4. Overview
A negotiable instrument is a contract with
assignable rights
Under UCC Revised Article 3, negotiation is
the transfer of voluntary or involuntary
possession of a negotiable instrument by a
person (other than issuer) to another person
who becomes its holder [3–201]
Example: when an employer pays employee with
paycheck, the employee is a holder
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5. Requirements for Negotiation
Order paper: instrument is payable to the
order of a specific payee
Negotiated by transfer of possession of paper
after indorsement by the payee [3–201(b)]
Bearer paper: instrument is payable “to
bearer” or “to cash”
Negotiated by mere transfer of possession of
paper [3–201(b)]
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6. Indorsement
Indorsement is a signature that, alone or with
other words, is made on an instrument for a
specific purpose
Signature may not be that of the maker,
drawer, or acceptor
Proper purposes: (i) negotiating the
instrument, (ii) restricting payment of the
instrument, or (iii) incurring indorser’s
liability on the instrument” [3–204(a)]
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7. Exception to Indorsement
Indorsement is required for negotiation
except in the case of depositary banks
Depositary banks often receive unindorsed
checks under “lockbox” arrangements with
customers receiving a high volume of checks
Depositary bank becomes a holder and warrantor
of an item delivered to it for collection, whether or
not indorsed by customer, if the customer at the
time of delivery qualified as a holder [4–205]
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8. Effects of Indorsement
The form or lack of indorsement may affect
future attempts to negotiate the instrument
Indorsement makes a person indorsing the
item liable for payment if person primarily
liable (e.g., maker of a note) does not pay
Example: If promissory note indorsed by the
original promisee to a bank and bank can’t
recover funds from original promisor, promisee
still owes the bank
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9. Kinds of Indorsement
A special indorsement is the indorser’s
signature plus words indicating to whom, or
to whose order, the instrument is payable
An instrument is indorsed in blank if the
indorser signs without specifying to whom
the item is payable
A restrictive indorsement specifies the
purpose of the indorsement or how the
instrument must be used
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10. Examples of Indorsement
A special indorsement:
Alfie indorses a check payable to him with “Payable
to Brenda,” thus Brenda must indorse it with her
signature to negotiate the item further
Indorsement in blank:
John Woo indorses a check payable to him with his
signature “John Woo;” check is now bearer paper and
bearer could negotiate it immediately or transform it
into special indorsement by adding “Pay to the order
of ________” above Woo’s indorsement
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11. Examples of Restrictive
Indorsements
Indorsements for deposit: “For Deposit Only” or
“For Deposit to Account ## at First State Bank”
See Lehigh Presbytery v. Merchants Bancorp. Inc.:
bank failed to apply value given for checks
consistently with restrictive indorsements on the
checks
Indorsements for collection: “Pay any bank,
banker, or trust company” or “For collection
only” (added by banks for collection process)
Beneficial indorsements: “Pay to Abe Lincoln,
Attorney at Law, in Trust for Clarence Darrow”
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12. Recission of Indorsement
Negotiation effects an instrument transfer
even if the negotiation is made:
(1) by a minor, a company exceeding its powers, or
any other person without contractual capacity; (2) by
fraud, duress, or mistake of any kind; (3) in breach of
duty; or (4) as part of an illegal transaction
Under these circumstances, the indorsement
is subject to rescission before negotiation to
a holder in due course [3–202]
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13. Holder in Due Course
A holder in due course takes a negotiable
instrument free of all personal defenses,
claims to the instrument, and claims in
recoupment of the obligor or of a third party
A holder in due course does not take free of
the real defenses, which go to the validity of
the instrument or of claims that develop after
s/he becomes a holder
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14. Requirements for
“Holder in Due Course” Status
Person must be a holder of a negotiable
instrument, and take it (1) for value, (2) in
good faith, (3) without notice of defects or
evidence of apparent forgery or alteration
that raises a question of authenticity
See Golden Years Nursing Home, Inc. v. Gabbard
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15. Golden Years Nursing Home,
Inc. v. Gabbard
Facts:
Golden Years Nursing Home received Social
Security checks made payable either to
individual patients or to “Golden Years
Nursing Home for [an individual patient]”
For 5 years, office manager Gabbard
embezzled by having some patients indorse
their checks in blank, then she would cash or
deposit the checks for herself
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16. Golden Years Nursing Home,
Inc. v. Gabbard
Procedural History & Appellate Decision:
Golden Years Nursing Home sued Gabbard
and bank where checks had been cashed
Basis for suing bank was that patients had
assigned interest in checks to nursing home
Appellate court found for bank because
checks provided to bank cashed checks in
good faith without notice of defenses, thus
became holder in due course
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17. Notice of Defects
A holder in due course must not have notice
that the instrument is overdue or dishonored,
has an uncured default, contains unauthorized
signature or alteration, has a property or
possessory interest claim, or has any defense
against it or claim in recoupment to it
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18. Overdue Instruments
If a negotiable instrument is payable on
demand, it is overdue:
(1) day after demand for payment made; (2) 90 days
after its date if a check; and (3) if other than a check,
if outstanding for an unreasonable time for the
instrument and trade practice [3–304(a)]
If a negotiable instrument due on a certain
date is not paid by that date, it becomes
overdue at the beginning of the next day
after the due date
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19. Dishonored Instruments
A negotiable instrument has been
dishonored when the holder has presented
it for payment (or acceptance) and payment
(or acceptance) has been refused
The classic
“bounced”
check
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20. Notice of Claims
If a person taking a negotiable
instrument would be on notice of
adverse claim, alteration, forged
signature, or irregularity, person is
not a holder in due course
Cannot negotiate instrument
See Firstar Bank, N.A. v. First
Service Title Agency, Inc.
Potential defenses: fraud, duress,
infancy, failure of consideration
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21. Shelter Rule
Article 3 shelter rule: the transferee of an
instrument obtains rights the transferor had,
including the transferor’s right to enforce the
instrument and any right as a holder in due
course [3–203(b)]
Exception: a transferee involved in fraud or
illegality affecting the instrument
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22. Holder in Due Course
Rights & Limitations
Revised Article 3 establishes four categories
of claims and defenses relevant to a holder
in due course: real defenses, personal
defenses, claims to an instrument, and
claims in recoupment
Real defenses attack the instrument’s
validity and may be used as reasons against
payment of a negotiable instrument to any
holder, including a holder in due course
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23. Real Defenses
Real defenses limit the rights of a holder in
due course and refer to maker’s status, or
the creation or discharge of the instrument:
Status: maker’s minority, infancy or lack of
capacity status
Instrument creation: duress, illegality, fraud
Discharge: by bankruptcy or payment
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24. Personal Defenses
Personal defenses are legal reasons for
avoiding or reducing a person’s liability for
payment of a negotiable instrument and
arise out of the transaction that issued the
negotiable instrument
A holder in due course of a negotiable
instrument (or one who can claim the rights
of one) is not subject to personal defenses
or claims
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25. Personal Defenses
Personal defenses include basic defects in
contracts as well as defects in the creation
of the instrument
In General Credit Corp. v. New York Linen
Co., Inc., a holder in due course of a check
was not subject to personal defense of
failure of consideration that the drawer of the
check had against the payee of the check
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26. Holder in Due Course
Rights & Limitations
Claims to an instrument concern property or
possessory rights in an instrument or its
proceeds: claim to instrument ownership
because owner wrongfully deprived of
possession, claim of a lien, or claim for
rescission of an indorsement
A holder in due course takes free of claims
that arose before s/he holder status but is
subject to those arising after holder status
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27. Holder in Due Course
Rights & Limitations
Claims in recoupment arise out of the
transaction that gave rise to the instrument
and offset, rather than prevent, liability
A holder in due course is protected
Primarily based in
warranty or breach of
contract disputes
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29. Consumer Protection Issues
Holder in due course rules may harm
consumers, thus some states and the
Federal Trade Commission limited the
holder in due course rule as it affects
consumers
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30. FTC Notice
FTC requires sellers who extend credit by
note to include the following statement:
NOTICE: ANY HOLDER OF THIS CONSUMER CREDIT
CONTRACT IS SUBJECT TO ALL CLAIMS AND
DEFENSES WHICH THE DEBTOR COULD ASSERT
AGAINST THE SELLER OF THE 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.
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31. Music Acceptance Corp. v.
Lofing
Facts:
Lofing bought a Steinway piano from a Steinway
dealer financed by an installment note from MAC
Consumer note contained the FTC notice
The piano was defective and Lofing stopped
paying on the note, selling the piano to mitigate
damages, then sued dealer, Steinway, and MAC
Issue: Did the Notice allow plaintiff to assert the
breach of warranty as grounds for not continuing
to pay off the note to MAC?
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32. Music Acceptance Corp. v.
Lofing
Legal Reasoning and Holding:
The FTC adopted a rule…identical to that in
Lofing’s sales contract
In abrogating the holder in due course rule for
consumer credit transactions, FTC reallocated the
cost of seller misconduct to creditor
The jury’s finding that dealer breached its
warranties mandates that the judgment in favor of
MAC and against Lofing be reversed. Judgment in
favor of Lofing.
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33. Test Your Knowledge
True=A, False = B
Order paper is a negotiable instrument payable to
the order of cash.
Indorsement is a signature that is made on an
instrument for a specific purpose
If Jamil writes a check to Mary, Jamil may indorse
the back himself to negotiate it.
A check is rendered non-negotiable if it is
indorsed on the back, “For Deposit to Account
#5000005 at First State Bank.”
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34. Test Your Knowledge
True=A, False = B
Indorsement is required for negotiation except in the
case of depositary banks.
The shelter rule states that a transferee of a
negotiable instrument obtains all rights that the
transferor had.
Megan writes Sam a check dated Jan. 2, 2007 and
Sam indorses the check the next day to Bryan’s
Grocery. Bryan’s presented the check for payment to
a bank on July 1, 2007. The bank must honor the
negotiable instrument.
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35. Test Your Knowledge
Multiple Choice
Dan (16 years old) signed an installment note with
Dude’s for a surfboard. Dude’s sold the note at a
discount to Factors Co. The board broke after 1
month and Dan stopped paying. Factors Co. is:
(a) a holder in due course, but Dan is a minor and
like any contract, may assert minority status to void
the contract
(b) not a holder in due course & has no rights
(c) is a holder in due course and Dan must continue
to pay on the note or be in breach of contract
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36. Test Your Knowledge
Multiple Choice
Requirements for holder in due course
status include:
(a) take a negotiable instrument for value
(b) take the instrument in good faith
(c) take without notice of defects or claims against
the instrument
(d) all of the above
(e) all of the above plus be in the business of taking
negotiable instruments
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37. Thought Questions
What do you think of
the FTC rule limiting the
rights of a holder in due
course in consumer
transactions? Do you
think the FTC rule
achieves the underlying
policy to protect
consumers?
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Notas do Editor
When an employer gives an employee a paycheck payable “to the order of Susan Adams,” she is the holder of the check because she is in possession of an instrument payable to an identified person (Susan Adams) and she is that person. A person is a holder if in possession of an instrument (1) that is payable to bearer or (2) made payable to an identified person and she is that identified person [1–201(20)]
Reminder: the word is “ in dorsement” and not “ en dorsement”! The signature must be made by the holder or by someone who is authorized to sign on behalf of the holder, such as “Jane Doe on behalf of Doe & Company, Inc.”
As of 1/1/09, the Bank of New York Mellon was the world's largest depositary for American and global depositary receipts.
Except in the case of depositary banks, if an order instrument is transferred without indorsement, the instrument has not been negotiated and the transferee cannot qualify as a holder. The Town of Freeport case, illustrates this issue.
A qualified indorsement is one where the indorser disclaims her liability to make the instrument good if the maker or drawer defaults on it. Words such as “Without Recourse” are used to qualify an indorsement. They can be used with either a blank indorsement or a special indorsement and thus make it a qualified blank indorsement or a qualified special indorsement. The use of a qualified indorsement does not change the negotiable nature of the instrument. Its effect is to eliminate the contractual liability of the particular indorser.
However, under these circumstances the indorsement is subject to rescission before the instrument has been negotiated to a transferee who can qualify as a holder in due course or a person paying the instrument in good faith and without knowledge of the factual basis for rescission or other remedy [3–202]
From 1972 until 1991, Nancy Gabbard, the office manager for the Golden Years Nursing Home, received at the nursing home Social Security checks drawn on the United States Treasury and made payable either to individual patients or to “Golden Years Nursing Home for [an individual patient].” From 1986 until 1991, Gabbard engaged in an embezzling scheme whereby she would have certain patients indorse their own checks in blank, that is, each patient would sign his own name on the back of the check placing no restrictions on the manner in which the check could subsequently be negotiated. Gabbard would then cash the checks and either keep the cash or deposit the funds into her personal bank account.
In 1992, after Gabbard’s scheme was discovered, Golden Years brought suit against Gabbard and also against the Star Bank Corporation where the checks had been cashed. The patients had in other documents assigned their interests in the checks to Golden Years, and the claim against the bank alleged that it had converted Golden Years’ property by cashing checks with forged indorsements. One of the issues in the lawsuit was whether the checks had been properly negotiated to Star Bank. The trial court granted summary judgment to Golden Years, finding that the bank was not a holder in due course because the checks contained “forged indorsements.” Star Bank appealed. On appeal, the court found for Star Bank based on (UCC 3–202): “Thus, in this case, Gabbard became a holder of the checks when the checks, indorsed in blank by the patient-payees, were delivered to her. When Star Bank accepted the checks that were indorsed with the genuine signatures of the payees, the checks bore no indication that they had been assigned to Golden Years. Star Bank cashed the checks in good faith without notice of any defenses and thus became a holder in due course.”
The standard is a reasonable person standard. Examine the check in the photo. Would a student negotiate this check? This is an irregular paper! In Firstar Bank, N.A. v. First Service Title Agency, Inc., the court concluded that a bank could not qualify as a holder in due course of an instrument because it took them with obvious irregularities that called their authenticity into question.
Personal defenses include: lack or failure of consideration, breach of contract, breach of warranty, fraud in the inducement, incapacity, illegality, duress, unauthorized completion or alteration, defects in issuance, failure to countersign a traveler’s check, modification of contract by separate agreement, payment violating a restrictive indorsement.
The photo is a “hint” for the upcoming case, Music Acceptance Corp. v. Lofing
Dan Lofing purchased a Steinway grand piano from Sherman Clay & Co., Steinway & Sons’ Sacramento dealer, and received financing through Sherman Clay’s finance company, Music Acceptance Corporation (MAC). The consumer note for $19,650.94 prepared by MAC and signed by Lofing included the following in boldface type: NOTICE 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 PURSUANT HEREIN OR WITH THE PROCEEDS HEREOF. RECOVERY HEREUNDER SHALL NOT EXCEED AMOUNTS PAID BY THE DEBTOR HEREUNDER. Lofing received a warranty from Steinway that provided the company “will promptly repair or replace without charge any part of this piano which is found to have a defect in material or workmanship within five years” from the date of sale. Lofing became disenchanted with the piano after experiencing a variety of problems with it. There was a significant deterioration in the action and tonal quality of the piano which the Sherman Clay piano technician was unable to remedy despite lengthy and repeated efforts. A Steinway representative who was called in to inspect the piano concluded that it was in “terrible condition” and expressed surprise that it had ever left the factory. He concluded that the piano would have to be completely rebuilt at the factory. Because the piano was impossible to play and was ruining his technique, Lofing stopped making payments on the piano. To mitigate his damages, Lofing sold the piano for $7,000 and purchased a Kawai piano from another dealer. He brought suit against Sherman Clay, Steinway, and MAC for, among other things, breach of warranty. One of the issues in the litigation was whether the Notice in the note allowed him to assert the breach of warranty as a grounds for not continuing to pay off the note to MAC.
Court: “The FTC adopted a rule…identical to that included in Lofing’s sales contract…. In abrogating the holder in due course rule in consumer credit transactions, the FTC preserved the consumer’s claims and defenses against the creditor-assignee. The FTC rule was therefore designed to reallocate the cost of seller misconduct to the creditor…. More importantly, it is irrelevant whether the FTC rule applies. Even if such a notice was not required to be given, the fact remains that it was: Lofing’s contract included the precise language mandated by the FTC rule. Put simply, Lofing is in the same position whether we apply the FTC rule or the language of his particular contract. The jury’s finding that Sherman Clay breached its warranties mandates that the judgment in favor of MAC and against Lofing be reversed. Judgment in favor of Lofing.”
False. Order paper is an instrument payable to the order of a specific payee . Bearer paper is payable “to bearer” or “to cash. True. False. Signature may not be that of the maker, drawer, or acceptor False. This is a restrictive indorsement, but it does not render the check non-negotiable.
True. True. False. The check is overdue. A check is payable on demand and it is overdue if presented 90 days after its date. The holder, Bryan’s, is not a holder in due course since it had notice that the check was overdue by reading the date on the check.
The correct answer is (a).
The correct answer is (d).
Opportunity to discuss policy issues of consumer protection and negotiable instruments.
