23 The Essentials

of Negotiability

LEARNING OUTCOMES FACING A LEGAL PROBLEM

The five learning outcomes Midwestern Style Fabrics sells $50,000 worth of
labeled LO1 through LO5 are
designed to help improve your fabric to D&F Clothiers, Inc., each fall on terms
understanding of the chapter. requiring payment to be made in ninety days. One
After reading this chapter, you year, however, Midwestern wants cash, but D&F
should be able to . . .
wants the usual term of payment in ninety days. What can Midwestern
LO1 Identify the basic types and D&F do so that both of their wants are satisfied?
of negotiable instruments.
LO2 List the requirements of
a negotiable instrument.
LO3 State what may
constitute a signature.
LO4 Decide whether a
variable-interest-rate
note is negotiable.
LO5 Describe the process
of negotiation. The vast number of commercial transactions that take place daily in the mod-
ern business world would be inconceivable without negotiable instruments. A
negotiable instrument negotiable instrument is any written promise or order to pay a sum of money.
A written and signed Drafts, checks, and promissory notes are typical examples. Negotiable instru-
unconditional promise or order ments are transferred more readily than ordinary contract rights. Also, per-
to pay a specified sum of money sons who acquire negotiable instruments are normally subject to less risk than
on demand or at a definite time
the ordinary assignee of a contract right.
to order (to a specific person or
entity) or to bearer.

Negotiable Instruments and the UCC

Both Article 3 and Article 4 of the Uniform Commercial Code (UCC) apply to
transactions involving negotiable instruments. To understand the applicability
of Article 3, it is necessary to distinguish between negotiable and nonnegotiable
instruments. To qualify as a negotiable instrument, an instrument must meet
special requirements relating to form and content. These requirements will be
discussed later in this chapter.
When an instrument is negotiable, its transfer from one person to another
is governed by Article 3 of the UCC. Indeed, the UCC defines instrument
as a “negotiable instrument.” Therefore, whenever the term instrument is
used in this book, it refers to a negotiable instrument. Transfers of non-
negotiable instruments are governed by rules of assignment of contract
rights (see Chapter 15). Article 4 of the UCC governs bank deposits and
collections.

294
C HA PTER 23 ■ The Essentials of Negotiability 295

Types of Instruments
The UCC specifies four types of negotiable instruments: drafts, checks, notes, LO1 Identify the basic types
and certificates of deposit (CDs). These are frequently divided into the two clas- of negotiable instruments.
sifications that we will discuss in the following sections: orders to pay (drafts
and checks) and promises to pay (promissory notes and CDs).
Negotiable instruments may also be classified as demand instruments or
time instruments. A demand instrument (an instrument that is payable when
payment is requested) either states that it is payable on demand (or “at sight”) issue
or does not state any time for payment. Because a check specifies no time for The first transfer, or delivery,
payment, a check is payable on demand. A demand instrument is payable of an instrument to a holder.
immediately after it is issued. Issue is the first delivery of an instrument by the draft
party who creates it to any party, for the purpose of giving rights in the instru- Any instrument drawn on a
ment to any person. Time instruments are payable at a future date. drawee (such as a bank) that
orders the drawee to pay a
certain sum of money.
DRAFTS AND CHECKS (ORDERS TO PAY) drawer
A person who initiates a draft
A draft is an unconditional written order that involves three parties. The party
(including a check), thereby
creating it (the drawer) orders another party (the drawee) to pay money, usually ordering the drawee to pay.
to a third party (the payee). The drawee must be obligated to the drawer, either
by an agreement or through a debtor-creditor relationship, for the drawee to be drawee
The person who is ordered to pay
obligated to the drawer to honor (pay) the order.
a draft or check. With a check, a
A time draft is payable at a definite future time. Exhibit 23–1 below shows financial institution is always the
a typical time draft. A sight (or demand) draft is payable on sight—that is, drawee.
when it is presented for payment. A sight draft may be payable on acceptance.
payee
Acceptance is the drawee’s written promise to pay the draft when it comes due.
A person to whom an instrument
The usual manner of accepting is by writing the word accepted across the face is made payable.
of the instrument, followed by the date of acceptance and the signature of the
drawee. A draft can be both a time and a sight draft; such a draft is one payable trade acceptance
at a stated time after it is presented for payment. A draft drawn by the seller of
goods on the purchaser and
A trade acceptance is a draft frequently used in the sale of goods. The seller
accepted by the purchaser’s
is both the drawer and the payee on this draft. Essentially, the draft orders the written promise to pay the draft.
buyer to pay a specified sum of money to the seller, usually at a stated time Once accepted, the purchaser
in the future. Trade acceptances are the standard credit instruments in sales becomes primarily liable to pay
transactions (see Exhibit 23–2 on the next page). the draft.

EXHIBIT 23–1
A Typical Time Draft
Payee Whiteacre, Minnesota
January 16 20 11 $

Ninety days after above date

PAY TO THE ORDER OF

DRAFT

Eastman Supply Company

One thousand and no/100 DOLLARS

VALUE RECEIVED AND CHARGE THE SAME TO ACCOUNT OF
Ourtown Real Estate

First National Bank of Whiteacre

To
By Jane Adam s, Pre s.
Whiteacre, Minnesota Jane Adams

Drawee Drawer
296
EXHIBIT 23–2
A Typical Trade Acceptance
check
A draft drawn by a drawer
ordering the drawee bank or
financial institution to pay a
certain amount of money to
the holder on demand.
promissory note
A written instrument signed by a
maker unconditionally promising
to pay a certain sum in money to
a payee or a holder on demand
or on a specified date.
maker
One who issues a promissory
note or certificate of deposit
(that is, one who promises to
pay a certain sum to the holder
of the note or CD).
bearer
A person in the possession of an
instrument payable to bearer or
indorsed in blank.
UNIT FOUR ■ Negotiable Instruments
Drawee-Acceptor Payee
Mytown, California 20 11
To
June 15, 2011
T R A D E A C C E P TA N C E
On PAY TO THE ORDER OF
DOLLARS
The obligations of the acceptor hereof arise out of the purchase of goods from the drawer. The drawee may accept this bill payable at any
bank or trust company in the United States which drawee may designate.
Accepted at on 20 11
Payable at
Buyer’s Signature
By Agent or Officer By Joe Jones, Pres.
Drawee-Acceptor Drawer
The most commonly used type of draft is a check. The writer of the check
is the drawer, the bank on which the check is drawn is the drawee, and the
person to whom the check is payable is the payee. With certain types of checks,
such as cashier’s checks, the bank is both the drawer and the drawee. The bank
customer purchases a cashier’s check from the bank—that is, pays the bank
the amount of the check—and indicates to whom the check should be made
payable. The bank, not the customer, is the drawer of the check (as well as the
drawee). (Checks will be discussed more fully in Chapter 25.)
When traveler’s checks are drawn on a bank, they are checks, but they require
the purchaser’s authorized signature before becoming payable. A negotiable
instrument may be a check even though it states that it is something else—a
money order, for example.
IN THE COURTROOM
ACTUAL CASE EXAMPLE
Fluffy Reed Foundation, Inc., issues a check to Flatiron Linen, Inc.,
for $4,100, drawn on an account at First American State Bank. When
Flatiron attempts to deposit the check, First American returns it due to
insufficient funds in the account. Fluffy asks First American not to pay the check if
it is resubmitted for payment. Five months later, when the account has sufficient
funds, Flatiron takes the check to First American and exchanges it for a cashier’s
check in the amount of $4,100. When the bank rediscovers that Fluffy asked it not
to pay the original check, the bank refuses to pay the cashier’s check. Flatiron files
a suit against First American. Should a cashier’s check be treated as the equiva-
lent of cash? Yes. In a 2001 case, Flatiron Linen, Inc. v. First American State Bank,
a Colorado state court held that a bank may not refuse to pay a cashier’s check
once the check is issued. Because the bank is both the drawer and the drawee of a
cashier’s check, the check is a promise by the bank to pay the amount of the check
from its own resources on demand. Once a bank issues and delivers a cashier’s
check to the payee, the transaction is complete.
PROMISSORY NOTES AND CDS (PROMISES TO PAY)
A promissory note is a written promise between two parties. One party is the
maker of the promise to pay. The other is the payee, or the one to whom the
promise is made. A promissory note, which is often referred to simply as a note,
can be made payable at a definite time or on demand. It can name a specific
payee or merely be payable to bearer. A bearer is a person in possession of an
C HA PTER 23 ■ The Essentials of Negotiability 297

instrument that is payable to bearer, is not payable to an identified person,

does not state a payee, or is indorsed (signed) in blank—that is, signed without
additional words. Indorsements, which are signatures with or without addi- indorsement
tional words or statements, are discussed later in this chapter. A typical prom- A signature placed on an
issory note is shown in Exhibit 23–3 below. instrument for the purpose of
Notes are used in a variety of credit transactions and often carry the name transferring one’s ownership
of the transaction involved. EXAMPLE 23.1 In real estate transactions, a prom- rights in the instrument.
issory note for the unpaid balance on a house, secured by a mortgage on the
property, is called a mortgage note.• EXAMPLE 23.2 A note payable in install-
ments, such as for payment for a television set over a twelve-month period, is
called an installment note.•
A note that is secured by personal property is called a collateral note,
because the property pledged as security for the satisfaction of the debt is
called collateral. To minimize the risk of loss when lending funds, a creditor
often requires the debtor to provide some collateral, or security, beyond a prom-
ise that the debt will be repaid. When this security takes the form of personal
property (such as a motor vehicle), the creditor has an interest in the property
known as a security interest. Security interests will be discussed in more detail
in Chapter 32.
A certificate of deposit (CD) is a bank’s note. It is an acknowledgment by a certificate of deposit (CD)
bank that it has received a certain sum and that it promises to repay it. CDs in An instrument evidencing a
small denominations are often sold by savings and loan associations, savings promissory acknowledgment by a
banks, and commercial banks. They are called small CDs and are for amounts bank of a receipt of money with
up to $100,000. Certificates of deposit for amounts more than $100,000 are an engagement to repay it.
called large (or jumbo) CDs. Exhibit 23–4 on the next page shows a typical
small CD.

What Is a Negotiable Instrument?

For an instrument to be negotiable, it must meet the following requirements: LO2 List the requirements of
a negotiable instrument.
1. It must be in writing.
2. It must be signed by the maker or the drawer.
3. It must be an unconditional promise or order to pay.
4. It must state a fixed amount of money.
5. It must be payable on demand or at a definite time.
6. It must be payable to order or to bearer, unless it is a check.

EXHIBIT 23–3
Payee
A Typical Promissory Note
$ Whiteacre, Minnesota 20 11 Due 11
1. INV. & ACCTS. 2. CONSUMER GOODS

NO.
SAVINGS

after date.
OFFICER
for value received, the undersigned jointly and severally promise to pay to the order
BY
of THE FIRST NATIONAL BANK OF WHITEACRE at its office in Whiteacre,
ACCRUAL
Minnesota, $ dollars with interest thereon from date hereof
SEC. AGREEMENT

NEW REN’L
INSURANCE

at the rate of percent per annum (computed on the basis of actual days and
SECURED
a year of 360 days) indicated in No. below.
UNSECURED
7 INTEREST IS PAYABLE AT MATURITY
8 INTEREST IS PAID TO MATURITY
9 INTEREST IS PAYABLE BEGINNING ON 20
SECURITIES

3. EQUIP.
OTHER

SIGNATURE SIGNATURE

SIGNATURE SIGNATURE

Co-makers
298
EXHIBIT 23–4
A Typical Small
Cer tificate of Deposit
LO3 State what may
constitute a signature.
signature
The name or mark of a person,
written by that person or at his or
her direction. In commercial law,
any name, word, or mark used
with the intention to authenticate
a writing constitutes a signature.
UNIT FOUR ■ Negotiable Instruments
THE FIRST NATIONAL BANK OF WHITEACRE
NEGOTIABLE CERTIFICATE OF DEPOSIT
13992
Payee
(Bearer) WHITEACRE, MINN. 20 11
THIS CERTIFIES to the deposit in this Bank the sum of $
DOLLARS
11 against presentation and surrender of this certificate, and
which is payable to bearer on the ____________ day of ____________, 20 ______
3
bears interest at the rate of ______ % per annum, to be computed (on the basis of 360 days and actual days elapsed) to, and payable at,
maturity. No payment may be made prior to, and no interest runs after, that date. Payable at maturity in federal funds, and if desired, at
Manufacturers Hanover Trust Company, New York.
THE FIRST NATIONAL BANK OF WHITEACRE
By
SIGN A TUR E
Maker
WRITTEN FORM
Negotiable instruments must be in written form. There are certain practical
limitations concerning the writing and the substance on which the writing is
placed:
1. The writing must be on material that lends itself to permanence.
EXAMPLE 23.3 Instruments carved in blocks of ice or recorded on other imper-
manent surfaces would not qualify as negotiable instruments.•
2. The writing must have portability. Although this is not a spelled-out legal
requirement, if an instrument is not movable, it obviously cannot meet the
requirement that it be freely transferable.
SIGNATURES
For an instrument to be negotiable, it must be signed by (1) the maker, if it is
a note or a certificate of deposit, or (2) the drawer, if it is a draft or a check. If
a person signs an instrument as the agent for the maker or drawer, the maker
or drawer has effectively signed the instrument, provided the agent has the
appropriate authority.
Extreme latitude is granted in determining what constitutes a signature.
EXAMPLE 23.4 A signature may consist of a symbol (such as initials or a thumb-
print) signed or adopted by a party as his or her signature. A signature may be
made manually or by means of a device (a rubber stamp) or a machine (such as
those often used to write payroll checks).•
The location of the signature on the document is unimportant. The usual
place, however, is the lower right-hand corner. EXAMPLE 23.5 A handwritten
statement in the body of the instrument, such as “I, Kammie Orlik, promise to
pay Janel Tan,” is sufficient to act as a signature.•
UNCONDITIONAL PROMISE OR ORDER TO PAY
The terms of the promise or order must be included in writing in a negotiable
instrument. These terms must not be conditioned on the occurrence or nonoc-
currence of some other event or agreement.
Promise or Order. For an instrument to be negotiable, it must contain an
express order or promise to pay. A mere acknowledgment of the debt, which
might logically imply a promise, is not sufficient, because the promise must
be an affirmative, written undertaking. EXAMPLE 23.6 The traditional I.O.U.
(“I.O.U. $10 [Signed] Bobby”) might logically imply a promise. It is not a nego-
tiable instrument, however, because it does not contain an express promise to
repay the debt.• If such words as “to be paid on demand” or “due on demand”
C HA PTER 23 ■ The Essentials of Negotiability 299

are added, the need for an affirmative promise is satisfied. EXAMPLE 23.7 If a
buyer signs a promissory note that states, “I promise to pay $500 to the order of
the seller for the purchase of a Tectonics television set,” then the requirement
for a negotiable instrument is satisfied.•

Unconditionality of a Promise or Order. Only unconditional promises or

orders can be negotiable. A negotiable instrument’s utility as a substitute for
money or as a credit device would be dramatically reduced if it had conditional
promises attached to it. It would be expensive and time consuming to inves-
tigate conditional promises. Therefore, the transferability of the negotiable
instrument would be greatly restricted. Furthermore, the payee or any holder
of the instrument would risk the possibility that the condition would not occur.
Certain necessary conditions commonly used in business transactions
do not make an otherwise negotiable instrument nonnegotiable, however.
EXAMPLE 23.8 Many instruments state the terms of the underlying agreement
or refer to the consideration paid for the investment as a matter of standard
business practice. Such statements are not considered conditions and do not
affect negotiability.• Similarly, mere reference to another agreement does not
affect negotiability. An instrument that is made subject to the other agreement,
however, is nonnegotiable. Also, terms in an instrument that provide for pay-
ment only out of a particular fund or source do not render the instrument con-
ditional—it remains negotiable. EXAMPLE 23.9 A note that restricts the source
of payments to a certain account is negotiable.•

A FIXED AMOUNT OF MONEY

Negotiable instruments must state with certainty a fixed amount of money
to be paid at any time the instrument is payable. This requirement promises
clarity and certainty in determining the value of the instrument. Also, to be
negotiable, an instrument must be payable entirely in money. EXAMPLE 23.10 A
promissory note that provides for payment in diamonds or forty hours of ser-
vices is not payable in money and thus is nonnegotiable.•

Fixed Amount. The term fixed amount means an amount that is ascertain-
able from the instrument. EXAMPLE 23.11 A demand note payable with 5 per-
cent interest meets the requirement of fixed amount because its amount can be
determined at the time it is payable.•
The amount or rate of interest may be determined with reference to infor-
mation that is not contained in the instrument but that is readily ascer-
tainable by reference to a formula or a source described in the instrument.
EXAMPLE 23.12 When an instrument is payable at the legal rate of interest (a
rate of interest fixed by statute), at a judgment rate of interest (a rate of inter-
est fixed by statute that is applied to a monetary judgment awarded by a court
until the judgment is paid or terminated), or as fixed by state law, the instru-
ment is negotiable.•
Mortgage notes tied to a variable rate of interest (fluctuating as a result of LO4 Decide whether a
market conditions) have become popular because these notes protect lenders variable-interest-rate
when rates rise and benefit borrowers when rates decline. A variable-rate note note is negotiable.
can be negotiable. Only the principal is subject to the requirement that to be
negotiable a writing must contain a promise or order to pay a fixed amount.
The interest may be stated as a variable amount.

Payable in Money. Only instruments payable entirely in money are negotia-

ble. The UCC defines money as “a medium of exchange authorized or adopted by
a domestic or foreign government as a part of its currency.” EXAMPLE 23.13 An
instrument payable in government bonds or in shares of Microsoft stock is not
negotiable, because neither is a medium of exchange recognized by the U.S.
government.•
300
order instrument
A negotiable instrument that
is payable “to the order of an
identified person” or “to an
identified person or order.”
UNIT FOUR ■ Negotiable Instruments
PAYABLE ON DEMAND OR AT A DEFINITE TIME
A negotiable instrument must be payable on demand or at a definite time.
Clearly, to ascertain the value of a negotiable instrument, it is necessary to
know when the maker, drawee, or acceptor is required to pay. It is also neces-
sary to know when the obligations of secondary parties will arise. Furthermore,
it is necessary to know when an instrument is due in order to calculate when
the statute of limitations may apply. Finally, with an interest-bearing instru-
ment, it is necessary to know the exact interval during which the interest will
accrue to determine the present value of the instrument.
Payable on Demand. Instruments that are payable on demand include those
that contain the words “payable at sight” or “payable on demand” and those
that say nothing about when payment is due. The nature of the instrument
may indicate that it is payable on demand. EXAMPLE 23.14 A check, by defini-
tion, is payable on demand.• If no time for payment is specified, and if the
person responsible for payment must pay when the instrument is presented,
then the instrument is payable on demand.
Payable at a Definite Time. If an instrument is not payable on demand, to
be negotiable it must be payable at a definite time specified on the face (front)
of the instrument. The maker or drawee is under no obligation to pay until the
specified time.
When an instrument is payable on or before a stated date (“payable on or
before February 1, 2012”), it is clearly payable at a definite time, although the
maker has the option of paying before the stated maturity date. This uncer-
tainty does not violate the definite time requirement. In contrast, an instru-
ment that is undated and made payable “one month after date” is clearly
nonnegotiable. There is no way to determine the maturity date from the face
of the instrument.
IN THE COURTROOM
An instrument dated February 1, 2011, states, “One year after the
death of my grandfather, James Ezersky, I promise to pay to the
order of Henry Ling $500. [Signed] Mary Ezersky.” Is this instrument
negotiable? No. Because the date of the grandfather’s death is uncer-
tain, the maturity date is uncertain, even though the event is bound to occur. Even if
the grandfather has already died, the instrument is not negotiable because it does
not specify the time for payment.
PAYABLE TO ORDER OR TO BEARER
To ensure a proper transfer, the instrument must be “payable to order or to
bearer” at the time it is issued or first comes into the possession of the holder.
Note, however, that a check that meets all other requirements for negotiabil-
ity is a negotiable instrument even if the words “the order of” or “bearer” are
missing.
Order Instruments. An instrument is an order instrument if it is payable to
the order of an identified person (“Pay to the order of Buke”) or to an identified
person or order (“Pay to Itzhak or order”). This allows that person to transfer
the instrument to whomever he or she wishes. Thus, the maker or drawer is
C HA PTER 23 ■ The Essentials of Negotiability 301

agreeing to pay either the person specified or whomever that person might
designate. In this way, the instrument retains its transferability.
To qualify as order paper, the person specified must be identified with cer-
tainty, because the transfer of an order instrument requires an indorsement.
EXAMPLE 23.15 If an instrument states, “Pay to the order of my kissing cousin,”
the instrument is nonnegotiable, as a holder could not be sure which cousin
was intended to indorse and properly transfer the instrument.•

Bearer Instruments. A bearer instrument is an instrument that does not bearer instrument
designate a specific payee. The maker or drawer of a bearer instrument agrees A negotiable instrument that is
to pay anyone who presents the instrument for payment. An instrument con- payable to the bearer, including
taining any of the following terms is a bearer instrument: instruments payable to “cash.”

■ “Payable to the order of bearer.”

■ “Payable to James Jarrot or bearer.”
■ “Payable to bearer.”
■ “Payable to X.”
■ “Pay cash.”
■ “Pay to the order of cash.”

Transfer by Assignment or Negotiation

Once issued, a negotiable instrument can be transferred by assignment or by
negotiation.

TRANSFER BY ASSIGNMENT
Recall from Chapter 15 that an assignment is a transfer of rights under a con-
tract. Under general contract principles, a transfer by assignment to an assignee
gives the assignee only those rights that the assignor had. As explained in
Chapter 15, any defenses that can be raised against an assignor normally can
be raised against the assignee. When a transfer fails to qualify as a negotiation,
it becomes an assignment. The transferee is then an assignee.

TRANSFER BY NEGOTIATION
Negotiation is the transfer of an instrument in a form in which the transferee negotiation
(the person to whom the instrument is transferred) becomes a holder. A holder The transferring of a negotiable
is a person who possesses a negotiable instrument if the instrument is payable instrument to another in
to bearer or, in the case of an instrument payable to an identified person, if the such form that the transferee
becomes a holder.
identified person is in possession.
A holder, at the very least, receives the rights of the previous possessor.
holder
Unlike an assignment, a transfer by negotiation can make it possible for a The person who, by the terms
holder to receive more rights in the instrument than the prior possessor had. of a negotiable instrument, is
(A holder who receives greater rights is known as a holder in due course, which legally entitled to payment on it.
will be discussed in Chapter 24.) There are two methods of negotiating an
instrument so that the receiver becomes a holder. The method used depends on
whether the instrument is an order instrument or a bearer instrument.

Negotiating Order Instruments. If the instrument is an order instrument, LO5 Describe the process
it is negotiated by delivery with any necessary indorsements. An indorsement of negotiation.
is a signature placed on an instrument for the purpose of transferring one’s
ownership in the instrument. An indorsement in blank specifies no particular
indorsee and can consist of a mere signature. Types of indorsements and their
consequences are listed in Exhibit 23–5 on the following page.
302 UNIT FOUR ■ Negotiable Instruments

EXHIBIT 23–5
Types of Indorsements and Their Consequences

WORDS CONSTITUTING TYPE OF

THE INDORSEMENT INDORSEMENT INDORSER’S SIGNATURE LIABILITYa

“Rosemary White” Blank Unqualified signature liability on proper presentment and

notice of dishonor.b

“Pay to Sam Wilson, Special Unqualified signature liability on proper presentment and
Rosemary White” notice of dishonor.

“Without recourse, Qualified (blank for No signature liability. Transfer warranty liability if
Rosemary White” further negotiation) breach occurs.c

“Pay to Sam Wilson, Qualified (special for No signature liability. Transfer warranty liability if
without recourse, further negotiation) breach occurs.
Rosemary White”

“Pay to Sam Wilson on
condition he completes
painting my house at
23 Elm Street by 9/1/11,
Rosemary White”
Restrictive—conditional Signature liability only if condition is met. If condition is
(special for met, signature liability on proper presentment and notice of
further negotiation) dishonor.

“Pay to Sam Wilson only, Restrictive—prohibitive Signature liability only on Sam Wilson receiving payment.
Rosemary White” (special for If Wilson receives payment, signature liability on proper
further negotiation) presentment and notice of dishonor.

“For deposit, Restrictive—for Signature liability only on White having amount deposited in
Rosemary White” deposit (blank for her account. If deposit is made, signature liability on proper
further negotiation) presentment and notice of dishonor.

“Pay to Ann South in Restrictive—trust Signature liability only on payment of Ann South for John
trust for John North, (special for North’s benefit. If restriction is met, signature liability on
Rosemary White” further negotiation) proper presentment and notice of dishonor.

a. Signature liability refers to the liability of a party who signs an instrument. The basic questions include whether there is any liability
and, if so, whether it is unqualified or restricted.
b. When an instrument is dishonored—that is, when, for example, a drawer’s bank refuses to cash the drawer’s check on proper
presentment—an indorser of the check may be liable on it if he or she is given proper notice of dishonor.
c. The transferor of an instrument makes certain warranties to the transferee and subsequent holder, and thus, even if the transferor’s
signature does not render him or her liable on the instrument, he or she may be liable for breach of a transfer warranty. Transfer
warranties will be discussed in Chapter 24.

IN THE COURTROOM
Carrington Corporation issues a payroll check “to the order of Elliot
Goodseal.” Goodseal takes the check to the supermarket, signs his
name on the back (an indorsement), gives it to the cashier (a delivery),
and receives cash. Is the transfer of the check from Goodseal to the
supermarket an assignment or a negotiation? A negotiation. Goodseal “delivered”
the check to the supermarket with the necessary indorsement (his signature).

Negotiating Bearer Instruments. If an instrument is payable to bearer, it

is negotiated by delivery—that is, by transfer into another person’s possession.
Indorsement is not necessary. The use of bearer instruments involves more
risk through loss or theft than the use of order instruments.
C HA PTER 23 ■ The Essentials of Negotiability 303

IN THE COURTROOM
Alan Tyson writes a check “Payable to cash” and hands it to Blaine
Parrington (a delivery). Tyson has issued the check (a bearer instru-
ment) to Parrington. Parrington places the check in his wallet, which
is subsequently stolen. The thief has possession of the check. At this
point, negotiation has not occurred, because delivery must be voluntary on the
part of the transferor. If the thief “delivers” the check to an innocent third person,
however, will negotiation be complete? Yes. Only delivery is necessary to negotiate
a bearer instrument. If the thief delivers the check to an innocent third person, all
rights to it pass to that third person. Parrington loses all rights to recover the pro-
ceeds of the check from that person. Of course, Parrington can recover his money
from the thief if the thief can be found.

Converting an Order Instrument to a Bearer Instrument and Vice

Versa. The method used for negotiation depends on the character of the
instrument at the time the negotiation takes place. EXAMPLE 23.16 A check
originally payable to “cash” but subsequently indorsed with the words “Pay to
Ernestine” must be negotiated as an order instrument (by indorsement and
delivery), even though it was previously a bearer instrument.• An instrument
payable to the order of a named payee and indorsed in blank (by the payee’s
signature) becomes a bearer instrument.

ANSWERING THE LEGAL PROBLEM

In the legal problem set out at the beginning of this
chapter, Midwestern Style Fabrics normally sells
$50,000 worth of fabric to D&F Clothiers each fall
on terms requiring payment in ninety days. One
year Midwestern wants cash, but D&F wants the usual ninety-day
term. What can Midwestern and D&F do so that both of their wants
are satisfied? Midwestern can draw a trade acceptance that orders
D&F to pay $50,000 to the order of Midwestern Style Fabrics ninety
days hence. D&F can accept by signing the face of the paper and
returning it to Midwestern. The advantage to Midwestern of the trade
acceptance is that D&F’s acceptance creates an enforceable promise to
pay the draft in ninety days. Midwestern can sell a trade acceptance to
another party more easily than it can assign a debt to pay $50,000.

Terms and Concepts for Review

bearer 296 drawer 295 negotiation 301
bearer instrument 301 holder 301 order instrument 300
certificate of deposit (CD) 297 indorsement 297 payee 295
check 296 issue 295 promissory note 296
draft 295 maker 296 signature 298
drawee 295 negotiable instrument 294 trade acceptance 295
304 UNIT FOUR ■ Negotiable Instruments

Chapter Summary—The Essentials of Negotiability

LO1 Identify the basic types of negotiable instruments. The four types of negotiable instruments—
drafts, checks, promissor y notes, and certificates of deposit—can be classified as: (1) demand
instruments, which are payable on demand when the holder presents them to the maker or drawer;
(2) time instruments, which are payable on a future date; (3) orders to pay, which include checks
and drafts; and (4) promises to pay, which include promissor y notes and certificates of deposit.

LO2 List the requirements of a negotiable instrument. To be negotiable, an instrument must:

(1) Be in writing—A writing can be on anything that is readily transferable and has a degree of
permanence.
(2) Be signed by the maker or drawer.
(3) Be an unconditional promise or order to pay—A promise must be more than a mere
acknowledgment of a debt (the words I/We promise or Pay meet this criterion), and payment
cannot be expressly conditioned on the occurrence of an event or be subject to or governed
by another contract.
(4) State a fixed amount of money—An amount can be a fixed sum even if it is payable with
interest, and money is any medium of exchange recognized as the currency of a government.
(5) Be payable on demand or at a definite time—A demand instrument is payable on sight,
presentation, or issue, or does not state any time for payment, while an instrument is payable
at a definite time even if it is payable on or before a stated date or within a fixed period after
sight or if the drawer or maker has an option to extend the time for a definite period.
(6) Be payable to order or bearer—An order instrument must identify the payee with certainty,
and an instrument that indicates it is not payable to an identified person is payable to bearer.

LO3 State what may constitute a signature. A signature can be anywhere on the face of an
instrument, can be in any form (including a word, a mark, or a rubber stamp) that purports to be a
signature and authenticates the writing, and can be made in a representative capacity.

LO4 Decide whether a variable-interest-rate note is negotiable. A note tied to a variable rate of
interest, which fluctuates as a result of market conditions, can be negotiable. Only the principal is
subject to the requirement that to be negotiable a writing must contain a promise or order to pay
a fixed amount.

LO5 Describe the process of negotiation. A transfer by assignment gives the assignee only those
rights that the assignor possessed. Any defenses against payment that can be raised against an
assignor can normally be raised against the assignee. In a transfer by negotiation, the transferee
becomes a holder and can acquire more rights in the instrument than the previous possessor
had. An order instrument is negotiated by indorsement and deliver y. A bearer instrument is
negotiated by deliver y only.

Issue Spotters
1. Jim owes Sherry $700. Sherry asks Jim to sign a
negotiable instrument regarding the debt. Which of
the following, if included on that instrument, would
make it negotiable: “I.O.U. $700,” “I promise to pay
$700,” or an instruction to Jim’s bank stating, “I wish
you would pay $700 to Sherry”? Explain why.
2. Jack gets his paycheck from his employer, indorses
the back (“Jack”), and goes to cash it at his credit
union. On the way, he loses the check. Paige finds it.
Has the check been negotiated to Paige? How might
Jack have avoided any loss?

Before the Test

Check your answers to the Issue Spotters and, at the First, click on “Answers to Issue Spotters” to compare
same time, take the interactive quiz for this chapter. Go to your answers. Next, select “Interactive Quiz” to assess
www.cengage.com/blaw/te and click on “Chapter 23.” your mastery of the concepts in this chapter.
C HA PTER 23 ■ The Essentials of Negotiability
Hypothetical Questions
23–1. Requirements of Negotiability. The following note
is written by Muriel Evans on the back of an envelope:
“I, Muriel Evans, promise to pay Karen Marvin or bearer
$100 on demand.” Is this a negotiable instrument?
Discuss fully.
23–2. Indorsements. Bertram writes a check for $200,
payable to “cash.” He puts the check in his pocket and
drives to the bank to cash the check. As he gets out of
his car in the bank’s parking lot, the check slips out of
his pocket and falls to the pavement. Jerrod walks by
moments later, picks up the check, and later that day
Real-World Case Problems
23–3. Transfer by Negotiation. In July 1988, Chester
Crow executed a promissory note payable “to the order
of THE FIRST NATIONAL BANK OF SHREVEPORT
or BEARER” in the amount of $21,578.42 at an interest
rate of 3 percent per year above the “prime rate in effect
at The First National Bank of Shreveport” in Shreveport,
Louisiana, until paid. The note was a standard preprinted
promissory note. In 1999, Credit Recoveries, Inc., filed a suit
in a Louisiana state court against Crow, alleging that he
owed $7,222.57 on the note, plus interest. Crow responded
that the debt represented by the note had been canceled
by the bank in September 1994. He further contended that
in any event, to collect on the note, Credit Recoveries had
to prove its legitimate ownership of it. When no evidence
of ownership was forthcoming, Crow filed a motion to dis-
miss the suit. Is the note an order instrument or a bearer
instrument? How might it have been transferred to Credit
Recoveries? With this in mind, should the court dismiss the
suit on the basis of Crow’s contention? [Credit Recoveries,
Inc. v. Crow, 862 So.2d 1146 (La.App. 2d Cir. 2003)]
23–4. Negotiability. In September 2001, Cory Babcock
and Honest Air Conditioning & Heating, Inc., bought a new
Ethical Questions
23–5. Should the requirements for negotiability be
strictly enforced?
23–6. In November 2000, Monay Jones signed a promis-
sory note in favor of a mortgage company in the amount of
$261,250, using the deed to her home in Denver, Colorado,
as collateral. Fifth Third Bank soon became the holder
of the note. When Jones defaulted on the payment in
September 2001, she and the bank agreed to raise the
note’s balance to $280,231.23. She again defaulted. In
November, the bank received a check from a third party as
payment on Jones’s note. It was the bank’s policy to refuse
personal checks as payment of large debts. The bank rep-
resentative who worked on Jones’s account noted receipt
of the check in the bank’s records and forwarded it to the
305
delivers it to Amber, to whom he owes $200. Amber
indorses the check “For deposit only. [Signed] Amber
Dowel” and deposits it into her checking account. In light
of these circumstances, answer the following questions:
(a) Is the check a bearer instrument or an order
instrument?
(b) Did Jerrod’s delivery of the check to Amber consti-
tute a valid negotiation? Why or why not?
(c) What type of indorsement did Amber make?
(d) Does Bertram have a right to recover the $200 from
Amber? Explain.
2001 Chevrolet Corvette from Cox Chevrolet in Sarasota,
Florida. Their retail installment sales contract (RISC)
required monthly payments until $52,516.20 was paid.
The RISC imposed many other conditions on the buyers
and seller with respect to the payment for, and handling
of, the Corvette. Cox assigned the RISC to General Motors
Acceptance Corp. (GMAC). In August 2002, the buyers
sold the car to Florida Auto Brokers, which agreed to pay
the balance due on the RISC. The check to GMAC for
this amount was dishonored for insufficient funds, how-
ever, after the vehicle’s title had been forwarded. GMAC
filed a suit in a Florida state court against Honest Air
and Babcock, seeking $35,815.26 as damages for breach
of contract. The defendants argued that the RISC was
a negotiable instrument. A ruling in their favor on this
point would reduce any damages due GMAC to less than
the Corvette’s current value. What are the requirements
for an instrument to be negotiable? Does the RISC qual-
ify? Explain. [General Motors Acceptance Corp. v. Honest
Air Conditioning & Heating, Inc., 933 So.2d 34 (Fla.App.
2 Dist. 2006)]
“payoff department.” A week later, the bank discovered
that the check had been lost without having been posted to
Jones’s account or submitted for payment. The bank noti-
fied Jones, and both parties searched, without success, for
a copy of the check or evidence of the identity of its maker,
the drawee bank, or the amount. The bank filed a suit in
a Colorado state court to foreclose on Jones’s home. She
insisted that the note had been paid in full by a cashier’s
check issued by an Arkansas bank at the request of her
deceased aunt. What evidence supports a finding that
Jones gave the bank a check? Does it seem more likely that
the check was a cashier’s check or a personal check? Would
it be fair to find that the check had paid the note in full?
[Fifth Third Bank v. Jones, 168 P.3d 1 (Colo.App. 2007)]
Chapter 23 Work Set

True-False Questions

_____ 1. A negotiable instrument can be transferred only by negotiation.

_____ 2. A bearer instrument is payable to whoever possesses it.

_____ 3. To be negotiable, an instrument must be in writing.

_____ 4. To be negotiable, an instrument must expressly state when payment is due.

_____ 5. An instrument that does not designate a specific payee is an order instrument.

_____ 6. Indorsements are required to negotiate order instruments.

_____ 7. An order instrument is payable to whoever properly possesses it.

_____ 8. Indorsements are required to negotiate bearer instruments.

_____ 9. To be negotiable, an instrument must include an unconditional promise to pay.

_____ 10. The person who signs or makes an order to pay is the drawer.

Multiple-Choice Questions

_____ 1. Jasmine writes out a check payable to the order of Nancy. Nancy receives the check but wants to negotiate
it further to her friend Max. Nancy can negotiate the check further by
a. indorsing it.
b. delivering it to the transferee.
c. doing both a and b.
d. none of the above methods.

_____ 2. Kurt receives from Lee a check that is made out “Pay to the order of Kurt.” Kurt turns it over and writes
on the back, “Pay to Adam. [Signed] Kurt.” Kurt’s indorsement is a
a. blank indorsement.
b. special indorsement.
c. restrictive indorsement.
d. qualified indorsement.

_____ 3. Ray is the owner of Espresso Express. Dan’s Office Supplies sells Ray supplies for Espresso Express. To
pay, Ray signs a check “Espresso Express” in the lower left-hand corner. The check is
a. not negotiable, because “Espresso Express” is a trade name.
b. not negotiable, because Ray signed the check in the wrong location.
c. negotiable, and Ray is bound.
d. negotiable, but Ray is not bound.
306
C HA PTER 23 ■ The Essentials of Negotiability 307

_____ 4. Alex makes out a check “Pay to the order of Mel.” Mel indorses the check on the back by signing his name.
Before Mel signed his name, the check was
a. bearer paper.
b. order paper.
c. both a and b.
d. none of the above.

_____ 5. Jules owes money to Vern. Vern owes money to Chris. Vern signs an instrument that orders Jules to pay
to Chris the money that Jules owes to Vern. This instrument is a
a. note.
b. check.
c. certificate of deposit.
d. draft.

_____ 6. Don’s checks are printed “Pay to the order of ” followed by a blank. On one of the checks, Don writes in the
blank “Mac or bearer.” The check is
a. a bearer instrument.
b. an order instrument.
c. both a and b.
d. none of the above.

_____ 7. Lisa writes out a check payable to the order of Jeff. Negotiation occurs when Jeff receives the check. Jeff
subsequently negotiates the check by
a. indorsing it only.
b. delivering it only.
c. indorsing and delivering it.
d. none of the above methods.

_____ 8. Ann receives an instrument that reads, “May 1, 2011. Sixty days after date, I promise to pay to the order
of bearer $1,000 with interest at an annual rate of 5 percent. Due on June 30, 2011. [Signed] Bob Smith.”
This instrument is
a. a draft and negotiable.
b. a draft and nonnegotiable.
c. a promissory note and negotiable.
d. a promissory note and nonnegotiable.

GamePoints

1. You are playing Kill ‘Em Again, Inc., in which your avatar, Nick, drives around Urban City to duel zombies. To
play, the game requires that you buy a ride. So you sign the following on-screen instrument. What type of instrument
is this? Assuming an on-screen item otherwise qualifies, does this instrument meet the requirements for negotiabil-
ity under the UCC?

May 1, 2011
I promise to pay to the order of Urban City Car Company $20,000 (Twenty thousand dollars) with interest at
the rate of 7% per annum.
Signature: Nick

2. The video game Pita Pizza Pi revolves around the antics in a café run by a sandwich, a slice of pizza, and a
mathematical singularity. When you play the game, your character is Pete, the pie purveyor. To pay for a delivery of
your wares, you give Pita Pizza a draft drawn by you ordering the three buyers to pay you the price of the goods at a
specified future date. The buyers sign the draft and give it back to you. What type of draft is this?
 24 Transferability
and Liability
LEARNING OUTCOMES
The six learning outcomes
labeled LO1 through LO6 are
designed to help improve your
understanding of the chapter.
After reading this chapter, you
should be able to . . .
LO1 State the difference
between holders and
holders in due course.
LO2 List the requirements
for holder-in-due-course
status.
LO3 Outline the liability
of parties who sign
negotiable instruments.
LO4 Identify transfer warranties,
which extend to both
signers and nonsigners of
negotiable instruments.
LO5 List presentment
warranties, which extend
to both signers and
nonsigners of negotiable
instruments.
LO6 Point out defenses against
the payment of negotiable
instruments.
LO1 State the difference
between holders and
holders in due course.
holder in due course (HDC)
Any holder who acquires a
negotiable instrument for value;
in good faith; and without notice
that the instrument is overdue,
that it has been dishonored, or
that any defense or claim to it
exists on the part of any person.
308
FACING A LEGAL PROBLEM
Marcia Morrison issues a $500 note payable to
Reinhold Smith in payment for goods. Smith
negotiates the note to Judy Larson, who promises
to pay Smith for it in thirty days. During the next
month, Larson learns that Smith has breached the contract by
delivering defective goods and that Morrison will not honor the
$500 note. Smith has left town. Can Larson hold Morrison liable on
the note?
Problems arise when a holder seeking payment of a negotiable instrument
learns that a defense to payment exists or that another party has a prior
claim to the instrument. In such situations, for the person seeking payment, it
becomes important to have the rights of a holder in due course (HDC). An HDC
takes a negotiable instrument free of all claims and most defenses of other
parties.
We open this chapter by distinguishing between an ordinary holder and an
HDC. We then examine the requirements for HDC status, the kinds of liabil-
ity associated with negotiable instruments, and the defenses that parties may
have to payment on an instrument. Our discussion concerns primarily nego-
tiable instruments that have already been negotiated.
Holder versus Holder in Due Course
A holder is a person who possesses a negotiable instrument if the instrument
is payable to bearer or, in the case of an instrument payable to an identified
person, if the identified person is in possession. In other words, the holder is
the person who, by the terms of the instrument, is legally entitled to enforce
payment of it.
A transferee of a negotiable instrument who is characterized merely as
a holder obtains only those rights that the predecessor-transferor had in
the instrument. In the event that there is a conflicting, superior claim to or
defense against the instrument, an ordinary holder will not be able to collect
payment.
In contrast, a holder in due course (HDC) is a special-status transferee of a
negotiable instrument who, by meeting certain acquisition requirements, takes
the instrument free of most defenses and all claims to it. Stated another way,
C HA PTER 24 ■ Transferability and Liability 309

an HDC normally can acquire a higher level of immunity than can an ordinary
holder in regard to defenses against payment on the instrument and claims of
ownership to the instrument by other parties.

Requirements for HDC Status

An HDC must first be a holder of a negotiable instrument and must take the LO2 List the requirements
instrument: for holder-in-due-course
status.
1. For value.
2. In good faith.
3. Without notice that it is overdue, that it has been dishonored, that any per-
son has a defense against it or a claim to it, or that the instrument contains
unauthorized signatures or alterations or is so irregular or incomplete as to
call into question its authenticity.
The underlying requirement of “due course” status is that a person must first
be a holder on that instrument. Regardless of other circumstances surrounding
acquisition, only a holder has a chance to become an HDC.

TAKING FOR VALUE

An HDC must have given value for the instrument. The concept of value in the
law of negotiable instruments is not the same as the concept of consideration in
the law of contracts (see Chapter 10). An executory promise (a promise to give
value in the future) is valid consideration to support a contract. It does not,
however, normally constitute value sufficient to make one an HDC.
Instead, a holder exchanging a promise for an instrument takes the instru-
ment for value only to the extent that the promise has been performed. If the
holder plans to pay for the instrument later or plans to perform the required
services at some future date, the holder has not yet given value. In that case,
the holder is not yet an HDC. To the extent that the holder has paid for the
instrument or performed the promise, however, the holder can be an HDC.
A holder takes an instrument for value if the holder has done any of the
following:
1. Performed the promise for which the instrument was issued or transferred.
2. Acquired a security interest or other lien in the instrument (other than a
lien obtained by a judicial proceeding). Security interests and other liens
will be discussed in Chapters 32 and 33.
3. Taken an instrument in payment of, or as security for, an antecedent (preex-
isting) debt.
4. Given a negotiable instrument as payment.
5. Given, as payment, a commitment that cannot be revoked (withdrawn or
recalled).
A person who receives an instrument as a gift or who inherits it has not met
the requirement of value. In these situations, the person becomes an ordinary
holder and does not possess the rights of an HDC.

TAKING IN GOOD FAITH

The second requirement for HDC status is that the holder take the instrument
in good faith. This means that the purchaser-holder must have acted honestly
in the process of acquiring the instrument. Good faith is honesty in fact and the
observance of reasonable commercial standards of fair dealing. The good faith
requirement applies only to the holder. It is immaterial whether the transferor
acted in good faith. EXAMPLE 24.1 A person who in good faith takes a negotiable
instrument from a thief may become an HDC.•
310 UNIT FOUR ■ Negotiable Instruments

Because of the good faith requirement, one must ask whether the purchaser,
when acquiring the instrument, honestly believed that the instrument was not
defective. One must also ask whether the purchaser, when taking the instru-
ment, observed reasonable commercial standards (that is, conformed with what
others might have done). EXAMPLE 24.2 If a person purchases a $10,000 note for
$200 from a stranger on a street corner, the issue of good faith can be raised on
the grounds of the suspicious circumstances as well as the grossly inadequate
consideration.•

TAKING WITHOUT NOTICE

The final requirement for HDC status involves a lack of notice that the instru-
ment is defective. A person will not be afforded HDC protection if he or she
acquires an instrument knowing, or having reason to know, that it is defective
in any one of the following ways:
1. It is overdue.
2. It has been dishonored.
3. There is an uncured (uncorrected) default (failure to pay) with respect to
another instrument issued as part of the same series.
4. The instrument contains an unauthorized signature or has been altered.
5. There is a defense against the instrument or a claim to the instrument.
6. The instrument is so irregular or incomplete as to call into question its
authenticity.

What Constitutes Notice? Notice of a defective instrument is given when-

ever the holder has (1) actual knowledge of the defect; (2) receipt of a notice
about a defect; or (3) reason to know that a defect exists, given all the facts
and circumstances known at the time in question. The holder must also have
received the notice at a time and in a manner that gives the holder a reason-
able opportunity to act on it. Facts that a purchaser might know but that do not
of themselves make an instrument defective, such as bankruptcy proceedings
against the maker or drawer, do not constitute notice that the instrument is
defective.

IN THE COURTROOM
ACTUAL CASE EXAMPLE
Allianz Corporation opens a checking account with Wells Fargo Bank
to reimburse its employees for medical expenses. Mary Carpenter is
the only authorized signatory. James Carden opens an account with
Charles Schwab & Company, using a check drawn on the Allianz account in the
amount of $300,000. The check does not contain the usual and customary check-
processing information, but does contain Carpenter’s forged signature. Schwab
presents the check to Wells Fargo, which pays it and debits Allianz’s account.
Carden withdraws $275,000. When Wells Fargo and Schwab learn that the check
was unauthorized, Schwab returns the balance in the Carden account—$25,000—
to Wells Fargo, which credits Allianz’s account. Allianz files a suit against Schwab to
recover the rest of the funds. Is a party who accepts a forged check with notice of
the check’s invalidity disqualified from HDC status? Yes. In a 2002 case, Travelers
Casualty and Surety Co. of America v. Wells Fargo Bank, N.A., a federal court held
Schwab liable for the loss on the check. The missing information gave Schwab
notice of the check’s invalidity.

Overdue Instruments. Any negotiable instrument is either payable at a

definite time (time instrument) or payable on demand (demand instrument).
What constitutes notice that an instrument is overdue will vary depending on
whether it is a time or a demand instrument.
C HA PTER 24 ■ Transferability and Liability 311

A holder of a time instrument who takes the paper the day after its expressed
due date is on notice that it is overdue. Nonpayment by the due date should
indicate to any purchaser who is obligated to pay that the primary party has
a defense to payment. EXAMPLE 24.3 A promissory note due on May 15 must
be acquired before midnight on May 15. If it is purchased on May 16, the pur-
chaser will be an ordinary holder, not an HDC.•
Sometimes, instruments read, “Payable in thirty days.” EXAMPLE 24.4 A
note dated December 1 that is payable in thirty days is due by midnight on
December 31.• If the payment date falls on a Sunday or holiday, the instru-
ment is payable on the next business day. If a debt is to be paid in installments
or through a series of notes, the maker’s default on any installment of principal
(not interest) or on any one note of the series will constitute notice to the pur-
chaser that the instrument is overdue.
A purchaser has notice that a demand instrument is overdue if he or she
takes the instrument knowing that demand has been made the day before.
A purchaser also has notice if he or she takes a demand instrument that has
been outstanding for an unreasonable period of time after its date. A reason-
able time for a check is ninety days or less. A reasonable time for other demand
instruments depends on the circumstances.

Signature Liability
The key to liability on a negotiable instrument is a signature. A person is not LO3 Outline the liability
liable on an instrument unless (1) the person signed the instrument, or (2) the of parties who sign
person is represented by an agent or representative who signed the instrument negotiable instruments.
and the signature is binding on the represented person. The following sections
discuss the types of liability that exist in relation to negotiable instruments
and the conditions that must be met before liability can arise.

PRIMARY LIABILITY
A person who is primarily liable on a negotiable instrument is absolutely
required to pay the instrument, subject to certain defenses. Primary liability
is unconditional. The primary party’s liability is immediate when the instru-
ment is signed or issued and effective when the instrument becomes due. No
action by the holder of the instrument is required. Makers and acceptors are
primarily liable.
The maker of a promissory note promises to pay the note. If the note is com-
plete when the maker signs it, then the maker’s obligation is to pay it according
to its terms. If the note is incomplete when the maker signs it, then the maker’s
obligation is to pay it according to its terms when it is completed as authorized.
If the completion is unauthorized but the note is negotiated to a holder in due
course (HDC), then the maker must pay the HDC according to the unauthor-
ized terms.
The drawee-acceptor of a draft or check is in nearly the same position as the
maker of a promissory note. A drawee’s acceptance of a draft, which it makes by
signing the draft, guarantees that the drawee will pay the draft when it is pre-
sented later for payment. When a drawee accepts a draft, the drawee becomes
an acceptor and is primarily liable to all subsequent holders. A drawee that acceptor
refuses to accept a draft that requires the drawee’s acceptance has dishonored The person (the drawee) who
the instrument. accepts a draft and who engages
to be primarily responsible for its
payment.
SECONDARY LIABILITY
Drawers and indorsers have secondary liability. In the case of notes, an indors-
er’s secondary liability does not arise until the maker, who is primarily liable,
has defaulted on the instrument. With regard to drafts (and checks), a drawer’s
312 UNIT FOUR ■ Negotiable Instruments

secondary liability does not arise until the drawee fails to pay or to accept the
instrument, whichever is required. EXAMPLE 24.5 Lo An writes a check on her
account at Universal Bank payable to the order of Val Carerra. If Universal
Bank does not pay the check when Carerra presents it for payment, then Lo An
is liable to Carerra.•
Parties who are secondarily liable on a negotiable instrument promise to
pay on that instrument only if the following events occur:
1. The instrument is properly and timely presented.
2. The instrument is dishonored.
3. If the secondarily liable party is an unqualified indorser, timely notice of
dishonor is given. EXAMPLE 24.6 Oman writes a check on his account at
State Bank payable to Bea. Bea indorses the check in blank and cashes it
at Midwest Grocery, which transfers it to State Bank for payment. If State
Bank refuses to pay it, Midwest must timely notify Bea to hold her liable.•

Proper Presentment. Presentment by a holder must be made to the proper

person, must be made in a proper manner, and must be timely.
The party to whom the instrument must be presented depends on what type
of instrument is involved. A note or certificate of deposit must be presented to
the maker for payment. A draft is presented by the holder to the drawee for
acceptance, payment, or both, whichever is required. A check is presented to
the drawee-bank for payment.
Presentment can be properly made in any of the following ways, depending
on the type of instrument involved:
1. By any commercially reasonable means, including oral, written, or electronic
communication (but presentment is not effective until the demand for pay-
ment or acceptance is received).
2. Through a clearinghouse procedure used by banks (see Chapter 25), such as
for deposited checks.
3. At the place specified in the instrument for acceptance or payment.
One of the most crucial criteria for proper presentment is timeliness. Failure
to present on time is the most common cause for the discharge of unqualified
indorsers from secondary liability (see Exhibit 24–1).

Proper Notice. Once an instrument is dishonored, notice must be given to

hold secondary parties liable. Notice may be given in any reasonable man-
ner. This includes oral notice, written notice, or electronic notice (notice by fax,
modem, e-mail, and the like) and notice written or stamped on the instrument
itself. Any necessary notice must be given by a bank before its midnight dead-
line (midnight of the next banking day after receipt). Notice by any party other

EXHIBIT 24–1
TYPE OF
Time for Proper Presentment
INSTRUMENT FOR ACCEPTANCE FOR PAYMENT

Time On or before due date. On due date.

Demand Within a reasonable time Within a reasonable time.

(after date or issue or after
secondary party becomes
liable on the instrument).

Check Not applicable. Within thirty days of date to hold

drawer secondarily liable. Within
thirty days of indorsement to hold
indorser secondarily liable.
C HA PTER 24 ■ Transferability and Liability 313

than a bank must be given within thirty days following the day on which the
person receives notice of dishonor.

UNAUTHORIZED SIGNATURES
People normally are not liable to pay on negotiable instruments unless their
signatures appear on the instruments. The general rule is that an unauthor-
ized signature is wholly inoperative and will not bind the person whose name
is forged.
There are two exceptions to this rule:
1. Any unauthorized signature is wholly inoperative unless the person whose
name is signed ratifies (affirms) it. EXAMPLE 24.7 A signature made by an
agent who exceeded the scope of his or her authority can be ratified by the
principal, either expressly, by affirming the validity of the signature, or
impliedly, by other conduct, such as keeping any benefits received in the
transaction or failing to repudiate the signature.•
2. A person may be precluded from denying the effectiveness of an unauthor-
ized signature if the person’s negligence led to the unauthorized signature.
EXAMPLE 24.8 Suppose that a person writes and signs a check, leaves blank
the amount and the name of the payee, and then leaves the check in a place
available to the public. That person can be estopped (prevented), on the basis
of negligence—that is, for failing to use reasonable care—from denying lia-
bility for its payment.• Whatever loss occurs may be allocated, however,
between certain parties on the basis of comparative negligence (that is, if
two parties fail to use reasonable care, the amount of any loss can be appor-
tioned between them according to the degree to which each was negligent).
An unauthorized signature operates as the signature of the unauthorized
signer in favor of an HDC. For example, a person who forges a check can be
held personally liable by an HDC.

SPECIAL RULES FOR UNAUTHORIZED INDORSEMENTS

Generally, when there is a forged or unauthorized indorsement, the burden of
loss falls on the first party to take the instrument with such an indorsement.
Two situations are possible, however, in which the loss falls on the maker or
drawer. We look at those situations here.

Imposters. An imposter is one who, by use of the mails, telephone, or personal imposter
appearance, induces a maker or drawer to issue an instrument in the name One who, with the intent
of an impersonated payee. If the maker or drawer believes the imposter to be to deceive, pretends to be
the named payee at the time of issue, the indorsement by the imposter is not somebody else.
treated as unauthorized when the instrument is transferred to an innocent
party. This is because the maker or drawer intended the imposter to receive
the instrument.
In these situations, the unauthorized indorsement of a payee’s name can be
as effective as if the real payee had signed. The imposter rule provides that an
imposter’s indorsement will be effective—that is, not a forgery—insofar as the
drawer goes.

IN THE COURTROOM
A man walks into Mark’s sports equipment store and purports to be
Jerry Lewis soliciting contributions in the fight against muscular dystro-
phy. Mark has heard of Lewis’s charitable efforts but has never met
or seen him. Wishing to support a worthy cause, Mark writes out a
check for $250 payable to Jerry Lewis and hands it to the imposter. The imposter
314
fictitious payee
A payee on a negotiable
instrument whom the maker or
drawer does not intend to have
an interest in the instrument.
Indorsements by fictitious
payees are not forgeries under
negotiable instruments law.
LO4 Identify transfer warranties,
which extend to both
signers and nonsigners of
negotiable instruments.
transfer warranty
A guaranty made by any person
who transfers a negotiable
instrument for consideration to
all subsequent transferees and
holders who take the instrument
in good faith.
UNIT FOUR ■ Negotiable Instruments
indorses the check in the name of Jerry Lewis and cashes it at a Stop and Shop
convenience store. Mark discovers the fraud and stops payment on the check,
claiming that the payee’s signature is forged. Can Mark recover the amount of the
check from Stop and Shop? No. Mark cannot claim a forgery against the store but
must seek redress from the imposter instead. If Mark had sent the check to the
real Jerry Lewis, but the check had been stolen and negotiated to the store on a
forged indorsement, the imposter rule would not apply. In that situation, Stop and
Shop would have to seek redress against the forger.
The comparative negligence standard mentioned in connection with the
liability of banks paying over unauthorized signatures also applies in cases
involving imposters. EXAMPLE 24.9 If a bank fails to exercise ordinary care in
cashing a check made out to an imposter and this failure substantially con-
tributes to the drawer’s loss, the drawer may have a valid claim against the
bank.•
Fictitious Payees. The so-called fictitious payee rule deals with the intent
of the maker or drawer to issue an instrument to a payee who has no interest
in the instrument. This most often takes place when (1) a dishonest employee
deceives the employer into signing an instrument payable to a party with no
right to receive the instrument or (2) a dishonest employee or agent has the
authority to issue an instrument on behalf of the employer. In these situations,
the payee’s indorsement is not treated as a forgery, and the employer can be
held liable on the instrument by an innocent holder.
IN THE COURTROOM
Dan Symes draws up the payroll list from which the salary checks for
the Honsu Company’s employees are written. He fraudulently adds
the name Penny Trip (a friend not entitled to payment) to the payroll,
thus causing checks to be issued to her. Trip cashes the checks at the
Lone Star Grocery Store and shares the proceeds with Symes. Can Lone Star hold
Honsu liable on the checks? Yes. Trip’s indorsement is not treated as a forgery,
and Honsu can be held liable on them by Lone Star.
Warranty Liability
In addition to the signature liability discussed in the preceding section, trans-
ferors make certain implied warranties regarding the instruments that they
are negotiating. Liability under these warranties is not subject to the condi-
tions of proper presentment, dishonor, and notice of dishonor. These warranties
arise even when a transferor does not indorse the instrument (as in delivery of
a bearer instrument). Warranties fall into two categories: those that arise from
the transfer of a negotiable instrument and those that arise on presentment.
TRANSFER WARRANTIES
A person who transfers an instrument for consideration makes certain warran-
ties to the transferee and, if the transfer is by indorsement, to all subsequent
transferees and holders who take the instrument in good faith. There are five
transfer warranties. They are as follows:
1. The transferor is entitled to enforce the instrument.
2. All signatures are authentic and authorized.
3. The instrument has not been materially altered.
C HA PTER 24 ■ Transferability and Liability 315

4. The instrument is not subject to a defense or claim of any party that can be
asserted against the transferor.
5. The transferor has no knowledge of any insolvency proceedings against the
maker, the acceptor, or the drawer of an unaccepted instrument.
Unless the person who transfers an instrument receives consideration, the
manner of transfer and the negotiation that is used determine how far and to
whom a transfer warranty will run. Transfer by indorsement and delivery of
order paper extends warranty liability to any subsequent holder who takes the
instrument in good faith. The warranties of a person who transfers without
indorsement (by delivery of bearer paper) will extend only to the immediate
transferee.

IN THE COURTROOM
Wylie forges Kim’s name as a maker of a promissory note. The note is
made payable to Wylie. Wylie indorses the note in blank, negotiates it
to Bret, and then leaves the country. Bret, without indorsement, deliv-
ers the note to Fern. Fern, in turn without indorsement, delivers the
note to Rick. On Rick’s presentment of the note to Kim, the forgery is discovered.
Can Rick hold Fern (the immediate transferor) liable for breach of warranty that all
signatures are genuine? Yes. The note is bearer paper. Rick cannot hold Bret liable,
however, because Bret is not Rick’s immediate transferor but is a prior nonindors-
ing transferor.

PRESENTMENT WARRANTIES
Any person who obtains payment or acceptance of an instrument makes to any LO5 List presentment
other person who in good faith pays or accepts the instrument the following warranties, which extend
warranties: to both signers and
nonsigners of negotiable
1. The person obtaining payment or acceptance is entitled to enforce the draft instruments.
or is authorized to obtain payment or acceptance on behalf of a person who
is entitled to enforce the draft. (This is, in effect, a warranty that there are
no missing or unauthorized indorsements.)
2. The draft has not been altered.
3. The person obtaining payment or acceptance has no knowledge that the
signature of the drawer of the draft is unauthorized.
These warranties are often referred to as presentment warranties, because presentment warranty
they protect the person to whom the instrument is presented. These warran- A warranty made by any person
ties cannot be disclaimed with respect to checks. A claim for breach must be who presents an instrument for
given to the warrantor within thirty days after the claimant knows, or has payment or acceptance.
reason to know, of the breach and the identity of the warrantor.
The second and third presentment warranties do not apply in certain cases
(to certain persons) in which the presenter is an HDC. EXAMPLE 24.10 It is
assumed that a drawer or a maker will recognize his or her own signature and
that a maker or an acceptor will recognize whether an instrument has been
materially altered.•

Defenses
Defenses can bar collection from persons who would otherwise be primarily LO6 Point out defenses against
or secondarily liable on an instrument. There are two general categories of the payment of negotiable
defenses—universal defenses and personal defenses. instruments.
316
universal defense
A defense that can be used to
avoid payment to all holders of a
negotiable instrument, including
a holder in due course (HDC).
Also called a real defense.
personal defense
A defense that can be used
to avoid payment to an
ordinary holder of a negotiable
instrument. In contrast, personal
defenses cannot be used to
avoid payment to a holder in due
course (HDC).
UNIT FOUR ■ Negotiable Instruments
UNIVERSAL DEFENSES
Universal defenses (also called real defenses) are valid against all holders,
including HDCs or holders who take through an HDC. Universal defenses
include the following:
1. Forgery of a signature on the instrument.
2. Fraud in the execution. If a person is deceived into signing a negotiable
instrument, believing that he or she is signing something other than a nego-
tiable instrument (such as a receipt), fraud in the execution is committed
against the signer.
3. Material alteration. An alteration is material if it changes the contract terms
between any two parties in any way. EXAMPLE 24.11 Material alterations
include completing an instrument, adding words or numbers, or making any
other change in an unauthorized manner that relates to the obligation of a
party.•
4. Discharge in bankruptcy. This is a defense on any instrument regardless
of the status of the holder, because the purpose of bankruptcy is to settle
finally all of the insolvent party’s debts.
5. Minority. Minority is a universal defense only to the extent that state law
recognizes it as a defense to a simple contract.
6. Illegality, mental incapacity, or extreme duress. When the law declares that
an instrument is void because it was issued in connection with illegal con-
duct, by a person who was adjudged mentally incompetent by a court, or
by a person under an immediate threat of force or violence (for example, at
gunpoint), the defense is universal.
PERSONAL DEFENSES
Personal defenses are used to avoid payment to an ordinary holder. There are
many personal defenses. They include the following:
1. Breach of contract or breach of warranty. When there is a breach of warranty
or a breach of the contract for which the instrument was issued, the maker
of a note can refuse to pay it, or the drawer of a check can stop payment.
2. Fraud in the inducement (ordinary fraud). A person who issues a negotiable
instrument based on false statements by the other party will be able to
avoid payment, unless the holder is an HDC.
3. Illegality, mental incapacity, or ordinary duress. If the law declares that an
instrument is voidable because it was issued in connection with illegal con-
duct, by a person who is mentally incompetent, or by a person under ordi-
nary duress (an unlawful threat to induce the person to do something that
he or she would not otherwise do), the defense is personal.
4. Previous payment of the instrument.
Discharge
Discharge from liability on an instrument can come from payment, cancella-
tion, or as previously discussed, material alteration. The liability of all par-
ties is discharged when the party primarily liable on an instrument pays to a
holder the amount due in full. Payment by any other party discharges only the
liability of that party and later parties.
The holder of a negotiable instrument can discharge any party to the instru-
ment by cancellation. EXAMPLE 24.12 Writing the word “Paid” across the face
of an instrument constitutes cancellation.• Destruction or mutilation of a
C HA PTER 24 ■ Transferability and Liability 317

negotiable instrument is considered cancellation only if it is done with the

intention of eliminating an obligation on the instrument. Thus, if destruction
occurs by accident, the instrument is not discharged, and the original terms
can be established.

ANSWERING THE LEGAL PROBLEM

In the legal problem set out at the beginning of
this chapter, Marcia Morrison gives a $500 note to
Reinhold Smith to pay for goods. Smith delivers
defective goods, and Morrison refuses to pay the note.
In the meantime, Smith has negotiated the note to Judy Larson, who
promised to pay Smith for it in thirty days. Larson learns of Smith’s
breach and Morrison’s refusal to pay the $500 note. Smith has left
town. Can Larson hold Morrison liable on the note? That will depend
on whether Larson is an HDC. Because Larson had not yet given value
at the time that she learned of Morrison’s defense to payment of the
note (breach of contract), Larson is a mere holder, not an HDC. Thus,
Morrison’s defense is valid against Larson. If Larson had paid Smith
for the note at the time of transfer, she would be an HDC and could
hold Morrison liable on the note.

Linking the Law to Your Career:

Writing and Indorsing Checks
If you choose a career in business, you
will certainly be writing and receiving
checks. Both activities can involve
pitfalls.
Checks Drawn in Blank
The danger in signing a blank check
is clear. Anyone can write in an
unauthorized amount and cash the
check. Although you may be able to
assert lack of authorization against
the person who filled in the check,
subsequent holders may be able to
enforce the check as completed. While
you are haggling with the person who
inserted the unauthorized amount
and who may not be able to repay it,
you will also have to honor the check
for the unauthorized amount to a
subsequent holder in due course.
Checks Payable to “Cash”
It is equally dangerous to write out
and sign a check payable to “cash”
until you are actually at the bank.
Checks payable to “cash” are bearer
instruments. This means that if you
lose or misplace the check, anybody
who finds it can present it (with proper
identification) to the bank for payment.
Checks Indorsed in Blank
A negotiable instrument with a blank
indorsement also has dangers. As a
bearer instrument, it may be as easily
transferred as cash. When you make
a bank deposit, therefore, you should
indorse the back of the check in blank
only in the presence of a teller who
simultaneously gives you a receipt for
the deposit. If you choose to sign it
ahead of time, always insert the words
“For deposit only” before you sign your
name.
As a precaution, you should
consider obtaining an indorsement
stamp from your bank. Then, when
you receive a check payable to
your business, you can indorse it
immediately. The stamped indorsement
will indicate that the check is for
deposit only to your business account
specified by its number.

Terms and Concepts for Review

acceptor 311 imposter 313 transfer warranty 314
fictitious payee 314 personal defense 316 universal defense 316
holder in due course (HDC) 308 presentment warranty 315
318 UNIT FOUR ■ Negotiable Instruments

Chapter Summary—Transferability and Liability

LO1 State the difference between holders and holders in due course. A holder is a person in the
possession of an instrument drawn, issued, or indorsed to him or her, to his or her order, to
bearer, or in blank. A holder obtains only those rights that the transferor had in the instrument. A
holder in due course is a holder who, by meeting certain requirements, takes an instrument free
of most defenses and claims to which the transferor was subject.

LO2 List the requirements for holder-in-due-course status. To be a holder in due course, a holder
must take an instrument (1) for value—by per forming the promise for which the instrument
was issued or transferred, by acquiring a security interest or other lien in the instrument (other
than a lien by a judicial proceeding), by taking the instrument in payment of or as security for
an antecedent debt, by giving a negotiable instrument as payment, or by giving an irrevocable
commitment as payment; (2) in good faith—honesty in fact and the obser vance of reasonable
commercial standards of fair dealing; and (3) without notice—that the instrument is overdue, that
it has been dishonored, that it is part of a series of which at least one instrument has an uncured
defect, that it contains an unauthorized signature or has been altered, that a claim or defense
exists, or that it is so irregular or incomplete as to call its authenticity into question.

LO3 Outline the liability of parties who sign negotiable instruments. Ever y party (except a qualified
indorser) who signs a negotiable instrument is either primarily or secondarily liable for payment of
the instrument when it comes due. Primar y liability requires payment on a negotiable instrument
according to its terms. Secondar y liability requires payment on an instrument only if presentment
is proper and timely, the instrument is dishonored, and a timely notice of dishonor is received.
Makers and acceptors are primarily liable (an acceptor is a drawee that promises in writing to
pay an instrument when it is presented for payment at a later time). Drawers and indorsers are
secondarily liable.

LO4 Identify transfer warranties, which extend to both signers and nonsigners of negotiable
instruments. Any person who transfers an instrument for consideration makes the following
warranties to subsequent transferees and holders (although they can be disclaimed in any
instrument except a check): (1) the transferor is entitled to enforce the instrument; (2) all
signatures are authentic and 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; and (5) the transferor has no knowledge of any insolvency proceedings against the
maker, the acceptor, or the drawer of the instrument.

LO5 List presentment warranties, which extend to both signers and nonsigners of negotiable
instruments. Any person who presents an instrument for payment or acceptance makes the
following warranties to any other person who in good faith pays or accepts the instrument
(although they can be disclaimed in any instrument except a check):
(1) The person obtaining payment or acceptance is entitled to enforce the instrument or is
authorized to obtain payment or acceptance on behalf of a person who is entitled to enforce
the instrument (in effect, that there are no missing or unauthorized indorsements).
(2) The instrument has not been altered.
(3) The person obtaining payment or acceptance has no knowledge that the signature of the
drawer of the instrument is unauthorized.

LO6 Point out defenses against the payment of negotiable instruments. Universal defenses, which
are valid against all holders, including holders in due course (HDCs) and holders with the rights
of HDCs, include forger y, fraud in the execution, material alteration, discharge in bankruptcy,
minority (in some states), and illegality, mental incapacity, or extreme duress if under state law
the contract is void. Personal defenses, which are valid against ordinar y holders but not HDCs
or those with the rights of HDCs, include breach of contract, breach of warranty, fraud in the
inducement, lack or failure of consideration, and illegality or mental incapacity, undue influence,
or ordinar y duress if under state law the contract is voidable.
C HA PTER 24 ■ Transferability and Liability
Issue Spotters
1. Adam issues a $500 note to Bill due six months from
the date issued. One month later, Bill negotiates the
note to Carol for $250 in cash and a check for $250. To
what extent is Carol an HDC of the note?
2. Roy signs corporate checks for Standard Corporation.
Roy makes a check payable to U-All Company, to
Before the Test
Check your answers to the Issue Spotters and, at the
same time, take the interactive quiz for this chapter. Go to
www.cengage.com/blaw/te and click on “Chapter 24.”
Hypothetical Questions
24–1. Defenses. Fox purchased a used car from Emerson
for $1,000. Fox paid for the car with a check, written
in pencil, payable to Emerson for $1,000. Emerson,
through careful erasure and alterations, changed the
amount on the check to read $10,000 and negotiated
the check to Sanderson. Sanderson took the check for
value, in good faith, and without notice of the alteration
and thus met the UCC requirements for holder-in-due-
course status. Can Fox successfully raise the universal
defense of material alteration to avoid payment on the
check? Explain.
Real-World Case Problems
24–3. Holder in Due Course. American International
Group, Inc. (AIG), an insurance company, issued a check
to Jermielem Merriwether in connection with a personal-
injury matter. Merriwether presented the check to A-1
Check Cashing Emporium (A-1) for payment. A-1’s clerk
forgot to have Merriwether sign the check. When he could
not reach Merriwether to ask him to come back to A-1 to
sign the check, the clerk printed Merriwether’s name on
the back and deposited it for collection. When the check
was not paid, A-1 sold it to Robert Triffin, who is in the
business of buying dishonored checks. When Triffin could
not get the check honored, he sued AIG, contending that
he, through A-1, had the right to collect on the check as a
holder in due course (HDC). The trial court rejected that
claim. Triffin appealed. On what basis could he claim
HDC status? [Triffin v. American International Group,
Inc., ___ A.2d ___ (N.J.Super. 2008)]
24–4. Unauthorized Indorsements. Stephen Schor, an
accountant in New York City, advised his client, Andre
319
whom Standard owes no money. Roy signs the check,
forges U-All’s indorsement, and cashes the check at
First State Bank, the drawee. Does Standard have any
recourse against the bank for the payment? Explain
your answer.
First, click on “Answers to Issue Spotters” to compare
your answers. Next, select “Interactive Quiz” to assess
your mastery of the concepts in this chapter.
24–2. Signature Liability. Marion makes a promissory
note payable to the order of Perry. Perry indorses the note
by writing “without recourse, Perry” (see Chapter 23) and
transfers the note for value to Steven. Steven, in need
of cash, negotiates the note to Harriet by indorsing it
with the words “Pay to Harriet, Steven.” On the due date,
Harriet presents the note to Marion for payment, only to
learn that Marion has filed for bankruptcy and will have
all debts (including the note) discharged in bankruptcy.
Discuss fully whether Harriet can hold Marion, Perry, or
Steven liable on the note.
Romanelli, Inc., to open an account at J. P. Morgan Chase
Bank, N.A., to obtain a favorable interest rate on a line
of credit. Romanelli’s representative signed a signature
card, which he gave to Schor. When the accountant later
told Romanelli that the rate was not favorable, the firm
told him not to open the account. Schor signed a blank
line on the signature card, changed the mailing address
to his office, and opened the account in Romanelli’s name.
In a purported attempt to obtain credit for the firm else-
where, Schor had its principals write checks payable
to themselves for more than $4.5 million, ostensibly to
pay taxes. He indorsed and deposited the checks in the
Chase account and eventually withdrew and spent the
funds. Romanelli filed a suit in a New York state court
against the bank, alleging that a drawer is not liable on
an unauthorized indorsement. Is this the rule? What are
its exceptions? Which principle applies to these facts,
and why? [Andre Romanelli, Inc. v. Citibank, N.A., 60
A.D.3d 428, 875 N.Y.S.2d 14 (1 Dept. 2009)]
320 UNIT FOUR ■ Negotiable Instruments
Ethical Questions
24–5. Why is good faith required to attain HDC status?
24–6. Should a bank that acts in “bad faith” be pre-
cluded from raising the fictitious payee rule as a defense?
Explain your answer.
24–7. Clarence Morgan, Jr., owned Easy Way Automotive,
a car dealership in D’Lo, Mississippi. Easy Way sold a
truck to Loyd Barnard, who signed a note for the amount
of the price payable to Trustmark National Bank in six
months. Before the note came due, Barnard returned
the truck to Easy Way, which sold it to another buyer.
Using some of the proceeds from the second sale, Easy
Way sent a check to Trustmark to pay Barnard’s note.
Meanwhile, Barnard obtained another truck from Easy
Video Question
24–8. Go to this text’s Web site at www.cengage.com/
blaw/te, and select “Chapter 24.” Click on “Video
Questions” and view the video titled Negotiability &
Transferability: Indorsing Checks. Then answer the fol-
lowing questions.
1. According to the instructor in the video, what are the
two reasons why banks generally require a person to
indorse a check that is made out to cash (a bearer
instrument), even when the check is signed in the
presence of the teller?
2. Suppose that your friend makes out a check payable
to cash, signs it, and hands it to you. You take the
check to your bank and indorse the check with your
Way financed through another six-month note payable
to Trustmark. After eight of these deals, some of which
involved more than one truck, an Easy Way check to
Trustmark was dishonored. In a suit in a Mississippi
state court, Trustmark sought to recover the amounts of
two of the notes from Barnard. Meanwhile, Easy Way’s
account was subject to other overdrafts, Morgan commit-
ted suicide, and Barnard was unable to obtain a mort-
gage because the unpaid notes affected his credit rating.
Is Barnard liable on the notes? Why or why not? How
do the circumstances of this case underscore the impor-
tance of practicing business ethics? [Trustmark National
Bank v. Barnard, 930 So.2d 1281 (Miss.App. 2006)]
name and the words “without recourse.” What type
of indorsement is this? How does this indorsement
affect the bank’s rights?
3. Now suppose that you go to your bank and write a
check on your account payable to cash for $500. The
teller gives you the cash without asking you to indorse
the check. After you leave, the teller slips the check
into his pocket. Later, the teller delivers it (without
an indorsement) to his friend Carol in payment for a
gambling debt. Carol takes your check to her bank,
indorses it, and deposits the money. Discuss whether
Carol is a holder in due course.
Chapter 24 Work Set

True-False Questions

_____ 1. Every person who possesses an instrument is a holder.

_____ 2. Anyone who takes an instrument for value, in good faith, and without notice is a holder in due course (HDC).

_____ 3. Personal defenses can be raised to avoid payment to an HDC.

_____ 4. For HDC status, good faith means an honest belief that an instrument is not defective.

_____ 5. Knowing that an instrument has been dishonored puts a holder on notice, and he or she cannot become
an HDC.

_____ 6. Generally, no one is liable on an instrument unless his or her signature appears on it.

_____ 7. Warranty liability is subject to the same conditions of proper presentment, dishonor, and notice of dishonor
as signature liability.

_____ 8. Drawers are secondarily liable.

_____ 9. An unauthorized signature usually binds the person whose name is forged.

Multiple-Choice Questions

_____ 1. Don signs a note that states, “Payable in thirty days.” The note is dated March 2, which means it is due
April 1. Jo buys the note on April 12. She is
a. an HDC to the extent that she paid for the note.
b. an HDC to the extent that the note is not yet paid.
c. not an HDC.
d. none of the above.

_____ 2. Jack’s sister Paula steals one of Jack’s checks, makes it payable to herself, signs Jack’s name, and cashes
it at First National Bank. Jack tells the bank that he will pay it. If Jack later changes his mind, he will
a. be liable on the check.
b. be liable only to the extent of the amount in his checking account.
c. not be liable on the check.
d. be none of the above.

_____ 3. Anna, who cannot read English, signs a promissory note after Ted, her attorney, tells her that it is a credit
application. Anna has
a. a defense of fraud assertable against a holder or an HDC.
b. a defense of fraud assertable against a holder only.
c. a defense against payment on the note under FTC Rule 433.
d. no defense against payment on the note.
321
322 UNIT FOUR ■ Negotiable Instruments

_____ 4. Ben contracts with Amy to fix her roof. Amy writes Ben a check, but Ben never makes the repairs. Carl knows
Ben breached the contract, but cashes the check anyway. Carl cannot attain HDC status in regard to
a. any defense Amy might have against payment.
b. only any personal defense Amy might have against payment.
c. only Ben’s breach, which is Amy’s personal defense against payment.
d. none of the above.

_____ 5. Able Company issues a draft for $1,000 on July 1, payable to the order of Baker Corporation. The draft is
drawn on First National Bank. Before the bank accepts the draft, who has primary liability for payment?
a. Able Company.
b. Baker Corporation.
c. First National Bank.
d. No one.

_____ 6. Bill issues a check for $4,000, dated June 1, to Ed. The check is drawn on First National Bank. Ed
indorses the check and transfers it to Jane. Which of the following will trigger the liability of Bill and Ed
on the check, based on their signatures?
a. Presentment only.
b. Dishonor only.
c. Both presentment and dishonor.
d. Neither presentment nor dishonor.

_____ 7. Standard Company issues a draft for $500 on May 1, payable to the order of Ace Credit Corporation. The
draft is drawn on First State Bank. If the bank does not accept the draft, who is liable for payment?
a. Standard Company.
b. Ace Credit Corporation.
c. First State Bank.
d. No one.

_____ 8. United Business Corporation authorizes Vic to use company checks to buy office supplies. Vic writes a
check to Wholesale Supplies, Inc., for $100 over the price of a purchase, for which the seller returns cash.
When Wholesale presents the check for payment, it may recover
a. nothing.
b. the amount stated in the check.
c. the amount of the overpayment only.
d. the price of the supplies only.

GamePoints

1. In the video game Bills & Coins, each player tracks income, spending, investments, and taxes in a simulated
real-world environment to exceed the net worth of the other players with whom business is transacted. Your charac-
ter, Money Man, is given the following instrument:
Silky, Gametown, Ohio July 14, 2011
Pay to the order of Money Man $1,500.00
One thousand five hundred and 00/100 dollars
United Bank, Lake City, Ohio Silky
Under the principles of the UCC, who is primarily liable on this item? Who is secondarily liable? If United Bank does
not pay it, from whom can you seek payment and what steps must you take to obtain it?

2. You work in the warehouse of Entrée Entertainment, Inc., which distributes video games, including the best-
selling Fettuccini Alfredo. Your job requires you to match deliveries to invoices. You notice that several Glowworm
Packaging Co. invoices were double-paid. With a little sleuthing, you learn that half of the checks were indorsed
by Holly, Entrée’s bookkeeper, and deposited in her personal account. Assuming that Holly was not entitled to the
checks, who is likely liable on them and why?
 Checks, the Banking
System, and E-Money 25
FACING A LEGAL PROBLEM LEARNING OUTCOMES
O’Banion was the owner and operator of Superior The four learning outcomes
labeled LO1 through LO4 are
Construction. When Superior ran into financial designed to help improve your
problems, O’Banion arranged with Merchants understanding of the chapter.
Bank to honor overdrafts on the corporate account. After reading this chapter, you
should be able to . . .
O’Banion continued to write checks. When the account became
overdrawn, however, the bank refused to pay the checks. O’Banion LO1 Identify a bank’s duty to
honor checks.
suffered from a bad credit reputation, and Superior eventually went
out of business. Can O’Banion hold the bank liable for failing to pay LO2 State the rules regarding
liability arising from forged
the checks? drawers’ signatures or
alterations.
LO3 Outline a bank’s duty to
accept deposits.
LO4 Discuss the law with
respect to e-money.
Checks are the most common type of negotiable instruments regulated by the
Uniform Commercial Code (UCC). Checks are convenient to use because they
serve as substitutes for cash. To be sure, most students today tend to use debit
cards, rather than checks, for many of their retail transactions. Indeed, debit
cards account for more retail payments than checks. Nonetheless, commercial
checks remain an integral part of the American economic system, and they are
therefore worthy of study.
This chapter identifies the legal characteristics of checks and the legal
duties and liabilities that arise when a check is issued. Then it considers the
check deposit-and-collection process—that is, the actual procedure by which
checks move through banking channels, causing the underlying cash dollars to
be shifted from one bank account to another.

Checks
The bank-customer relationship begins when the customer opens a checking
account and deposits funds that will be used to pay for checks written. The
rights and duties of the bank and the customer are contractual and depend on
the nature of the transaction.
A check does not operate as an immediate legal assignment of funds between
the drawer and the payee. The funds in the bank represented by that check
do not immediately move from the drawer’s account to the payee’s account.
Furthermore, no underlying debt is discharged until the drawee-bank honors
the check and makes final payment. To transfer checkbook dollars among dif-
ferent banks, each bank acts as the agent of collection for its customer.
Whenever a bank-customer relationship is established, certain rights and
duties arise. The respective rights and duties of banks and their customers are
discussed in detail in the following sections.
323
324
LO1 Identify a bank’s duty to
honor checks.
overdraft
A check written on a checking
account in which there are
insufficient funds to cover the
check.
stale check
A check, other than a certified
check, that is presented for
payment more than six months
after its date.
stop-payment order
An order by the drawer of a draft
or check directing the drawer’s
bank not to pay the check.
UNIT FOUR ■ Negotiable Instruments
Honoring Checks
When a bank provides checking services, it agrees to honor the checks written
by its customers with the usual stipulation that there be sufficient funds avail-
able in the account to pay each check. When a drawee-bank wrongfully fails to
honor a check, it is liable to its customer for damages resulting from its refusal
to pay. When the bank properly dishonors a check for insufficient funds, it has
no liability to the customer.
The customer’s agreement with the bank includes a general obligation to
keep sufficient funds on deposit to cover all checks written. The customer is
liable to the payee or to the holder of a check in a civil suit if a check is not
honored. If intent to defraud can be proved, the customer can also be subject to
criminal prosecution for writing a bad check.
OVERDRAFTS
When the bank receives an item properly payable from its customer’s checking
account, but there are insufficient funds in the account to cover the amount
of the check, the bank can do one of two things. It can dishonor the item, or it
can pay the item and charge the customer’s account, creating an overdraft. To
hold the customer liable for the overdraft, the customer must have authorized
the payment and the payment must not violate any bank-customer agreement.
The bank can subtract the difference from the customer’s next deposit. If there
is a joint account, however, the bank cannot hold any joint-account customer
liable for payment of an overdraft unless the customer has signed the item or
has benefited from the proceeds of the item.
STALE CHECKS
The bank’s responsibility to honor its customers’ checks is not absolute. A bank
is not obliged to pay an uncertified check presented for payment more than six
months after its date. Commercial banking practice regards a check outstand-
ing for longer than six months as a stale check. A bank has the option of paying
or not paying on such a check without liability. The usual banking practice is to
consult the customer, who can then ask the bank not to pay the check. If a bank
pays in good faith without consulting the customer, it has the right to charge
the customer’s account for the amount.
DEATH OR INCOMPETENCE OF A CUSTOMER
Neither the death nor the mental incompetence of a customer revokes the
bank’s authority to pay an item until the bank knows of the situation and has
had reasonable time to act on the notice. Even when a bank knows of the death
of a customer, for ten days after the date of death, it can pay or certify checks
drawn on or before the date of death—unless a person claiming an interest in
that account, such as an heir or an executor of the estate, orders the bank to
stop payment. Without this provision, banks would constantly be required to
verify the continued life and competence of their drawers.
STOP-PAYMENT ORDERS
Only a customer or any person authorized to draw on the account can order
payment of a check (or any item payable by the bank) to be stopped—that is,
ask for a stop-payment order. This right does not extend to holders—that is,
payees or indorsees—because the drawee-bank’s contract is not with them, but
only with its drawers. Also, a stop-payment order must be received within a
reasonable time and in a reasonable manner to permit the bank to act on it.
C HA PTER 25 ■ Checks, the Banking System, and E-Money 325

Checking Account EXHIBIT 25–1

Bank of America Stop-Payment Order
®
A Stop-Payment Order
BANK USE ONLY
To: Bank of America NT&SA*
I want to stop payment on the following check(s). TRANCODE:
21—ENTER STOP PAYMENT
ACCOUNT NUMBER: (SEE OTHER SIDE TO REMOVE)

SPECIFIC STOP NON READS:

*CHECK UNPROC. STMT HIST:
*ENTER DOLLAR AMOUNT: NUMBER: PRIOR STMT CYCLE:
THE CHECK WAS SIGNED BY: HOLDS ON COOLS:
THE CHECK IS PAYABLE TO: REJECTED CHKS:
THE REASON FOR THIS STOP PAYMENT IS: LARGE ITEMS:
FEE COLLECTED:
STOP RANGE (Use for lost or stolen check(s) only.)
DATE ACCEPTED:
DOLLAR AMOUNT: 000 TIME ACCEPTED:
*ENTER *END
STARTING CHECK NUMBER: CHECK NUMBER:
THE REASON FOR THIS STOP PAYMENT IS:

I agree that this order (1) is effective only if the above check(s) has (have) not yet been cashed
or paid against my account, (2) will end six months from the date it is delivered to you unless
I renew it in writing, and (3) is not valid if the check(s) was (were) accepted on the strength of
my Bank of America courtesy-check guarantee card by a merchant participating in that
program. I also agree (1) to notify you immediately to cancel this order if the reason for the
stop payment no longer exists or (2) that closing the account on which the check(s) is (are)
drawn automatically cancels this order.
IF ANOTHER BRANCH OF THIS BANK OR ANOTHER PERSON OR ENTITY BECOMES A
“HOLDER IN DUE COURSE” OF THE ABOVE CHECK, I UNDERSTAND THAT PAYMENT MAY
BE ENFORCED AGAINST THE CHECK’S MAKER (SIGNER).
*I CERTIFY THE AMOUNT AND CHECK NUMBER(S) ABOVE ARE CORRECT.
I have written a replacement check (number and date of check).

(Optional—please circle one: Mr., Ms., Mrs., Miss) CUSTOMER’S SIGNATURE X DATE

*The abbreviation NT&SA stands for National Trust & Savings Association.

Although a stop-payment order can be given orally, usually by phone, it is

binding on the bank for only fourteen calendar days unless confirmed in writ-
ing. A written stop-payment order (see Exhibit 25–1) or an oral order confirmed
in writing is effective for six months, at which time it must be renewed in
writing. If the stop-payment order is not renewed, the check can be paid by the
bank, as a stale check, without liability.
If the drawee-bank pays the check over the customer’s properly instituted
stop-payment order, the bank will be obligated to recredit the account of the
drawer-customer for the actual loss suffered by the drawer because of the pay-
ment. This loss may include damages for the dishonor of subsequent items
(that is, items that would have been paid if the stop-payment order had been
honored).
Cashier’s checks (see Chapter 23) are sometimes used in the business com-
munity as nearly the equivalent of cash. Except in very limited circumstances,
payment will not be stopped on a cashier’s check. Once such a check has been
issued by a bank, the bank must honor it when it is presented for payment.

PAYMENT ON A FORGED SIGNATURE OF THE DRAWER

When a bank pays a check on which the drawer’s signature is forged, generally
the bank suffers the loss. A bank may be able to recover at least some of the
amount of the loss, however, from a customer whose negligence contributed
to the forgery, from the forger of the check, or from a holder who cashes the
check.

The General Rule. A forged signature on a check has no legal effect as the LO2 State the rules regarding
signature of a drawer. For this reason, banks require signature cards from each liability arising from forged
customer who opens a checking account. The bank is responsible for determin- drawers’ signatures or
ing whether the signature on a customer’s check is genuine. The general rule alterations.
is that the bank must recredit the customer’s account when it pays on a forged
signature.

Customer Negligence. When the customer’s negligence substantially con-

tributes to the forgery, the bank will not normally be obliged to recredit the
customer’s account for the amount of the check.
326 UNIT FOUR ■ Negotiable Instruments

IN THE COURTROOM
Compu-Net, Inc., uses a check-writing machine to write its payroll
and business checks. A Compu-Net employee—Mac Malto—uses the
machine to write himself a check for $10,000. Compu-Net’s bank sub-
sequently honors it. Under what circumstances can the bank refuse to
recredit $10,000 to Compu-Net’s account for incorrectly paying on a forged check?
If the bank can show that Compu-Net failed to take reasonable care in controlling
access to the check-writing equipment, Compu-Net cannot legally require the bank
to recredit its account for the amount of the forged check.

A customer’s liability may be reduced, however, by the amount of a loss

caused by negligence on the part of a bank. EXAMPLE 25.1 If a customer can
show that the bank should have been alerted to possible fraud (for instance,
if the bank knew the customer’s checks had been stolen), the loss may be allo-
cated between the customer and the bank.•

Timely Examination Required. A bank can either return canceled checks to

the customer or provide the customer with information to allow him or her to
reasonably identify the checks paid (number, amount, and date of payment). In
the second situation, the bank must maintain the ability to furnish legible cop-
ies of the checks on the customer’s request for a period of seven years.
A customer must examine monthly statements and canceled checks promptly
and with reasonable care and report any forged signatures promptly. This
includes forged signatures of indorsers. The failure to examine and report, or
any carelessness by the customer that results in a loss to the bank, makes the
customer liable for the loss. Even if the customer can prove that reasonable
care was taken against forgeries, discovery of such forgeries and notice to the
bank must take place within specific time frames for the customer to require
the bank to recredit his or her account.
When a series of forgeries by the same wrongdoer takes place, the customer,
to recover for all the forged items, must discover and report the first forged
check to the bank within thirty calendar days of the receipt of the bank state-
ment and canceled checks. Failure to notify the bank within this period of time
discharges the bank’s liability for all similar forged checks that it pays prior to
notification.

IN THE COURTROOM
ACTUAL CASE EXAMPLE
David Boyd is the president of Espresso Roma Corporation, which has
a checking account with Bank of America. Espresso employs Joseph
Montanez, whose duties include bookkeeping. Using stolen company
computer programs, Montanez prints company checks on his home computer. He
forges the checks in amounts totaling more than $300,000. When bank state-
ments containing the forged checks arrive in the mail, Montanez sorts through the
statements and removes the checks. Eighteen months later, Boyd discovers the
forgeries and reports them to the bank. Boyd files a suit against the bank, alleg-
ing unauthorized payment of the checks. Is the bank’s liability for payment of the
checks discharged? Yes. In a 2002 case, Espresso Roma Corp. v. Bank of America,
N.A., a California state court held that the bank was not liable because Boyd did
not report the first forged check to the bank within thirty days of his receipt of the
item. A customer must notify a bank no more than thirty days after the first forged
item is included in a monthly statement.
C HA PTER 25 ■ Checks, the Banking System, and E-Money 327

When the Bank Is Also Negligent. If the customer can prove that the bank was
also negligent, then the bank will also be liable. In this situation, an alloca-
tion of the loss between the bank and the customer will be made on the basis
of comparative negligence. In other words, even though a customer may have
been negligent, the bank may have to recredit the customer’s account for a por-
tion of the loss if the bank also failed to exercise ordinary care (ordinary care
means the observance of reasonable commercial standards, with respect to the
banking business in the geographical area).
Regardless of the degree of care exercised by the customer or the bank, a cus-
tomer who fails to report his or her forged signature within one year from the
date that the statement and canceled checks were made available for inspec-
tion loses the right to have the bank recredit his or her account.

Other Parties from Whom the Bank May Recover. When a bank pays a
check on which the drawer’s signature is forged, the bank has a right to recover
from the party who forged the signature.
The bank may also have a right to recover from the person (its customer or a
collecting bank) who cashes a check bearing a forged drawer’s signature. This
right is limited, however. A drawee-bank cannot recover from a person who
took the instrument in good faith and for value or who in good faith changed
position in reliance on the payment or acceptance. This means that in most
cases, a drawee-bank will not recover from the person paid, because usually
there is a person who took the check in good faith and for value or who in good
faith changed position in reliance on the payment or acceptance.

PAYMENT ON A FORGED INDORSEMENT

A bank that pays a customer’s check bearing a forged indorsement must re-
credit the customer’s account or be liable to the customer-drawer for breach
of contract. EXAMPLE 25.2 Simon issues a $500 check “to the order of Antonio.”
Juan steals the check, forges Antonio’s indorsement, and cashes the check.
When the check reaches Simon’s bank, the bank pays it and debits Simon’s
account. The bank must recredit the $500 to Simon’s account because it failed
to carry out Simon’s order to pay “to the order of Antonio.” Of course, Simon’s
bank can in turn recover—for breach of warranty (see Chapter 24)—from the
bank that cashed the check when Juan presented it.•
Eventually, the loss usually falls on the first party to take the instrument
bearing the forged indorsement because a forged indorsement does not trans-
fer title. Thus, whoever takes an instrument with a forged indorsement cannot
become a holder.
The customer, in any event, has a duty to report forged indorsements
promptly. Failure to report forged indorsements within a three-year period
after the forged items have been made available to the customer relieves the
bank of liability.

Accepting Deposits
A second fundamental service a bank provides for its checking-account custom- LO3 Outline a bank’s duty to
ers is that of accepting deposits of cash and checks. This section focuses on the accept deposits.
check after it has been deposited. Most deposited checks involve parties who
do business at different banks, but sometimes checks are written between cus-
tomers of the same bank. Either situation brings into play the bank collection
process.
328
depositary bank
The first bank to which an item
is transferred for collection, even
though it may also be the payor
bank.
payor bank
A bank on which an item is
payable as drawn (or is payable
as accepted).
collecting bank
Any bank handling an item for
collection, except the payor
bank.
intermediary bank
Any bank to which an item is
transferred in the course of
collection, except the depositary
or payor bank.
Federal Reserve System
A network of twelve central banks
headed by a board of governors,
to give the United States an
elastic currency, supervise and
regulate banking activities, and
facilitate the flow and discounting
of commercial paper. All national
banks and state-chartered banks
that voluntarily join the system
are members.
UNIT FOUR ■ Negotiable Instruments
THE COLLECTION PROCESS
The first bank to receive a check for payment is the depositary bank.
EXAMPLE 25.3 When a person deposits an Internal Revenue Service (IRS) tax-
refund check into a personal checking account at the local bank, that bank is
the depositary bank.• The bank on which a check is drawn (the drawee-bank)
is called the payor bank. Any bank (except the payor bank) that handles a
check during some phase of the collection process is a collecting bank. Any
bank (except the payor bank or the depositary bank) to which an item is trans-
ferred in the course of this collection process is called an intermediary bank.
During the collection process, any bank can take on one or more of the vari-
ous roles of depositary, payor, collecting, and intermediary bank. EXAMPLE 25.4 A
buyer in New York writes a check on her New York bank and sends it to a
seller in San Francisco. The seller deposits the check in her San Francisco bank
account. The seller’s bank is both a depositary bank and a collecting bank. The
buyer’s bank in New York is the payor bank. As the check travels from San
Francisco to New York, any collecting bank handling the item in the collec-
tion process (other than the ones already acting as depositary bank and payor
bank) is also called an intermediary bank. Exhibit 25–2 illustrates how banks
function in the collection process.•
Check Collection between Customers of the Same Bank. An item that is
payable by the depositary bank (also the payor bank) that receives it is called
an “on-us item.” If the bank does not dishonor the check by the opening of the
second banking day following its receipt, the check is considered paid.
IN THE COURTROOM
Otterley and Merkowitz both have checking accounts at First State
Bank. On Monday morning, Merkowitz deposits into his own check-
ing account a $300 check from Otterley. That same day, the bank
issues Merkowitz a provisional (temporary) credit for $300. When is
Otterley’s check considered honored, and when is Merkowitz’s provisional credit
final? When the bank opens on Wednesday, Otterley’s check is considered hon-
ored, and Merkowitz’s provisional credit becomes a final payment.
Check Collection between Customers of Different Banks. Once a depos-
itary bank receives a check, it must arrange to present it, either directly or
through intermediary banks, to the appropriate payor bank. Each bank in
the collection chain must pass the check on before midnight of the next bank-
ing day following its receipt. EXAMPLE 25.5 A collecting bank that receives a
check on Monday must forward it to the next collection bank before midnight
Tuesday.•
Unless the payor bank dishonors the check or returns it by midnight on the
next banking day following receipt, the payor bank is accountable for the face
amount of the check. Deferred posting (entering on the bank’s records) is per-
mitted, however, so that checks received after a certain time (say, 2:00 P.M.) can
be deferred until the next day. EXAMPLE 25.6 A check received by a payor bank
at 3:00 P.M. on Monday would be deferred for posting until Tuesday. In this
case, the payor bank’s deadline would be midnight Wednesday.•
How the Federal Reserve System Clears Checks. The Federal Reserve
System is a network of twelve government banks in which private banks have
accounts called reserve accounts. This system has greatly simplified the clear-
ing of checks—that is, the method by which checks deposited in one bank are
C HA PTER 25 ■ Checks, the Banking System, and E-Money 329

EXHIBIT 25–2
DRAWER The Check-Collection
Buyer issues check Process
to seller (payee).

DRAWEE AND PAYEE

PAYOR BANK Seller deposits check
New York bank in San Francisco
debits buyer’s bank (depositary and
(drawer’s) account for collecting bank).
the amount of the check.

INTERMEDIARY AND DEPOSITARY AND

COLLECTING BANK COLLECTING BANK
Denver bank sends San Francisco bank
check for collection sends check for
to New York bank collection to Denver
(drawee-bank and bank (intermediary
payor bank). and collecting bank).

transferred to the banks on which they were written. EXAMPLE 25.7 Suppose
that Pamela Moy of Philadelphia writes a check to Jeanne Sutton in San
Francisco. When Jeanne receives the check in the mail, she deposits it in her
bank. Her bank then deposits the check in the Federal Reserve Bank of San
Francisco, which transfers it to the Federal Reserve Bank of Philadelphia. That
Federal Reserve bank then sends the check to Moy’s bank, which deducts the
amount of the check from Moy’s account. Exhibit 25–3 on the following page
illustrates this process.•

Encoding and Retention Warranties. As part of the collection process,

checks may be encoded with information (such as the amount of the check)
that is read and processed by other banks’ computers. In many situations, a
check may be retained at its place of deposit, and only its image or informa-
tion describing it is presented for payment under a Federal Reserve agree-
ment, clearinghouse rule, or truncation agreement (truncation is presentation
of checks for payment by electronic means).
Any person who encodes information on a check, or with respect to a check,
after the check has been issued warrants to any subsequent bank or payor that
the encoded information is correct. This is also true for any person who retains
a check while transmitting its image or information describing it as presenta-
tion for payment. This person warrants that the retention and presentation of
the item complies with the Federal Reserve or other agreement.

AVAILABILITY OF DEPOSITS FOR WITHDRAWAL

In the traditional collection process, paper checks are physically transported
before they are cleared. The Expedited Funds Availability Act of 1987 and
Federal Reserve Regulation CC provide schedules that set out when the funds
represented by a check must be available for its depositor to withdraw. To
speed the process, Congress passed the Check Clearing in the 21st Century
Act (Check 21).
330 UNIT FOUR ■ Negotiable Instruments

EXHIBIT 25–3
How a Check Is Cleared

Pamela Moy
132 South Penn Ave. 20
Philadelphia, PA 45902

Pay to $

Dollars

FIRST NATIONAL BANK

OF PHILADELPHIA

Checking Account
CITY BANK Jeanne Sutton
San Francisco
+ $20.00

Reserve Account
FEDERAL RESERVE BANK City Bank
San Francisco
+ $20.00

Reserve Account
FEDERAL RESERVE BANK
First National Bank of Philadelphia
Philadelphia
– $20.00

Checking Account
FIRST NATIONAL BANK Pamela Moy
Philadelphia
– $20.00

Traditional Paper Processing. Any local check deposited must be avail-

able for withdrawal by check or as cash within one business day from the date
of deposit. The Federal Reserve Board of Governors has designated check-
processing regions. If the depositary and payor banks are located in the same
region, the check is classified as a local check. For nonlocal checks, the funds
must be available for withdrawal within not more than five business days.
In addition, the act requires the following:
1. The entire amount of certain deposits must be available (for withdrawal) on
the next business day. These deposits include cash deposits, wire transfers,
government checks, the first $100 of a day’s check deposits, cashier’s checks,
certified checks, and checks for which the depositary and payor banks are
branches of the same institution.
2. The first $100 of any other deposit must be available for cash withdrawal
on the opening of the next business day after deposit. If a local check is
deposited, the next $400 is to be available for withdrawal by no later than
5:00 P.M. the next business day.
A different availability schedule applies to deposits made at nonproprietary
automated teller machines (ATMs). These are ATMs that are not owned or
C HA PTER 25 ■ Checks, the Banking System, and E-Money 331

operated by the depositary institution. Basically, a five-day hold is permitted

on all deposits, including cash deposits, made at nonproprietary ATMs.
Other exceptions also exist. A depositary institution has eight days to make
funds available in new accounts (those open less than thirty days). It has an
extra four days on deposits over $5,000 (except deposits of government and
cashier’s checks), on accounts with repeated overdrafts, and on checks of ques-
tionable collectibility (if the institution tells the depositor it suspects fraud or
insolvency).

Check 21. Check 21 created a new negotiable instrument called a substitute

check. A substitute check is a paper reproduction of the front and back of an
original check. Banks create a substitute check from a digital image of the
original check. Every substitute check must include the following statement:
“This a legal copy of your check. You can use it in the same way you would use
the original check.”
Financial institutions can exchange digital images of checks instead of
the original paper checks. Banks that do not exchange checks electronically
are required to accept substitute checks as if they were the original checks.
Additionally, businesses and individuals must accept substitute checks as proof
of payment. Bank customers can no longer demand that their original checks
be returned with their monthly statements.
As Check 21 is implemented, the time required to process checks will be
substantially reduced. The Expedited Funds Availability Act requires that the
Federal Reserve Board revise the availability schedule for funds from depos-
ited checks to correspond to reductions in check-processing time. Therefore, as
the speed of check processing increases under Check 21, the Federal Reserve
Board will reduce the maximum time that a bank can hold funds from depos-
ited checks before making them available to the depositor. Thus, account hold-
ers will have faster access to their deposited funds.

LO4 Discuss the law with

E-Money respect to e-money.

digital cash
New forms of electronic payments (e-payments) have the potential to replace Funds contained on computer
physical cash—coins and paper currency—with virtual cash in the form of elec- software, in the form of secure
tronic impulses. This is the unique promise of digital cash, which consist of programs stored on microchips
funds stored on microchips and other computer devices. and other computer devices.

STORED-VALUE CARDS e-money

Prepaid funds recorded on a
The simplest kind of e-money system is one that uses stored-value cards. These computer or a card (such as a
are plastic cards embossed with a magnetic stripe containing magnetically smart card).
encoded data. Using a stored-value card, a person buys goods and services
offered by the issuer. EXAMPLE 25.8 University libraries typically have copy stored-value card
machines that students operate by inserting a stored-value card. Each time a A card bearing a magnetic stripe
student makes copies, the machine deducts the copy fee from the card.• that holds magnetically encoded
data, providing access to stored
funds.
SMART CARDS
Smart cards are plastic cards containing minute computer microchips. With a smart card
microchip, a smart card can do much more than maintain a running cash bal- A card containing a
microprocessor that permits
ance in its memory or authorize the transfer of funds.
storage of funds via security
programming, can communicate
Security Programming. A smart card carries and processes security pro- with other computers, and does
gramming. This gives smart cards an advantage over stored-value cards. not require online authorization
The microprocessors on smart cards can also authenticate the validity of for fund transfers.
332 UNIT FOUR ■ Negotiable Instruments

transactions. Retailers can program electronic cash registers to confirm the

authenticity of a smart card by examining a unique digital signature stored on
its microchip. (Digital signatures were discussed in Chapter 17.)

Deposit Insurance for Smart-Card Balances. Normally, all depository

institutions—including commercial banks and savings and loan associations—
offer federally backed insurance for deposits. The Federal Deposit Insurance
Corporation offers this deposit insurance. In 2008, the insurance limit reached
$250,000. For more on deposit insurance, see this chapter’s Linking the Law to
Your Career feature on page 334.
Most forms of e-money do not qualify as deposits and thus are not covered
by deposit insurance. If a bank becomes insolvent, an e-money holder is in the
position of a general creditor. He or she is entitled to reimbursement only after
nearly everyone else who is owed money is paid (except for other general credi-
tors). At that point, there may not be any funds left.

Legal Protection for Smart Cards. Some laws extend to e-money and
e-money transactions. The Federal Trade Commission Act of 1914 prohibits
unfair or deceptive practices in, or affecting, commerce. E-money issuers who
misrepresent the value of their products or make other misrepresentations on
which consumers rely may be liable for engaging in deceptive practices.
General common law principles, discussed in Chapter 1, also apply.
EXAMPLE 25.9 The rights and liabilities of e-money issuers and consumers are
subject to the common law of contracts. The parties’ relationships are affected
by the terms of the contracts to which they agree.• On the whole, however, it
is unclear how existing laws apply to e-money.

PRIVACY PROTECTION
At this time, it is not clear which, if any, laws apply to the security of e-money
payment information and e-money issuers’ financial records. This is partly
because it is not clear whether e-money issuers fit within the traditional defi-
nition of a financial institution.

E-Money Payment Information. Federal laws prohibiting unauthorized

access to electronic communications might apply to e-money transactions.
EXAMPLE 25.10 The Electronic Communications Privacy Act of 1986 prohibits
any person from knowingly divulging to any other person the contents of an
electronic communication while it is in transmission or in electronic storage.•

E-Money Issuers’ Financial Records. Under the Right to Financial Privacy

Act of 1978, before a financial institution may give financial information about
you to a federal agency, you must consent (or the agency must obtain a war-
rant). A digital cash issuer may be subject to this act if the issuer is deemed
to be (1) a bank by virtue of its holding customer funds or (2) any entity that
issues a physical card similar to a credit or debit card.

Consumer Financial Data. The Financial Services Modernization Act of

1999, also known as the Gramm-Leach-Bliley Act, places restrictions and
obligations on financial institutions to protect consumer data and privacy. All
financial institutions must provide their customers with information on their
privacy policies and practices. No financial institution can disclose nonpublic
C HA PTER 25 ■ Checks, the Banking System, and E-Money 333

personal information about a consumer to an unaffiliated third party unless

certain disclosure and opt-out requirements are met.

Online Banking
Banks have an interest in seeing the widespread use of online banking because
of the significant potential for profit. As in other areas of cyberspace, however,
it is unclear which laws apply to online banking activities.

ONLINE BANKING SERVICES

Most online bank customers use three kinds of services. One of the most pop-
ular is bill consolidation and payment. Another is transferring funds among
accounts. The third is applying for loans, although customers typically have to
appear in person to finalize the terms.
There are two important banking activities generally not yet available
online: depositing and withdrawing funds. With smart cards, however, people
could transfer funds on the Internet, thereby effectively transforming their
personal computers into ATMs.

REGULATORY COMPLIANCE
A bank is required to define its market area and provide information to reg-
ulators about deposits and loans under the Home Mortgage Disclosure Act
and the Community Reinvestment Act (CRA) of 1977. Under the CRA, banks
establish market areas contiguous to their branch offices. The banks map these
areas, using boundaries defined by counties or standard metropolitan areas,
and annually review the maps. This is to prevent discrimination in lending
practices.
How does a successful “cyberbank” delineate its community? Does an Internet
bank have any physical community? Is a written description of a cybercommu-
nity sufficient? Such issues are new, challenging, and certain to become more
complicated as Internet banking widens its scope.

ANSWERING THE LEGAL PROBLEM

In the legal problem set out at the beginning of
this chapter, when Superior Construction ran into
financial difficulties, Merchants Bank agreed to honor
Superior’s overdrafts. O’Banion, Superior’s owner
and operator, continued to write checks. When the account became
overdrawn, the bank refused to pay the checks. O’Banion suffered from
a bad credit reputation, and Superior eventually went out of business.
Can O’Banion hold the bank liable for failing to pay the checks? Yes.
When a bank agrees with a customer to pay overdrafts, the bank’s
refusal to honor checks on an overdrawn account is a wrongful
dishonor.
334 UNIT FOUR ■ Negotiable Instruments

Linking the Law to Your Career:

Banking Risks
You may choose a career that involves
running a small business, or you
might be involved in the world of
finance. Regardless, many careers
will undoubtedly lead to transactions
with banks. Your business may borrow
from a bank, deposit funds with a
bank, draw checks on a bank account,
conduct electronic fund transfers
through a bank, or engage in other
financial exchanges with banks.
You should be aware that the
federal government insures bank
deposits and this can often have
unintended consequences on bank
managers’ decisions.
Deposit Insurance
The Federal Deposit Insurance
Corporation (FDIC) and the Federal
Savings and Loan Insurance Corporation
(FSLIC) were created in the 1930s to
insure bank deposits. In 1971, the
National Credit Union Shares Insurance
Fund was added to insure credit union
deposits. Although the names and
form of some of these organizations
have changed over the years, the
principle remains the same: to insure
all accounts in banks, savings and loan
associations, and credit unions against
losses up to a specified limit.
Unintended Consequences
Federal insurance for bank deposits
may seem like a good idea, but
there are problems associated with
it. Depositors have little incentive to
investigate the financial condition or
lending activities of the depository
institutions in which they have
checking and savings accounts.
As a result, instead of banks being
owned and operated by individuals
who are prudent, many are managed
by those with a high tolerance for
taking risks with other people’s
money.
Bank managers must weigh the
trade-off between risk and return when
deciding which loan applicants should
receive funds. The riskier the loan,
the higher the interest rate a lending
institution will charge a borrower.
Thus, depository institution managers
have a greater incentive to make risky
loans. In the short run, the banks
make higher profits and the managers
receive higher salaries and bonuses.
If some of these risky loans are not
repaid, what is the likely outcome?
The banks’ losses are limited because
the federal government—you, the
taxpayer—will cover any shortfall
between the banks’ assets and their
liabilities. Consequently, federal deposit
insurance means that banks get to
enjoy all of the profits of risk taking
without bearing all of the consequences.

Terms and Concepts for Review

collecting bank 328 Federal Reserve System 328 smart card 331
depositary bank 328 intermediary bank 328 stale check 324
digital cash 331 overdraft 324 stop-payment order 324
e-money 331 payor bank 328 stored-value card 331

Chapter Summary—Checks, the Banking System, and E-Money

LO1 Identify a bank’s duty to honor checks. A bank has a duty to honor its customers’ checks if
the customers have sufficient funds on deposit to cover the checks. The bank is liable to its
customers for actual damages proved to be due to wrongful dishonor. The bank has a right to
charge a customer’s account for any item properly payable, even if the charge results in an
overdraft. The bank may charge a postdated check against a customer’s account, unless the
customer notifies the bank of the postdating in time to allow the bank to act on the notice. The
bank is not obligated to pay an uncertified check presented more than six months after its date.
A bank is liable for wrongful payment over a timely stop-payment order to the extent that the
customer suffers a loss, but a customer has no right to stop payment on a check that has been
certified or accepted by a bank. So long as a bank does not know of the death or incompetence
of a customer, the bank can pay an item without liability, and even with notice for ten days after
the customer’s death.
C HA PTER 25 ■ Checks, the Banking System, and E-Money 335

Chapter Summary—Checks, the Banking System, and E-Money, Continued

LO2 State the rules regarding liability arising from forged drawers’ signatures or alterations. A
customer has a duty to examine account statements with reasonable care on receipt and to notify
the bank promptly of any forged signatures or alterations. On a series of forged signatures or
alterations by the same wrongdoer, examination and report must be made within thirty calendar
days of receipt of the first statement containing a forged or altered item. The customer’s
failure to comply with these rules releases the bank from liability unless the bank failed to
exercise reasonable care, in which case liability may be apportioned according to a comparative
negligence standard. Regardless of care or lack of care, the customer is barred from holding the
bank liable after one year for forged customer signatures or alterations and after three years for
forged indorsements.

LO3 Outline the banks’ duty to accept deposits. A bank has a duty to accept deposits made by
its customers into their accounts. A bank also has a duty to collect payment on any checks
deposited by its customers. Funds represented by checks deposited must be made available to
customers according to the following rules:
(1) Check collection between customers of the same bank—A check payable by the depositar y
bank that receives it is an “on-us item,” and if the bank does not dishonor the check by the
opening of the second banking day following its receipt, the check is considered paid.
(2) Check collection between customers of different banks—Each bank in the collection process
must pass the check on to the next appropriate bank before midnight of the next banking day
following its receipt.
(3) Electronic check presentment—When checks are presented electronically, items are encoded
with information (such as the amount of the check) that is read and processed by other
banks’ computers, and in some situations, a check may be retained at its place of deposit,
with only its image or information describing it presented for payment.

LO4 Discuss the law with respect to e-money. Most forms of e-money are not covered by federal
deposit insurance, but general legal principles apply to e-money and e-money transactions.
E-money issuers who make misrepresentations on which consumers rely are liable for deceptive
practices.

Issue Spotters
1. Lynn draws a check for $900 payable to the order of
Jan. Jan indorses the check in blank and transfers it
to Owen. Owen presents the check to First National
Bank, the drawee bank, for payment. If the bank does
not honor the check, is Lynn liable to Owen? Could
Lynn also be subject to criminal prosecution? Explain
your answers.
2. Herb steals a check from Kay’s checkbook, forges
Kay’s signature, and transfers the check to Will for
value. Unaware that the signature is not Kay’s, Will
presents the check to First State Bank, the drawee.
The bank cashes the check. Kay discovers the forgery
and insists that the bank recredit her account. Can
the bank refuse to recredit Kay’s account? If not, can
the bank recover the amount paid to Will? Why or
why not?

Before the Test

Check your answers to the Issue Spotters and, at the First, click on “Answers to Issue Spotters” to compare
same time, take the interactive quiz for this chapter. Go to your answers. Next, select “Interactive Quiz” to assess
www.cengage.com/blaw/te and click on “Chapter 25.” your mastery of the concepts in this chapter.
336 UNIT FOUR ■ Negotiable Instruments
Hypothetical Questions
25–1. Online Banking. First Internet Bank operates
exclusively on the Web with no physical branch offices.
Although some of First Internet’s business is transacted
with smart-card technology, most of its business with its
customers is conducted through the mail. First Internet
offers free checking, no-fee money market accounts, mort-
gage refinancing, and other services. With what regula-
tion covering banks might First Internet find it difficult
to comply, and what might be the difficulty?
25–2. Forged Checks. Roy Supply, Inc., and R.M.R.
Drywall, Inc., had checking accounts at Wells Fargo
Real-World Case Problems
25–3. Forged Indorsements. In 1994, Brian and Penny
Grieme bought a house in Mandan, North Dakota. They
borrowed funds for the purchase through a loan program
financed by the North Dakota Housing Finance Agency
(NDHFA). The Griemes obtained insurance for the
house from Center Mutual Insurance Co. When a hail-
storm damaged the house in 2001, Center Mutual deter-
mined that the loss was $4,378 and issued a check for
that amount, drawn on Bremer Bank, N.A. The check’s
payees included Brian Grieme and the NDHFA. Grieme
presented the check for payment to Wells Fargo Bank of
Tempe, Arizona. The back of the check bore his signature
and in hand-printed block letters the words ND Housing
Finance. The check was processed for collection and paid,
and the canceled check was returned to Center Mutual.
By the time the insurer learned that NDHFA’s indorse-
ment had been forged, the Griemes had canceled their
policy, defaulted on their loan, and filed for bankruptcy.
The NDHFA filed a suit in a North Dakota state court
against Center Mutual for the amount of the check. Who
Ethical Questions
25–5. Why should a customer have to report a forged or
unauthorized signature on a paid check within a certain
time to recover the amount of the payment?
25–6. From the 1960s, James Johnson served as Bradley
Union’s personal assistant and was authorized by Union
to handle his banking transactions. Louise Johnson,
James’s wife, wrote checks on Union’s checking account
to pay his bills, normally signing the checks “Brad Union.”
Branch Banking & Trust Co. (BB&T) managed Union’s
account. In December 2000, on the basis of Union’s deteri-
orating mental and physical condition, a North Carolina
state court declared him incompetent. Douglas Maxwell
was appointed Union’s guardian. Maxwell “froze” Union’s
checking account and asked BB&T for copies of the can-
celed checks, which were provided by July 2001. Maxwell
Bank. Both accounts required all checks to carry two
signatures—that of Edward Roy and that of Twila June
Moore, both of whom were executive officers of both com-
panies. Between January 2006 and March 2008, the bank
honored hundreds of checks on which Roy’s signature
was forged by Moore. On January 31, 2009, Roy and the
two corporations notified the bank of the forgeries and
then filed a suit in a California state court against the
bank, alleging negligence. Who is liable for the amounts
of the forged checks? Why?
is most likely to suffer the loss in this case? Why? [State
ex rel. North Dakota Housing Finance Agency v. Center
Mutual Insurance Co., 720 N.W.2d 425 (N.Dak. 2006)]
25–4. Bank’s Duty to Honor Checks. Sheila Bartell was
arrested and subject to various charges related to bur-
glary, the possession for sale of methamphetamine, and
other crimes. She pleaded guilty in a California state
court to some charges in exchange for the dismissal of
others and an agreement to reimburse the victims. The
victims included “Rita E.,” who reported that her check-
book had been stolen and her signature forged on three
checks totaling $590. Wells Fargo Bank had “covered” the
checks and credited her account, however, so the court
ordered Bartell to pay the bank. Bartell appealed, argu-
ing that the bank was not entitled to restitution. What
principles apply when a person forges a drawer’s signa-
ture on a check? Is the bank entitled to recover from the
defendant? Explain. [People v. Bartell, 170 Cal.App.4th
1258, 88 Cal.Rptr.3d 844 (3 Dist. 2009)]
believed that Union’s signature on the checks had been
forged. In August 2002, Maxwell contacted BB&T, which
refused to recredit Union’s account. Maxwell filed a suit
on Union’s behalf in a North Carolina state court against
BB&T. Before Maxwell’s appointment, BB&T sent
monthly statements and canceled checks to Union, and
Johnson reviewed them, but no unauthorized signatures
were ever reported. On whom can liability be imposed in
the case of a forged drawer’s signature on a check? What
are the limits? Should Johnson’s position, Union’s incom-
petence, or Maxwell’s appointment affect the application
of these principles? Did anyone act unethically in this
case? Explain. [Union v. Branch Banking & Trust Co.,
176 N.C.App. 711, 627 S.E.2d 276 (2006)]