Commercial Paper, Banks, and the Banking System

Commercial Paper, Banks, and the Banking System


Commercial Paper, Banks, and the Banking System

Unit IV

Chapter 12 Introduction to UCC Article 3: Commercial Paper

In this chapter you will:

• Distinguish between an assignment and a negotiation.

• Identify the types of commercial paper.

• Identify the criteria that make an instrument negotiable.

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Chapter 13 Transfer and Negotiation of Commercial Paper and Rights of Holders

In this chapter you will:

• Understand how different types of commercial paper are issued and negotiated.

• Identify the requirement of endorsements.

• Explain how to negotiate paper to a holder in due course and the significance of this negotiation.

Chapter 14 Liability of Parties to Commercial Paper and Warranties of Transfer and of Presentment

In this chapter you will:

• Identify all of the parties on a negotiable instrument and their respective rights and liabilities.

Chapter 15 Banks, the Banking Process, and Electronic Transfers

In this chapter you will:

• Identify the types of checks commonly seen in banking.

• Understand the debtor–creditor relationship as it relates to businesses and banks.

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Introduction to UCC Article 3:

Commercial Paper


This chapter begins a unit dealing with commercial paper: checks, drafts, notes, and certificates of deposit. The law governing this area is in Article 3 of the Uniform Commercial Code. Commercial paper is an essential part of the business environment in which you operate. Your company pays its bills, borrows money, and deals with customers using all forms of commercial paper. Although it is technically possible to carry out business strictly on a cash basis, the realities of commerce necessitate the use of readily acceptable substitutes for cash as well as financial instru- ments that make it easy to lend and borrow money. It’s simply not practical—or safe—to carry what can often be very large sums of paper money needed for business transactions. It should come as no surprise, then, that the majority of business transactions are carried out by check or credit.

Commercial paper (which is also called a negotiable instrument) serves two major functions. First, it is a substitute for cash. When your business writes a check to purchase goods, this is a convenient and safe way to send a payment through the mail, for example, as opposed to sending cash. Second, commercial paper is a way to loan money. Notes are a common format for promising to pay some- one back for a loan. In order for commercial paper to be readily accepted as a substitute for cash or as a means of extending credit, persons accepting such paper or instruments must have some clear assurance that they will be honored when they are presented for payment.

Although negotiable instruments have been around for many centuries, the UCC has consolidated the common law into a single comprehensive code, updating and modernizing it. As an incentive to make commercial paper attractive to persons who accept it in the normal course of business, the law provides certain guarantees to those who accept such instruments in good faith and pay value for them.

12.1 Distinguishing Between an Assignment of Rights and a Negotiation

In order to understand what makes negotiable instruments “special,” it is necessary to under-stand the difference between an assignment and a negotiation. In any contract, there is a division of rights and duties between the parties. For example, sup- pose that the seller agreed to sell 70 new automobiles to the buyer, a wholesaler, for $2,100,000. The seller has the duty under this contract to deliver the automobiles and the right to be paid the $2,100,000. In turn, the buyer has the right to receive the automobiles and the duty to pay, as illus- trated in Figure 12.1.

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Figure 12.1: Rights and duties of two parties to a transaction

Note that each party to the contract has rights and duties. Every contract can be dia- grammed this way. While the seller in the diagram would most likely deliver the cars to the buyer and receive the money, there is another option that occurs in business of which you should be aware: the seller could take the right to the money and assign it to another person so that the latter would have the right to receive the money from the buyer. This is called an assignment of rights. Suppose that this seller owed money to a third party and, instead of receiving the money personally from the buyer, assigned the rights to the money he or she was going to receive from the buyer to that third party. Now the transac- tion would look like what is shown in Figure 12.2.

Figure 12.2: Rights and duties of parties to a contract assignment

The seller (the party who is assigning his or her rights) is called the assignor. The third party is the assignee. In this illustration, the buyer would pay the assignee the money instead of the seller, but the seller would still have the duty to deliver the automobiles. The assignment of rights illustrated has nothing to do with the duties; in other words, the duties are separate from the rights and must be performed regardless of what the parties “do” with their “rights.”

Section 12.1 Distinguished Between an Assignment of Rights and a Negotiation CHAPTER 12

RIGHTS To be paid

DUTIES To deliver


RIGHTS To the cars

DUTIES To pay for the cars



RIGHTS To be paid

DUTIES To deliver


RIGHTS To the cars

DUTIES To pay for the cars


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Section 12.1 Distinguished Between an Assignment of Rights and a Negotiation CHAPTER 12

Now let’s assume that the buyer and the seller have entered into the same transaction for automobiles, but this time, instead of the buyer giving the seller a check for $2,100,000, the buyer promises to pay by giving the seller an IOU stating “IOU $2,100,000 in 90 days.” We could configure this transaction to look like what is shown in Figure 12.3.

Figure 12.3: Buyer–seller transaction

Now assume that the seller has delivered the automobiles to the buyer and received the IOU. The seller then assigns the IOU (the right to the money) to a third-party assignee. Now the diagram would look like what is shown in Figure 12.4.

Figure 12.4: Third-party transaction

Now suppose that 15 days go by and the buyer goes out to his or her automobile lot and inspects the cars that the seller delivered. He or she discovers that the paint jobs on all of them are substandard, greatly reducing their value. He or she calls up the seller and says, “I don’t want these cars; they are not what I bargained for. I am not paying on that IOU that is due in 90 days.” The assignee thinks he or she is going to be paid in 90 days and knows nothing about the disagreement between the seller and the buyer.

So what effect will the substandard cars have on the promised payment to the third party? The answer to the question is this: We say that third parties (assignees) take subject to any disputes or defenses between the buyer and the seller. Thus, if the buyer refuses to pay, the third party will not get paid either. Of course, this is a major problem for the third party, who thought he or she was getting paid $2,100,000 after 90 days passed. Any third party who is aware that he or she might not get paid is going to refuse to be an assignee. Why would a third party want to take paper that is subject to problems between the seller and the buyer? The answer is, he or she would not. There is a solution to this problem, however. Article 3 of the UCC has created a way to transfer paper so that it is just like cash, and so that the assignee will be paid even if there is a problem between the seller and the buyer.

Using the concept of an assignment and the idea that the third party takes “subject to” the problems between the buyer and the seller, assume instead that in Figure 12.4 the buyer gave the seller a note in payment for the cars, a type of commercial paper, and that the note was negotiated (transferred) from the buyer to the seller to the third party. If the third


Delivery of the Automobiles

Payment by an IOU in 90 days


Delivery of the Automobiles

Payment by an IOU in 90 days

Payment by an IOU in 90 days

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Section 12.1 Distinguished Between an Assignment of Rights and a Negotiation CHAPTER 12

party qualifies as a special party called a holder in due course, the third party takes free from, and not subject to any disputes between, the buyer and the seller. In other words, the holder in due course gets paid regardless of any disputes between the buyer and the seller. If you think about it, that is just as if cash were being passed down the line, and the third party had the cash in hand. In this way, a note is just like cash, in that it is “taken free” from the dispute between the parties. Indeed, all commercial paper is set up to flow like cash and to give third parties the same benefits as people receiving cash.

IF a negotiable instrument is negotiated (not assigned) to a holder in due course (not an assignee), then the holder in due course takes free from personal defenses between the buyer and the seller, subject only to real defenses.

Thus, the system of commercial paper rests on four key concepts:

1. You must be able to distinguish between commercial paper that is negotiable and paper that is nonnegotiable;

2. You must be able to distinguish between assigning paper and properly negotiat- ing paper;

3. You must be able to determine if the third party in the chain of holders of paper is a holder in due course as opposed to an assignee; and

4. You must be able to tell if the defense raised between the buyer and the seller is a real defense or a personal defense.

To understand the rule of negotiable instruments, we will first discuss how to determine whether paper is negotiable or nonnegotiable.

12.2 Types of Commercial Paper

There are four types of commercial paper: drafts, checks, notes, and certificates of deposit. No matter what type of paper, it can be negotiable or nonnegotiable. First we will discuss the different types of commercial paper; then we will discuss what makes each of these negotiable or not.

Drafts and Checks

Drafts and checks are referred to as three-party paper because there are three parties to the instrument: the drawer, the drawee, and the payee. By definition, a draft is an order instrument by a drawer to a drawee to pay a specified payee. For example, think about the last time that you wrote a check. You were the drawer because you drew the check; the check says on its face, “Pay to the order of _____.” That is the order that you, the drawer, are giving to the bank, the drawee, to pay the payee. Thus we speak of a draft as order paper because it is an order by the drawer to the drawee to pay the payee.

While all drafts are three-party paper, not all drafts are checks. A check is a particular type of draft in which the drawee is always a bank; but a draft can be drawn on a private person or another entity. An illustration of a check appears in Figure 12.5, showing each of the parties.

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Section 12.2 Types of Commercial Paper CHAPTER 12

Figure 12.5: Sample check

Figure 12.6 depicts a draft that is not drawn on a bank, but instead, drawn on “Motley Dutcher.”

Figure 12.6: Sample draft

Are checks and drafts negotiable or nonnegotiable? To be negotiable (negotiability is dis- cussed in Section 12.3), six conditions must be met. If any of the elements are missing, then the instrument is nonnegotiable. Just because paper is a draft or a check does not ensure



DATE June 15, 2012

Michael Sherman

Jackie Sherman


Five Hundred and no








⑉0011957⑆ ⑈ 0597087 ⑈ 87159–095

June 15th, 2012

Elizabeth Eastie

Five thousand and no/100 ———— DOLLARS $5,000.00

Groton, New York


To Motley Dutcher Ithaca, New York


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Section 12.2 Types of Commercial Paper CHAPTER 12

its negotiability. All checks and drafts are negotiable checks and drafts or nonnegotiable checks and drafts.


Notes are two-party paper consisting of the person promising to pay (the maker) and the person to be paid (the payee). On the face of the note, the maker says, “I promise to pay.” This has great legal significance. Because the maker says, “I promise,” the maker is pri- marily liable on the instrument under a contract theory. Contrast this with a draft, in which the drawer orders the drawee to pay the payee. Since the drawer does not say, “I promise,” but instead is ordering the drawee to pay the payee, we say that no one is pri- marily liable on a draft. This will become important later when we discuss the liability of parties to commercial paper.

Another important characteristic of notes that is not true of drafts is that notes can be used for credit. This is because notes can be payable in the future, for example, “90 days from [date],” which extends credit for 90 days, as illustrated in Figure 12.7.

Figure 12.7: Sample note

After you inspect the instrument in Figure 12.7, notice that it is two-party paper, with a maker and a payee; thus, you can correctly conclude it is a note. Also notice that the maker, Chrissie MacIntosh, says, “I promise to pay,” which is the basis for her (primary) liability on the instrument.

June 24th, 2012




Ninety Days from date (without grace), I promise to pay to the order of Easton Joelie the sum of Twenty-Five Thousand and no/100 dollars for the value received with interest of 8.49 percent per annum compounded daily from the above date until paid. Both principal and interest are payable only in lawful money of the United States. Payable at: 107 Pleasant Avenue, Santa Fe, New Mexico Due: September 24, 2012

Chrissie MacIntosh



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Section 12.3 Negotiability Requirements CHAPTER 12

Certificates of Deposit

Another type of two-party paper that evidences debt is a certificate of deposit (CD). The only difference between a note and a CD is that a CD is issued only by a bank or other financial institution as evidence of its debt to a named creditor or depositor. When- ever you invest in a bank CD, you might think of the transaction as a deposit of money. In reality, however, you are lending the bank money under the terms specified by the CD. Under its terms, the bank issues you its promise to repay you, at a stated time in the future, your principal plus interest at a specified rate and sets forth penalties for failing to comply with the terms. This is illustrated in Figure 12.8.

Figure 12.8: Sample certificate of deposit

Are notes and CDs negotiable or nonnegotiable? Again, to be negotiable, the note or CD must meet six specific conditions. If any of those six elements are missing, then the instru- ment is considered nonnegotiable. Just because paper is a note or a CD does not neces- sarily make it negotiable. What makes paper negotiable is discussed in the next section.

12.3 Negotiability Requirements

Regardless of the form of commercial paper (checks, drafts, notes, or certificates of deposit), Article 3 of the UCC requires that, to be negotiable, such an instrument must meet all of the following criteria:

DATE: October 1, 2012

Senior Vice President


For value received, the BUBBA BANK promises to pay to Laurel and Moose Southard the principal sum of Ten Thousand Dollars ($10,000.00) with interest eighteen months (18 months) from the date hereof at the rate of Four and One Quarter Percent (4.25%) per annum compounded daily. The said principal and interest shall be payable in lawful money of the United States of America at 82 Apple Blossom Road, Santa Fe, New Mexico, or at any branch of the BUBBA BANK in the state.

BUBBA BANK 82 Apple Blossom Road Santa Fe, New Mexico

Jonathan Albanese




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Section 12.3 Negotiability Requirements CHAPTER 12

• It must be in writing; • It must be signed by the maker or drawer; • It must contain an unconditional promise or order to pay a sum certain in money; • It must contain no other promise or obligation; • It must be payable on demand or at a definite time; and • It must be payable to order or bearer unless it is a check.

An instrument that meets all these criteria qualifies as a negotiable instrument. An instru- ment that fails to meet one or more of the noted criteria may still be a valid instrument, but it will not qualify for the special status of a negotiable instrument but rather be nonnegotiable.

A Signed Writing

The UCC does not define what constitutes a writing for purposes of creating a negotiable instrument. Nonetheless, the requirement of being a signed writing has been liberally con- strued by the courts to include words written on nearly any portable surface that affords some permanence. No specific words need to be used in creating a negotiable instrument as long as the writing meets all the requirements for negotiability. Thus, even though most checks are routinely written on preprinted forms supplied by the financial institution in which the drawee maintains a checking account, a check can technically be written on nearly any surface capable of accepting writing. A valid check, note, draft, or even a CD can be written on a legal pad, loose-leaf paper, a shirt, or even a coconut shell (though it might take some convincing to get someone to accept such an instrument!).

Likewise, the writing can be set down using a typewriter, computer printer (impact, ink- jet, or laser will all do nicely), pen, crayon, pencil, or even lipstick. Using any medium that is easy to erase, however, can lead to problems if the instrument is later altered. And, as with a negotiable coconut, using an exotic writing implement may well make the instru- ment unacceptable to most payees.

As holds true for type of paper and writing implement, the requirement of a signature is rather liberally construed by the courts. The UCC specifically states:

A signature may be made (i) manually or by means of a device or machine, and (ii) by the use of any name, including any trade or assumed name, or by a word, mark, or symbol executed or adopted by a person with present intention to authenticate a writing.

Thus, an X marked on paper, a scanned signature, or a signature reproduced on a rubber stamp are all perfectly valid, as is the signed or printed name or initials of any signer, as long as these are used intentionally as a signature. This definition is particularly relevant to the age of electronic transactions in which we live.

Must Contain an Unconditional Promise to Pay a Sum Certain in Money

In order to be negotiable, an instrument must, on its face, make an unconditional promise to pay a specific amount of money. Hence, a check that reads: “Pay to the order of Paul

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Section 12.3 Negotiability Requirements CHAPTER 12

Payee $200 if the U.S. wins the 2015 Soccer World Cup” is not a negotiable instrument because the promise to pay is conditioned on a future event.

A negotiable instrument must be payable in cash. This requirement is met if it is payable in the legal tender of any country; thus, a draft payable in Japanese yen, euros, pounds ster- ling, or pesos is perfectly negotiable if it meets all the other requirements of a negotiable instrument. An instrument payable in a foreign currency, unless otherwise noted on the instrument itself, can be paid either in the stated currency or in the U.S. equivalent of the currency at the time and place of its presentment for payment.

In addition, the amount payable on the instrument must be ascertainable from the instru- ment itself, either directly or indirectly. Directly means that if you picked up the instru- ment, you would be able to figure out how much it is promising to pay. Indirectly means that if the instrument says, “I promise to pay you the current rate as determined by the cur- rent index,” then you would have to reference a source for this determination. Therefore, an instrument payable with fixed or variable interest is still negotiable, even if the interest payable must be ascertained by referring to information not provided in the instrument. This is because the amount can be determined indirectly by referencing a source. If the interest cannot be ascertained from the instrument itself or by reference to outside infor- mation, then the instrument is not ascertainable. For example, a note stating, “Payable to Laura R. at the judgment rate at the place of payment when the interest first accrues,” would be nonnegotiable because it would be impossible to determine the amount owed, even with outside information.

Must Contain No Other Order or Obligations

Negotiable instruments must contain an unconditional promise to pay only a sum certain in money. If the instrument cites other obligations or promises, along with the promise to pay money, then that instrument will not be negotiable. For example, a promise by a carpenter to “pay $50 and build a deck” contains additional promises, making the instru- ment nonnegotiable.

Must Be Payable on Demand or at a Definite Time

Negotiable instruments must be payable either on demand or at a definite time. Instru- ments such as checks, which are not usually payable at a specific time, are considered demand instruments: that is, they are payable at any time on demand as soon as they are issued. For instruments that are payable on or after a specific date, all that is required is that the payor clarify on the instrument itself when it is payable. Thus, an instrument that is payable “30 days from today” or “on July 1, 2012” is a time instrument and satisfies the requirement of specificity as to date payable.

It is very common in business to see commercial paper that contains either an accelera- tion clause or an extension clause. If you read one of these clauses, your first reaction would probably be that the instrument is nonnegotiable because these clauses look like they make the date due indefinite. Nevertheless, extension and acceleration clauses do not necessarily make paper nonnegotiable because they are an exception to the rule of a “definite time.”

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Key Terms CHAPTER 12

acceleration clause A contract provision that enables a lender to demand payment of a loan if a certain event happens (e.g., the debtor misses payments), making the entire debt due and payable.

Article 3 of the UCC The section of the Uniform Commercial Code that sets out the rules for commercial paper.

assignee The person who is assigned rights under a contract from an assignor.

assignment of rights Transferring one’s rights under a contract to a third party.

assignor The person who transfers rights under a contract.

bearer instruments Instruments payable to bearer, cash, or the order of cash.

certificate of deposit (CD) A type of two- party commercial paper issued by a bank or other financial institution as evidence of its debt to a named creditor or depositor. In it, the maker agrees to pay the payee a set amount of money after a certain amount of time.

check Three-party commercial paper in which the drawer orders the drawee (usu- ally a bank) to pay the payee.

An example of an acceleration clause would be “In the event the maker defaults or is late on payment, the entire note is due and payable.” Of course, because the maker’s default date is uncertain, this is not a definite time; nevertheless, the note is negotiable.

An extension clause that makes the note payable to a date certain in the future and is extended by the holder does not render the paper nonnegotiable. For example, an exten- sion clause might say: “The holder may, at her option, extend the time of payment to June 15, 2013.” Since the holder is extending the date of payment, and the date is certain, the note is still negotiable. However, if the instrument is payable only upon the occurrence of an event that is not certain to occur (such as “when the New York Yankees next win the World Series”), then it is nonnegotiable.

Must Be Payable to Order or to Bearer

An instrument must be payable either to the order of a specific person (or persons) or company, or to bearer. An instrument is payable to order if it states that it is payable to a specifically ascertainable person, company, or group of people. An instrument is payable to bearer if it is payable to no specifically identifiable person but rather to anyone who lawfully has it in his or her possession. To make an instrument payable to no specifically ascertainable person or company, one uses such terms as “pay to bearer,” “pay to the order of bearer,” “pay to cash,” “pay to the order of cash,” or similar language. A check made payable to “Life, the universe, and everything,” for example, is a bearer instrument, since it names no specifically ascertainable person; its effect is the same as drawing a check to the order of “Cash” as a payee. Alternatively, a check made payable to the order of “First National Bank of Ohio, savings account #A123456” would be payable to the registered owner or owners of the account and would be a negotiable instrument because there is sufficient information on the face of the instrument.

Key Terms

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Critical Thinking and Discussion Questions CHAPTER 12

Critical Thinking and Discussion Questions

1. What are the four types of commercial paper? 2. What is the fundamental difference between an assignment and a negotiation? 3. What are the basic requirements that every instrument must meet in order to be a

negotiable instrument? 4. Suppose that Hector wrote a note payable to your company and signed it with

an X. All other elements of a negotiable instrument were present. Would this be a negotiable note?

5. Suppose your company sold a product to a buyer who asked whether he could issue a draft payable to your company “on the condition that the product is satis- factory.” What would be the ramification of accepting such an instrument?

commercial paper Also called a negotiable instrument, paper used in business in the place of money: a note, draft, check, or certificate of deposit.

demand instrument A type of commercial paper that is payable at whatever time it is presented for payment.

draft Three-party paper in which the drawer orders the drawee to pay the payee; here, the drawee is not a bank, but an individual or a private company.

drawee The party on which an order for payment is made by the drawer. For checks, the drawee is always a bank.

drawer The maker of a draft ordering the drawee to make payment to a specified payee.

duties The obligation under a contract.

extension clause A contract provision allowing the parties to lengthen the term of the contract, after its expiration date.

holder in due course The third party to a transaction, following a payee, who has elevated status and can get paid on commercial paper even if a dispute arises between the seller and the buyer, in most circumstances.

instrument Another name for commercial paper.

negotiable instrument Instrument meet- ing all six requirements of negotiability so that the third party receiving it can be a holder in due course.

negotiated The transference of a negotia- ble instrument by physical delivery or by endorsement plus delivery.

note Two-party commercial paper in which the maker promises to pay the payee.

order instrument Commercial paper ordering the drawee to pay the payee. An instrument is payable to order if it states that it is payable to a specifically ascertain- able person, company, or group of people.

payee The person who is paid.

rights Entitlements of a person who enters into a contract.

third party The third person in line when commercial paper is transferred from the maker to the payee or from the drawer to the payee.

time instrument An instrument that is payable at a certain time, as stated on the face of the instrument.

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Critical Thinking and Discussion Questions CHAPTER 12

6. Miko issues a note to Lola for $500. The note is made payable one year from the date of issue with interest, but no interest rate is specified. Is the instrument valid, and if so, what interest rate applies?

7. Suppose that Brenda and Miguel enter into a valid, enforceable contract in which Brenda agrees to sell to Miguel 100 cords of wood for $1,000.

a. Draw a diagram showing each party’s respective rights and duties under the contact.

b. Now add to that diagram Carla, to whom Brenda promised her money from the wood deal.

c. How does the manner in which Brenda gets paid affect Carla’s rights in the contract?

d. Assume that Miguel promises Brenda in a written IOU that he will pay her in 90 days for the delivery of the wood. Brenda gives the IOU to Carla. Miguel receives the wood and is disgusted by its quality and refuses to pay on his IOU. What recourse does Carla have against Miguel? Against Brenda?

e. Assume that Brenda gave Carla a negotiable note instead of an IOU. Would your answer change? What recourse does Carla have against Miguel? Against Brenda?

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