Chapter 24: Introduction to Negotiable Instruments

Business Law, Sixth Edition
© 2019 BVT Publishing. All rights reserved.
S-1
Chapter 24:
Introduction to Negotiable
Instruments

S-2
Learning Objectives
• Distinguish between the kinds of
commercial paper.
• Understand the bank collection process.
• Describe the debtor-creditor relationship.
• Explain wrongful dishonor.
• Explain stop-payment orders.
• Recognize banks’ rights and duties.
• Recognize depositors’ rights and duties.

S-3
24.0 In the News
Here's What Happens When You Bounce a
Check: http://bvtlab.com/PcbhG
Returned checks or bank account overdrafts
often result in fees. That may not seem too bad,
but if they're not dealt with, bad checks can
cause you a lot of problems.
• Discuss the responsibilities of depositors.
• Discuss the banks options when a check is
presented with insufficient funds.

S-4
24.1 The Concept of Negotiability
(Slide 1 of 2)
Purpose of the negotiability trait:
• Prevent the parties to an underlying
contract from asserting defenses against
the person to whom the paper is
transferred.

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24.1 The Concept of Negotiability
(Slide 2 of 2)
• Three requirements must be met:
– Instrument must be negotiable.
– Instrument must be properly negotiated
to the transferee.
– Party to whom negotiable commercial
paper is negotiated must be a holder in
due course or have the rights of a holder
in due course.

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24.2a Terminology
• A note is two-party paper
– Maker is a party who promises to pay.
– Payee is the party to whom promise is made.
• Draft and check are three-party
instruments.
– A draft presupposes a debtor-creditor
relationship.
– The drawee is the debtor.
– The drawer is the creditor.
– The drawer-creditor orders the drawee-debtor to
pay money to a third party, who is the payee.

S-7
24.2b Notes
• A note is a two-party instrument.
• Issuer (the maker) promises to pay to the
order of a payee or to bearer.
• Evidence of an obligation to pay in the
future
• Employed in loan and secured sales
transactions

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24.2c Certificates of Deposit
• A two-party instrument
• Note in which a bank is the maker
– Bank’s written acknowledgment of money
on deposit that the bank promises to pay to
the depositor
• The promise to repay distinguishes the
CD from a deposit slip.
• Promissory note issued by a bank as a
means of investment.

S-9
24.2d Drafts
• Sometimes called a bill of exchange
• A simple order to pay money
• Addressed by one person (the drawer) to
another person (the payor or drawee)
• Requires that payor or drawee to pay on
demand or at a fixed future time a definite
amount to the order of a named person
(the payee or holder) or to the bearer

S-10
24.2d Checks
• A demand draft drawn on a bank
• A check drawn by a bank on itself is a
cashier’s check.
• Travelers’ checks
• A bank draft is a banker’s check.
• A certified check is one that has been
accepted by the drawee bank.

S-11
24.3a Terminology (Slide 1 of 3)
Article 4 of the Code: Bank Deposits and
Collections
– Provides uniform rules to govern the
collection of checks and other instruments
for the payment of money
– Governs the relationship of banks with
one another and with depositors in the
collection and payment of items

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Depositary bank
• First bank an item is transferred to for collection
Payor bank
• Bank where item is payable as drawn or
accepted
Intermediary bank
• Any bank an item is transferred to
Collecting bank
• Any bank handling the item for collection

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Presenting bank
• Any bank presenting an item to a payor bank
Timing is important in the check collection
process.
• Banking day is that part of any day on which a
bank is open to the public.
• Bank is permitted to establish a cutoff hour of
2 P.M. or later.
• Midnight deadline means midnight on its
banking day.

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24.3a Critical Thinking
CASE: Chambers
This case illustrates the liability of the parties
in a simply bank transaction. The court held
that once the bank cashes a check, it cannot
detain the customer or demand the cash be
returned.
• Why do you believe the bank wanted the
money back?
• Do you believe the result would be the same
today? Why?

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24.3b The Bank Collection Process
(Slide 1 of 2)
• Regional Federal Reserve banks play
a major role in this process.
• Availability of Funds
• Endorsements
• Electronic Check Processing

S-16
24.3b The Bank Collection Process
(Slide 2 of 2)
2) Payee deposits the check
in their bank account.
This is the Depository Bank:
the first bank an item is
transferred for collection.
3) May go to any number of
Collecting Banks: intermediary
banks that provisionally credit the
account of the prior bank
4) Presenting Bank: presents the
check to the Drawee’s bank for
payment
5) Drawee of Payor Bank: where
the item is payable as drawn or
accepted; debits the drawer’s
account
1) Drawer writes a check,
sends as payment of a bill.

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24.3b Critical Thinking
CASE: Douglas Companies:
A bank claimed that it followed Federal Reserve
Bank regulations in encoding checks, but the court
ruled that supposed compliance with the
regulations did not absolve the bank from an
encoding error that was made and resulted in
damage.
• Should Douglas have shared responsibility? Why?
• What should the bank have done to avoid liability for
the loss?

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24.3c Collecting Banks
Duty to use ordinary care in performing
its collection operations
• Presentment
– A demand for acceptance or payment made on
the marker, acceptor, drawee, or other payor by,
or on behalf of, the holder
• Settle
– To pay in cash by clearinghouse settlement, by
remittance, or as otherwise instructed.
• Midnight deadline rule

S-19
24.3d Payor Banks
An item is finally paid by a payor bank
when the bank:
• Pays the item in cash
• Settles for the item without reserving the
right to revoke the settlement
• Completes the process of posting the
item
• Makes a provisional settlement and fails
to revoke it
- Order of payment of checks

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24.4a The Debtor-Creditor Relationship
• Right to setoff
– The right of a creditor to seize money from the
account of a customer who is the debtor.
• A bank is under a duty to honor properly
payable checks drawn by its customer.
• Insufficient funds
– Bank may honor the properly payable checks.
– The customer is indebted to the bank.
– Most overdrafts are dishonored by the bank.

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24.4b Wrongful Dishonor
• Bank is liable to its customer for
damages proximately caused by the
wrongful dishonor.
• When the dishonor occurs by mistake, or
by a malicious or willful dishonor, liability
includes actual damages proved.
– Consequential damages proximately caused
by the wrongful dishonor
• Cannot recover damages on the basis of
defamation

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24.4c Stop-Payment Orders
• A drawer has the right to stop payment on
checks drawn on his/her account.
• Bank must be afforded a reasonable
opportunity to stop payment.
• Oral stop order is binding on the bank for
only fourteen days.
• Written stop order is effective for only six
months.
• A bank that honors a check is liable to the
drawer of the check.

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24.4d Banks’ Rights and Duties
• A bank is entitled, but not obligated, to pay
a check that is over six months old.
• Certified checks do not fall within the six-
month rule.
• In paying stale checks, the bank must act in
good faith and exercise ordinary care.
• A bank’s authority to pay checks continues
until it knows a customer has died or has
been judged incompetent, and the bank has
had a reasonable opportunity to act.

S-24
24.4d Critical Thinking
CASE: Freitag
The question is whether the bank or the estate
must bear a loss when a personal representative
of a deceased bank customer transferred funds
to their account without appropriate authorization.
• What obligation should the bank have in this case?
• Should the transfer of funds from the estate into
the personal account of Olson been a
“red flag” to the bank?

S-25
24.4e Depositors’ Rights and Duties
Customer must examine canceled checks for
forgeries and for alterations within a reasonable
time.
• Customer’s failure to examine and notify the bank will
prevent the customer from asserting the forgery
against the bank if the bank can establish that it
suffered a loss because of this failure. The Code
does not specify the period of time.
How might today’s electronic banking impact a
customer’s ability to review forgeries?
Need access to historical banking information? Better
read the fine print http://bvtlab.com/662dY

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24.4f Funds Transfers
Electronic Fund Transfer Act
• EFTA regulates the use of wire
transfers in point-of-sale transactions.
- Automatic deposits and withdrawals
- Debit cards
- Some prepaid cards

Chapter 24: Introduction to Negotiable Instruments

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Chapter 24: Introduction to Negotiable Instruments