Liability for WarrantiesContractual liability requires a signature on the paper. However, transferring negotiable instruments creates warranty liability. Every transferor of commercial paper warrants the existence of certain facts. Unless specifically excluded, these warranties are automatically charged to every transferor of commercial paper. Note that a person can be liable as a warrantor even if the person’s signature or name does not appear on the instrument, as, for example, when a person negoti-ates bearer paper by delivery alone.

The UCC specifies that each transferor who receives consideration and does not specifically limit liability makes a warranty that:

1. The transferor is entitled to enforce the instrument.

2. All signatures are genuine or authorized.

3. The instrument has not been altered.

4. The instrument is not subject to a defense or claim of any party that can be asserted against the transferor (explained in Chapter 25).

5. The transferor has no knowledge of any insolvency proceedings instituted with respect to the maker, acceptor, or drawer of an unaccepted draft.

P R E V I E W C A S E R E V I S I T E D

Facts: First National Bank of Chicago sent a form/notice to Muhamad Mustafa that his certificate of deposit (CD) was maturing. The bank received the form apparently signed by Mustafa with instructions to close the CD account. First mailed a cashier’s check for

$158,000 payable to Mustafa at his address. Michael Mustafa, Muhamad’s nephew who shared his address, deposited the check in his account at MidAmerica Federal Savings Bank. The check was indorsed by Michael and also bore the purported signature of Muhamad. Michael lost all the money gambling at a riverboat casino. When Muhamad later tried to redeem the CD, First issued a replace-ment check and sued MidAmerica for breach of warranty.Outcome: Because a bank that accepts and pays a check warrants the validity of the indorsements to subsequent transferees, the court held that MidAmerica, the bank that accepted the check with the forged indorsement, breached its warranties to First.

—First Natl. Bank v. MidAmerica Fed. Savings, 707 N.E.2d 673 (Ill. App.)

Liability of AgentsAn agent may sign a negotiable instrument, and the principal, not the agent, will be bound. If the agent, authorized by the principal, signs the instrument, “John Smith, Principal, by Jane Doe, Agent,” or more simply, “John Smith by Jane Doe,” the principal will be bound, but the agent will not be bound by the terms of the instrument.

The agent, in these cases, has signed the instruments, and has (1) indicated a representative capacity, and (2) identified the person represented. If both of these two disclosures are not made, the agent appears to have signed the instruments as a personal obligation, and the agent will be personally liable on them.

LO 2Agent liability



In addition to giving both disclosures and not being bound or giving neither and being bound, an agent could sign an instrument and give just one of these disclosures. There are two ways of doing this.

1. The agent could sign the instrument in such a way that the principal was named, but it was not shown that the agent was acting merely as an agent. If the agent signed “John Smith” and immediately below that “Jane Doe,” the agent and the principal would both be bound. The agent would be bound because she did not indicate that she was an agent, and the other party to the instrument might have relied on the signature of the agent as an individual.

2. The agent could sign the instrument in such a way that the principal was not named, but it would be clear that the agent signed as an agent. Such a case would occur if the agent signed “Jane Doe, Agent.” In this situation, only the agent would be bound by the instrument, since it would not be evident from the face of the instrument who the principal might be.

However, in these last two examples, there is ambiguity about the agent’s status. When a party to the instrument sues for payment, parol evidence may be introduced to prove the agency. So if the parties to the instrument knew that John Smith was the principal and Jane Doe was merely an agent, then only the principal would be bound on the instrument.

Facts: Kurt and Todd Schumacher were the payees of notes signed by Donald Tabor. Above Tabor’s signature was written “DBK Consultants, Inc.,” and below it, “Donald R. Tabor.” Tabor was the president, sole owner, and employee of DBK. There was no indication in the note that Tabor signed in other than his personal capacity. DBK was not mentioned in the body of the notes, nor had it authorized the loans. The money loaned was used for the Talmadge Fitness Center, a business unre-lated to DBK. The Schumachers argued Tabor, not DBK, was liable on the notes.

Outcome: The notes were ambiguous with respect to Tabor’s liability because the name DBK appeared above the signature line, and Tabor’s sig-nature was not qualified by his position in DBK. Therefore; the court said evidence of the parties’ intent was admissible. That intent was that Tabor was personally liable on the notes.

—In re Tabor, 232 B.R. 85 (N.D. Ohio)

C O U R T C A S E

In both (1) and (2), a holder in due course without knowledge that the agent was not supposed to be liable can enforce liability against the agent. However, if a holder in due course is not involved, the revision states that the undisclosed principal is liable. In addition, an agent who can prove that the original parties did not intend the agent to be liable will not be liable.

Holder in Due CourseHolder for value and in good faith with no knowledge of dishonor, defenses, or claims, or that paper is overdue



There is a special rule for checks signed by agents. If an agent signs a check in a representative capacity without indicating that capacity, but the check is on the principal’s account and the principal is identified, the agent is not liable. Almost all checks today are personalized to identify the individual on whose account the check is drawn. Therefore, the agent does not deceive anyone by signing such a check.

In the case of a corporation or other organization, the authorized agent should sign above or below the corporation or organization’s name and indicate the position held after the signature. For example, Edward Rush, the president of Acme Industries, should sign:

ACME INDUSTRIESBy Edward Rush, President

If the instrument were signed this way, Acme Industries, not Edward Rush, would be bound.

If an individual signs an instrument as an agent, “John Smith, Principal, by Jane Doe, Agent,” but the agent is not authorized to sign for the principal, the principal would not be bound. It would be as if the agent, Jane Doe, had forged John Smith’s signature. However, the agent who made the unauthorized signature would be bound. This protects innocent parties to the instrument who would not be able to enforce their rights against anyone if the unauthorized agent was not bound.

Holders in Due CourseNegotiable instruments have an important advantage over ordinary contracts. Remote parties can be given immunity against many of the defenses available against simple contracts. To enjoy this immunity, the holder of a negotiable instrument must be a holder in due course, or an innocent purchaser. The terms holder in due course and innocent purchaser describe the holder of a negotiable instrument who has obtained it under these conditions:

1. The holder must take the instrument in good faith and for value.

2. The holder must have no notice the instrument is overdue or has been dis-honored.

LO 3Holder in due course requirements

Facts: Attorney Eliot Disner’s clients, Irvin and Dorothea Kipnes, owed $100,100 on a settlement with Sidney and Lynne Cohen. The payment was due March 9. The Kipneses gave Disner checks totaling $100,100. Disner deposited them in his client trust account on the 9th. After the Kipneses’ bank said that the account could cover the $100,100, Disner wrote a trust account check for $100,100 to the Cohens’ attorney. The Kipneses stopped payment on their checks to Disner, so the

trust account check bounced. The Kipneses filed for bankruptcy, so the Cohens sued Disner.

Outcome: The court held that Disner was not liable since he was merely an agent for transferring money from his clients to the payees.

—Cohen v. Disner, 42 Cal. Rptr. 2d 782 (Cal. App.)

C O U R T C A S E



3. At the time the instrument is negotiated, the holder must have had no notice of any defense against or claim to the instrument.

For Value and in Good FaithThe law of negotiable instruments is concerned only with people who give some-thing for the paper. Thus, to attain the specially favored status of being a holder in due course, the holder must give value for the paper. Conversely, one who does not do so, such as a niece receiving a Christmas check from an uncle, cannot be a holder in due course. A mere promise does not constitute value.

The requirement that value be given in order to be a holder in due course does not mean that one must pay full value for a negotiable instrument. Thus, a person who purchases a negotiable contract at a discount can qualify as a holder in due course. The law states that it must be taken “for value and in good faith.” Good faith means honesty in fact and the observance of reasonable commercial standards of fair dealing.

Facts: James Camp contracted to perform some services for Shawn Sheth by October 15, so Sheth delivered a check for $1,300 to Camp but post-dated it to October 15. Camp negotiated the check to Buckeye Check Cashing, Inc., on October 13. Afraid that Camp was not going to perform, Sheth ordered his bank to stop payment on the check on October 14. Buckeye deposited the check with its bank on October 14 thinking it would reach Sheth’s bank on October 15. It was dishonored, so Buckeye sued Sheth.

Outcome: The court stated that receiving a postdated check should put a check-cashing busi-ness on notice that the check might not be good. Buckeye did not act in a commercially reasonable manner, so it did not take the check in good faith.

—Buckeye Check Cashing, Inc. v. Camp, 825 N.E.2d 644 (Ohio App.)

C O U R T C A S E

If the instrument is offered at an exorbitant discount, that fact may be evidence that the purchaser did not buy it in good faith. It is the lack of good faith that destroys one’s status as a holder in due course, not the amount of the discount. If the payee of a negotiable instrument for $3,000 offered to transfer it for a consideration of $2,900, and the purchaser had no other reason to suspect any infirmity in the instrument, the purchaser can qualify as a holder in due course. The instrument was taken in good faith. Conversely, if the holder had offered to discount the note by $1,000, the purchaser could not take it in good faith because it should be suspected that there is some serious problem with the contract because of the large discount.

Often, a purchaser pays for an instrument in cash and other property. An inflated value placed on the property taken in payment could conceal a discount large enough to destroy good faith. The test always is: Were there any circum-stances that should have warned a prudent person that the instrument was not genuine and in all respects what it purported to be? If there were, the purchaser did not take it in good faith.



If the holder is notified of a problem with the instrument or a defect in the title of the transferor before the full purchase price has been paid, the holder will be a holder in due course to the extent of the amount paid before notification of the problem or defect.

No Knowledge that Instrument is Past Due or DishonoredOne who takes an instrument known to be past due cannot be an innocent pur-chaser. However, a purchaser of demand paper on which demand for payment has been made and refused is still a holder in due course if the purchaser had no notice of the demand. A purchaser who has reason to know that any part of the principal is overdue, that an uncured default exists in payment of an instrument in the same series, or that acceleration of the instrument has been made has notice that the instrument is overdue. A note dated and payable in a fixed number of days or months shows on its face whether or not it is past due.

Uncured DefaultNot all payments on instrument fully made and not all made by due date

Facts: Regions Bank approved a loan for Raymond and Diane Crutchfield that included refinancing their home against which Union Planters held a loan. Regions hired Julia Gray, a closing agent with Security Title, to close the Regions loan, including the payoff to Union Planters. Regions transferred $129,000 to Gray to fund the new loan. Security Title issued a check, drawn on Southern Bank to Union Planters for $95,506.42, but the check bounced. Union Planters told Gray she must pro-vide a cashier’s check for the bad check. Gray issued a personal check, drawn on First National Bank, for $95,214.20, which she deposited in Security Title’s account at Southern Bank, to get a cashier’s check payable to Union Planters for $95,506.42. Gray delivered the cashier’s check to Union Planters. Greg Miller, president of Southern Bank, got a call from the Federal Reserve, telling him Gray’s

personal check drawn on First National was being returned for insufficient funds. The next day, Miller spoke with an official at Union Planters and told him Southern Bank would be returning its cashier’s check because Gray had obtained it through fraud. Union Planters sued Southern Bank, alleging it was a holder in due course of the cashier’s check and asking that Southern Bank be required to pay the cashier’s check. Southern alleged Union Planters was not a holder in due course because it took the cashier’s check with notice of Gray’s fraud.

Outcome: The court concluded that Union Planters took the cashier’s check without actual knowledge of dishonor.

—Southern Bank of Commerce v. Union Planters Nat. Bank, 375 Ark. 141 (Ark.)

C O U R T C A S E

An instrument transferred on the date of maturity is not past due but would be overdue on the next day. An instrument payable on demand is due within a reasonable time after issuance. For checks drawn and payable in the United States, thirty days is presumed to be a reasonable time.



No Knowledge of any Defense or Claim to the InstrumentWhen one takes a negotiable instrument by negotiation, to obtain the rights of an innocent purchaser there must be no knowledge of any defense against or claim adverse to the instrument. Knowledge of a claim may be inferred if, for example, the holder knows that a fiduciary has negotiated an instrument in payment of a personal debt. A fiduciary is a person in a relationship of trust and confidence such as a trustee. As between the original parties to a negotiable instrument, any act, such as fraud, duress, mistake, or illegality that would make a contract either void or voidable, will have the same effect on a negotiable instrument. However, as will be seen in the next chapter, many of these defenses are not effective if the instrument is negotiated to an innocent purchaser.

Knowledge of other potential irregularities does not destroy holder in due course status. Knowing that an instrument has been antedated or postdated, was incomplete and has been completed, that default has been made in the payment of interest, or that it was issued or negotiated in return for an executory prom-ise or accompanied by a separate agreement does not give a holder notice of a defense or claim.

Holder Through a Holder in Due CourseThe first holder in due course brings into operation all the protections that the law has placed around negotiable instruments. When these protections once accrue, they are not easily lost. Consequently, a subsequent holder, known as a holder through a holder in due course, may benefit from them even though not a holder in due course. For example, Doerhoff, without consider-ation, gives Bryce a negotiable note due in sixty days. Before maturity, Bryce indorses it to Cordell under conditions that make Cordell a holder in due course. Thereafter, Cordell transfers the note to Otke for no consideration. Otke is not a holder in due course, as she did not give any consideration for the note. But if Otke is not a party to any wrongdoing or illegality affecting this instrument, she acquires all the rights of a holder in due course. This is true because Cordell had these rights, and when Cordell transferred the note to Otke, he transferred all of his rights, which included his holder in due course rights.

Holders of Consumer PaperThe UCC rules regarding the status of a holder in due course have been modi-fied for holders of negotiable instruments given for consumer goods or services. Consumer goods or services are defined as goods or services for use primar-ily for personal, family, or household purposes. The changes resulted from both amendment to the UCC by the states—which means that the rules vary some-what from state to state—and the adoption of a Federal Trade Commission (FTC) rule.

Generally, the rights of the holder of consumer paper are subject to all claims, defenses, and setoffs of the original purchaser or debtor arising from the consumer transaction. A setoff is a claim a party being sued makes against the party suing. In the case of consumer sales, the FTC rule requires that consumer credit contracts contain specified language in bold print indicating that holders of the contracts are subject to all claims and defenses the debtor could assert

FiduciaryA person in relationship of trust and confidence

Holder through a Holder in Due CourseHolder subsequent to holder in due course

LO 4Holders of consumer paper

Consumer Goods or ServicesGoods or services primarily for personal, family, or household use

SetoffA claim by the party being sued against the party suing



against the seller. It means that no subsequent holder can be a holder in due course. The language is:

NOTICEANY HOLDER OF THIS CONSUMER CREDIT CONTRACT IS SUBJECT TO ALL CLAIMS AND DEFENSES WHICH THE DEBTOR COULD ASSERT AGAINST THE SELLER OF GOODS OR SERVICES OBTAINED PURSUANT HERETO OR WITH THE PROCEEDS HEREOF. RECOVERY HEREUNDER BY THE DEBTOR SHALL NOT EXCEED AMOUNTS PAID BY THE DEBTOR HEREUNDER.

The state laws generally make holder in due course rules inapplicable to con-sumer sales or limit the cutoff of consumer rights to a specified number of days after notification of assignment.

Normally, these rights of the debtor are available only when the loan was arranged by the seller or lessor of the goods or was made directly by the seller or lessor. The state laws do not apply to credit card sales on a credit card issued by someone other than the seller. However, federal law allows a credit card holder to refuse to pay credit card issuers in some cases when an earnest effort at returning the goods is made or a chance to correct a problem is given the seller.

Modifying or abolishing the special status of a holder in due course for con-sumer goods prevents frauds frequently practiced on consumers by unscrupulous businesspeople. Such individuals would sell shoddy merchandise on credit and immediately negotiate the instrument of credit to a bank or finance company. When the consumer discovered the defects in the goods, payment could not be avoided because the new holder of the commercial paper had purchased it with-out knowledge of the potential defenses and was therefore a holder in due course. Furthermore, the seller who had frequently left the jurisdiction or gone bank-rupt was unavailable to be sued. Thus, the consumer would be unable to assert a defense or rescind the transaction against either the seller or the holder. The modifications based on changes to the UCC and adoption of the FTC rule were enacted to remedy this problem. A consumer who purchases goods that are not delivered or worthless can avoid paying more and recover what has been paid.

Facts: Fred and Cathi Beemus bought a car and service contract from MacKay-Swift, Inc. They financed the purchase by means of an installment contract. Primus Automotive Financial Services, Inc., was the assignee of the installment contract that included the language required by the FTC rule for consumer goods. The Beemuses sued Primus, alleging that MacKay had charged amounts under the installment contract that violated the law. They further alleged that under the FTC rule, Primus

was liable for all claims they could bring against MacKay.

Outcome: The FTC rule allows consumer-debt-ors to assert against assignees all claims for recov-ery they have against the sellers if the contracts had not been assigned.

—Beemus v. Interstate Natl. Dealer Servs., Inc., 823 A.2d 979 (Pa. Super.)

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Allowing the consumer to have such rights against a holder who would oth-erwise be a holder in due course is designed to protect consumers who usually do not have knowledge of negotiable instrument laws. Normally, a bank or finance company, which may buy many instruments from the seller, can more easily ascertain whether the seller is reliable than individual consumers can.

Q U E S T I O N S

1. What are the two basic categories of liability incidental to negotiable instruments?

2. What can constitute a signature on a negotiable instrument?

3. What conditions need to be met in order to require a person with primary liabil-ity to carry out the terms indicated on the paper?

4. What is required for a proper presentment?

5. When does dishonor of a negotiable instrument occur?

6. According to the UCC, when must notice of dishonor be given?

7. How can indorsers escalate their liability to primary status?

8. What are the two exceptions to the rule that an unauthorized signature does not bind the person whose name is used?

9. Is it possible for a person to be liable as a warrantor even if that person’s signa-ture or name does not appear on a negotiable instrument? Explain.

10. What two things must an agent do in order to escape personal liability?

11. Can a holder who is notified of a problem with an instrument or a defect in the title of the transferor before the full purchase price has been paid be a holder in due course? Explain.

12. What is the effect of the modification of UCC rules regarding the status of a holder in due course when a negotiable instrument has been given for consumer goods or services?

C A S E P R O B L E M S

1. Cactus Roofing, LLC issued a check to “Espino Roofing and/or Tomas Hernandez” for $4,768.47 for roofing work that Hernandez had performed for Cactus. That morning, Hernandez cashed the check at Hurst Enterprises, LLC, d/b/a Mr. Payroll Check Cashing. Hernandez had previously cashed three other checks from Cactus at Mr. Payroll. All three checks had cleared without problems. Mr. Payroll paid Hernandez the amount of the check minus a 1 percent check-cashing fee and deposited the check in its account at Bank of the Panhandle. A day after issuing the check, Cactus discovered that Hernandez’s work had not been adequately completed. After unsuccessfully trying to contact Hernandez, Cactus stopped payment on the check. Mr. Payroll received the check back from its bank with notice that a stop payment had been issued. The manager of Mr. Payroll discovered the stop payment had been issued three days after Hernandez had cashed the check. Mr. Payroll sued Cactus, alleging it was a holder in due course. Was it?

2. Ellen and Roscoe Reagans bought a motor home from Paul Sherry Vans and R.V.’s, Inc., (Sherry), but it had a defect. The Reaganses sued Sherry, the manu-facturer, MountainHigh Coachworks, Inc., and Firstar Bank, N.A., now U.S. Bank

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National Association, the creditor that loaned them the money to buy the motor home. They alleged the bank was derivatively liable for their claims against Sherry based on an FTC-mandated notice in their loan disclosure, note, and secu-rity agreement with the bank: “ANY HOLDER OF THIS CONSUMER CREDIT CONTRACT IS SUBJECT TO ALL CLAIMS AND DEFENSES WHICH THE DEBTOR COULD ASSERT AGAINST THE SELLER OF GOODS OR SERVICES OBTAINED WITH THE PROCEEDS HEREOF.” Was the bank liable for the full amount of the Reaganses’ claims against Sherry?

3. Wal-Mart issued a check on a Wachovia Bank account payable to Alcon Laboratories, Inc.. (Alcon) for $563,288.95 and mailed the check to Alcon. A week later, Pit Foo Wong deposited the check in his account at Asia Bank in Flushing, New York. The payee had been altered from “Alcon Laboratories, Inc.” to “Pit Foo Wong.” Asia Bank presented the check to the Federal Reserve Bank (FRB) of New York, which then presented the check to the FRB in Richmond, which presented the check to Wachovia, and Wachovia paid it. Although Asia Bank allowed Wong to deposit the check, it was suspicious and put a hold on the funds. Wong’s account had a balance of $108.55, and its highest balance was $8,652.55. The next day, an Asia Bank employee called Wachovia and was told the check was “good” and Wachovia had already issued payment. Asia Bank continued to hold the funds. Alcon found out the check had been paid, but it had not received it. Alcon phoned Wal-Mart and was told Wal-Mart’s policy was to wait thirty days before tracing missing checks. Nine days later, Wong tried to wire a large portion of the funds to accounts in Malaysia by submitting five separate wire transfer applications to five different tellers. Because of this unusual behav-ior, Asia Bank contacted Wachovia again and was told the check had been paid. Asia Bank called Wal-Mart and a Wal-Mart customer service representative could not confirm that Wong was the proper payee. The Wal-Mart representative did not notify any superiors of Asia Bank’s inquiry. Asia Bank released the funds, and Wong made the wire transfers to Malaysia. When Wal-Mart discovered the Alcon check had been altered, it notified Wachovia, which sought reimburse-ment from Asia Bank. Asia Bank refused, so Wachovia sued the FRB for breach of presentment and transfer warranties. Was the FRB liable?

4. Alan H. Potamkin loaned The Classic Touch, Inc., $200,000. A promissory note prepared by Classic was signed by Suzanne De Maria, and the corporation’s name was typed under her name. Classic paid only $75,000, so Potamkin sued the corporation and De Maria. Is De Maria liable?

5. On January 3, DeSimone Auto, Inc., issued a check to Bruce Rickett for a car. As frequently happens the first few days of a year, DeSimone inadvertently dated the check with the prior year. Two days later, Rickett deposited the check in Commerce Bank. DeSimone and Rickett had agreed the check would not be cashed if the car were damaged. The car was damaged, so DeSimone stopped payment on the check and told Rickett to return it. Rickett had already gotten the funds from it. Commerce sued DeSimone and Rickett when the check was not paid, but Rickett could not be found. Commerce alleged it was a holder in due course. DeSimone argued it was not since the incorrect date put Commerce on notice the check could be overdue. Discuss whether a check should be overdue when incorrectly dated early in the year but actually negotiated within a few days of its issuance.

6. Kenneth Wulf’s job for Auto-Owners Insurance Co. was to decide whether Auto-Owners would pursue a claim. If so, he was to put a note in the file. When a

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check was received, clerical staff attached it to the file and gave the file to Wulf. He was to note receipt of the check in the file, complete a transmittal form, and return the check to the clerical staff. No record was kept of checks received or of pending claims. Wulf opened an account at Bank One in the name, “Auto Owners Insurance.” Wulf would work on a claim but not note anything in the file. When a check arrived, the clerical staff would attach it to the file and give it to Wulf. He would take the check; indorse it with a stamp he had made that said “Auto Owners Insurance Deposit Only” and deposit it in his Bank One account. The checks were payable to “Auto-Owners Insurance,” “Auto-Owners Insurance Company,” and “Auto-Owners Insurance Co.” When the embezzle-ment was discovered, Auto-Owners sued Bank One. Was Bank One liable?

7. Dan Lofing bought a grand piano from the Steinway dealer, Sherman Clay. Part of the purchase price was a note for $19,650, which included the FTC language limiting holder in due course rights. Music Acceptance Corp. (MAC) purchased the note from Clay. Lofing began to have serious problems with the piano, which Clay tried to fix many times, but after two years the piano was unplayable. Lofing stopped making payments on the note, and MAC sued for the balance due. Lofing sued MAC and Clay. The jury awarded Lofing damages against Clay for breach of contract and MAC damages against Lofing on the note. Lofing appealed, saying that the FTC language meant that if he had a claim or defense against Clay, MAC would be subject to the same claim or defense. How should the case be decided?

8. George Avery sent a letter to Jim Whitworth. Printed on the stationery was the name of Avery’s employer, V & L Manufacturing Co., and the words “George Avery, President.” The letter stated, “This is your note for $45,000.00, secured individually and by our Company.” Avery had signed the letter. V & L did not pay the entire $45,000, so Whitworth sued Avery. Avery said the stationery showed V & L was the debtor and he signed only in a representative capacity. Must Avery pay?

9. Janet Hollandsworth, an accountant for Dalton & Marberry, P.C., embezzled $130,000 by taking appropriately signed Dalton & Marberry checks payable to NationsBank and having the bank issue blank cashier’s checks. Dalton & Marberry sued NationsBank for failing to inquire whether Hollandsworth was authorized to do this. The bank alleged it was a holder in due course and was therefore not liable for negligence. Was NationsBank a holder in due course?

10. On a Friday, Tonia Campbell tried to cash a $17,000 check drawn on a Citibank account at a Citibank. When told that Citibank did not cash such a large check and that the fastest way to get the money was to open a Citibank account, Campbell opened a Citibank savings account with the check. On Saturday, she tried to make a withdrawal from the account at an ATM. She was told she had insufficient funds. Saturday and Sunday were not business days for Citibank. On Monday, she was told there was a “block” on her account, but later that day she had access to her money. She sued Citibank for wrongful dishonor and late payment—after the midnight deadline. Should Citibank be liable on either charge?

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