The Legal Environment Of Business

Dr. John Dehrer-Wendt

Uniform Commercial Code

UCC Article 3 Outline

      

  1. Overview

    Documents used to exchange credit or money are called "commercial paper".  It was created as an alternative to using cash or commodities.   Commercial paper comes in two basic forms -- orders and promises.  A promise involves two people, as when one party promises to pay another.  An order involves three parties, as when A orders B to pay C.  A negotiable instrument is a written unconditional promise or order to pay a certain amount to another party either on demand or at a definite time.  The most common form of a negotiable instrument is a check.

    Article 3 of the UCC covers negotiable instruments and Article 4 covers your relationship with your bank. 

  2. Types of Negotiable Instruments

A.  Promises

1.  Promissory Notes -- A written document in which a borrower agrees to repay a loan.  The maker makes and unconditional, written promiseto pay the payee a sum certain of money either on demand or at a specific time in the future.

2.  Certificate of Deposit  -- Issued by a financial institution, where the institution promises to payback to the depositor the sum deposited, plus interest at a stated rate at at specified time in the future.

B.  Orders

1.  Drafts -- Three party instruments. Drawer orders drawee to pay the payee.   A check is a special type of draft in which the drawee is the bank and the instrument is always payable on demand.

III.  Negotiablity

A.  Overview -- To be negotiable, an instrument must be:

1.  Written
2.  Be signed by the drawer or maker
3.  Contain an unconditional promise or order to pay a certain sum of money (3-105, 3-106, 3-112, 3-119)
4.  Be payable at a definite time or on demand (3-109)
5.  Payable to order (a specific person 3-110) or to the bearer (whoever has possession of the paper 3-111)

a.  "To order" means:

1)  Pay to the order of A
2)  Pay to A or his/her assigns
3)  Pay to A or his/her order
4)  Pay to the order of A and/or B, and
5)  Pay to A as the agent of B

b.  "To bearer" means:

1)  Pay bearer
2)  Pay to order of bearer
3)  Pay A or bearer, and
4)  Pay to the order of cash

B.  Advantages of Negotiable Instruments over Ordinary Contracts -- Even though negotiable instruments have more formal requirements, they do give holders some rights superior to those of someone trying to enforce and ordinary contract. 

In addition, negotiable instruments are easier to enforce than ordinary contracts for a number of reasons, including that consideration is presumed and past consideration is sufficient.

However, the most important reason is that in an ordinary contract, the assignee is subject ot personal defenses, in a negotiable instrument there can be a special holder of an instrument called a "Holder in Due Course."

IV.  Negotiation

A.  Overview --  The main reason negotiable instruments are used is due to safe and easy manner in which they can be transferred from one party to another.  The transfer processs where the transferee becomes a "holder" is known as "negotiation." 

A "holder" posesses an instrument that passed to himor her via an unbroken chain of negotiation and was issued, drawn, or indorsed to bearer or to his/her order.

1.  Bearer paper -- Negotiated just be change od possession ("delivery")

a.  Checks made out to "Cash" or indorsed in blank (the holder's name is just signed in the back. 

b.  Whoever holds the instrument, even those who are not the lawful owner, may use it.

2.  Order paper -- Requires not only delivery, but also the proper indorsement.  Without the proper indorsement, the person in possession is a mere transferee.  To get payment, transferee must show that they have title to the instrument. 

B.  Indorsements

Overview -- An indorsement is the signature of the holder on the negotiable instrument so the the title of the instrument and the holder's property interest in the instrument are transferred to the new holder. 

Types of Indorsements

Blank -- An instrument just signed by a particular indorsee.  This is the same as making the instrument payable to bearer.

Special Indorsements -- Specify to whom or to whose order the instrument is payable "Pay to the Order of Ed Mayer"

Restrictive Indorsements -- restrictive by making it dependent on certain conditions, to try to limit further transfer, to be designated for deposit, or for the benefit of someone else.

Disclaimer -- "Without Recourse" puts subsequent  holders on notice that the indorser disclaims liability on the instrument if it is not paid.

V.  Holders in Due Course

A.  Overview -- There is a special type of holder called a "Holder in Due Course" that is generally not subject to claims or personal defenses that could be raised by the original parties to the instrument. 

B.  Requirements for a Holder in Due Course (HDC) (3-302) -- The holder must take a negotiable instrument for value in good faith and without notice that it is overdue, has been dishonored, or has claims against it

C.  Defenses -- This is the heart and soul of the HDC status because the HDC's status distinguishes between "real" defenses (which works against even the HDC) and "personal" defenses which will not. 

The HDC is usually free of personal, but not real, defenses.

1.  Real Defenses (HDC loses) 

a.  Fraud in the execution.  The maker, drawer or indorser is led to believe that he/she is signing something else other than an instrument

b.  Forgery

c.  Other defenses enough to make the contract void, including extreme duress, illegality and in some cases incapacity

d.  Discharge of the instrument, if the holder knew or should have known of the discharge

e.  Discharge in bankruptcy

f.  Statute of limitation

g.  Important changes in the instrument -- those giving it a different legal effect, e.g. changing a $10 check to $10,000.

2.  Personal Defenses (HDC wins) includes

a.  Lack or failure of consideration

b.  Fraud in the inducement

c.  Ordinary contract defenses (e.g. another party's breach)

d.  Defenses making the contract voidable (e.g. undue influence, minors)

e.  Violation of a restrictive indorsement (e.g. a prior transferee's cashing a check indorse "for deposit only")

f.  Nonbankruptcy discharges of which the holder has no notice

g.  Lack of agency

h.  Unauthorized completion of an instrument

VI.  Liabilities Among Parties

A.  Overview -- With negotiable instruments, a person may be liable on the underlying contract and may also be liable on the instrument itself if it contains his signature.  The parties have either primary or secondary liability .  

Primary Liability includes makers and drawees -- The primary party is required to pay on an instrument as it existed when it was drafted by the maker or accepted by the drawee.   A secondary party usually can assume that the primary party will pay on the instrument

Secondary Liability includes drawers and indorsers -- When the primary party has not paid, the secondary party will be required to pay if: 1) the person seeking payment first went to the primary party, and 2) the secondary party received notice that the primary party refused to pay.  (Secondary parties can avoid potential liabilities on an instrument by signing "without recourse."

B.  Liability Based on the Instrument

1.  Negligent Persons (3-406) If a person's negligence substantially contributes to a material alteration or an unauthorized signature, that person cannot use the alteration or signature as a defense against a HDC.

Examples of Negligence:

a.  Upon receiving notice that forgeries are occurring, failure to act to prevent more forgeries

b.  Delivery of an instrument to the wrong person

c.  Failure to audit corporate books

2.  Impostors or Fictitious Payees (3-405) Indorsements are effective for negotiation when (1) an impostor induced the drawer or maker to issue the instrument to the impostor; or (2) the payee was never intended to have an interest in the instrument

3.  Signers Without Capacity or Authority (3-207) Negotiation is effective even though it may be subject to recission because of incapacity, illegality, duress, fraud, mistake or breach of duty.  Negotiation cannot be rescinded against a HDC if the problem amounts to a personal defense, not a real defense

VII.  Warranties on Presentment or Transfer

A.  Overview -- There can be liability on warranty.  Any person who receives   payment or acceptance of an instrument, or who transfers and receives consideration, makes certain warranties.

B.  Presentment Warranties -- Are given to any person who in food faith pays or accepts the instrument.  They are imposed on the person who obtains payment or acceptance and all prior transferors.  These warranties are:

1.  The person has good title to the instrument

2.  The person has know knowledge that the maker's or drawer's signature is unauthorized

3.  The instrument has not been materially altered

C.  Warranties on Transfer -- Are made by any person who transfers the instrument and receives consideration.  These warranties are:

1.  The person has good title

2.  All signatures are genuine or authorized

3.  The instrument has not been materially altered

4.  The transferor has no knowledge of any insolvency proceeding

5.  No party's defense is good against the transferor (e.g. "without recourse" limits this warranty to a guarantee that the transferor does not know of such a defense)

 

    1. The following are not forms of negotiable instruments under Article 3
    1. Investment Securities (covered under Article 8)
    2. Warehouse Receipts (covered under Article 7)
    3. Money (currency) (The purpose of negotiable instruments is to act as a substitute for money)
  1. Negotiability (3-104) (in order to tell if an instrument is negotiable, the holder of the note must look to the face of the instrument. Under 3-104 the instrument must meet the following requirements in order to be negotiable)
    1. Be in WRITING
    2. Be SIGNED by the maker of the note or the drawer of the check
    3. Be an UNCONDITIONAL promise (note) or order (draft) to pay.
    1. Negotiable
    1. If the instrument refers how the transaction arose. The instrument would be nonnegotiable if the instrument was governed or conditioned on the transaction
    2. If an instrument is secured by a mortgage, the instrument is still negotiable

 

    1. Sum Certain in Money
    2. Be PAYABLE ON DEMAND or at a DEFINTIED TIME
    3. Be PAYABLE TO ORDER or to BEARER
    1. Bearer paper – General Rule is that bearer paper will contain the word "Bearer"
    2. Order Paper – General Rule is that order paper should be issued to a specific named person with the words "or to his order" The Revised Article does not require the draft to be "payable to order’" the instrument may day "Pay To"
  1. Transfer and Negotiation
    1. General Rules
    1. In order to negotiate order paper, there must be endorsement and delivery
    2. In order to negotiate bearer paper, there must be delivery
    1. Endorsement
    1. General Rules
    1. Since endorsements appear in the back of an instrument, endorsements cannot change the negotiability of an instrument.
    2. Since no one is liable on an instrument unless his/her name appears on it, endorsements are used to create liability. Hence, the transferees can demand the unqualified endorsement of their immediate transferor
    1. Types of Endorsement
    1. Blank – Changes order paper to bearer paper
    2. Special – Changes bearer paper to order paper
    3. Qualified, e.g. "Without recourse" – a qualified endorsement that negate contract liability and limits certain transfer warranties to knowledge warranties
    4. Restrictive – Does not change the negotiability
  1. Holder in Due Course (CORE OF ARTICLE !!!!!!!!!)

The central question of Article 3 is to determine if the holder of an instrument is a HDC. The HDC is in a stronger position and subject to fewer defenses than a mere holder. In addition, the HDC can pass their status to other transferees under the "Shelter Principle."

    1. Creation of HDC
    1. A HOLDER – Under 1-201 (20) a holder is a person in possession of a negotiable instrument and who has good title. In other words, the instrument contains all necessary signatures, and there are no forgeries. If the instrument contains a forgery, then no one can be a holder since the potential holder does not have good title. If not one can be a holder, then no one can be a HDC.
    2. Of a NEGOTIABLE INSTRUMENT
    3. Who takes the instrument for VALUE
    4. In GOOD FAITH
    5. And WITHOUT NOTICE that the instrument is
    1. OVERDUE, or
    2. Has been DISHONORED, or
    3. Any DEFENSE or CLAIM to it on the part of any person
    1. Defenses – A HDC is subject to "universal" or "real" defenses, but is not subject to "personal" defenses. (KNOW THESE!!!!!!!!!!)
    1. Real or Personal Defenses (HDC is subject to and hence, loses)
    1. Infancy, Incapacity, Duress and Illegality (UCC 3-305(2)(a) and (b))
    2. Forgery (execution by one who is without authority to sign)
    3. Discharge in Bankruptcy
    4. Fraud in the Execution (Differs from "Fraud in the Inducement) (In Fraud in the Execution, the signer of the instrument has been deceived to believe the instrument they signed is not a negotiable instrument, e.g someone wants your autograph, but you just signed a promissory note. This is Fraud in the Execution and a HDC would lose).
    5. Material Alteration – While a HDC is subject to the defenses of a material alteration in the cases of a raised amount, the HDC is still an HDC for the original amount of the instrument
    1. Personal Defenses (HDC is not subject to, and hence, wins!)
    1. Breach of contract
    2. Non-performance of a condition precedent
    3. Lack of consideration
    4. Wrongful filling of a blank payable amount by the issuer
    5. Stolen instrument or other claims of ownership
    6. Fraud in the Inducement (e.g the Seller fraudulently induces a commercial buyer to sign a contract for aluminum siding, when infact the siding is made out of cardboard. An HDC is not subject to this type of fraud and can still demand payment. The commercial buyer’s recourse is to sue the salesman)
    1. The Shelter Principle – If a person can trace their ownership back to an HDC, then the person will have the rights of an HDC (e.g a transferee who receives the instrument as a gift)
  1. Liability
    1. Contract Liability – General Rule is that no one has contract liability on the instrument unless their signature appears
    1. Primary Liability – a party who has primary liability is required to pay the original tenor of the instrument
    1. The maker of a promissory note is primarily liable
    2. The acceptor of a draft (when a bank certifies a check) is primarily liable. No one is primarily liable on a check at issue!
    1. Secondary Liability – here the party is not immediately liable on the instrument
    1. Who is liable?
    1. Drawers
    2. Endorsers
  1. Discharge
    1. Discharge by Payment
    2. Discharge by Renunciation (This absolute surrender of rights to the instrument must be in writing)
    3. Certification (Certification by the bank discharges the drawer and any prior endorsers, if certification is asked by the holder. If the drawer requests certification, then the drawer remains secondarily liable

-30-

Index on Class Notes

MBLW 600

AMBA 740

Home