As we have seen throughout this unit, the primary purpose of negotiable instruments is to facilitate commercial transactions by acting as a substitute for cash or as evidence of debt and a guarantee of its repayment. We’ve also seen that there is an element of risk to persons who issue negotiable instruments. Such persons must generally pay holders in due course under the terms of the instrument and are barred from asserting most defenses to its payment. If we ended our discussion of commercial paper here, it might well seem that the risk inherent in the negotiation of these instruments is an unacceptable one. Fortunately, the makers and drawers of negotiable instru- ments do have a measure of protection against most adverse circumstances that can arise out of the transfer of these instruments.
Liability is based on two separate theories:
1. Through the contractual and signature liability that arises from the transfer of a negotiable instrument; and
2. From the warranties that automatically attach when such instruments are negotiated or pre- sented for payment to the drawees or makers.
In this chapter, we will explore the liability of parties to commercial paper as well as the warranties of transfer and presentment that arise from their negotiation.
14.1 Liability of Parties to Commercial Paper
There are essentially two types of liability that parties to commercial paper can have: signature liability and contractual liability. Signature liability arises from the act of signing a nego-tiable instrument in order to create or transfer it. Contractual liability attaches based on the relationship that parties have to one another with regard to the instrument being created or negoti- ated. We will examine both types of liability in turn.
Contractual and Signature Liability
Before a person can be found to have any liability on a negotiable instrument, either his or her signa- ture must appear on the instrument, or the instrument must be signed by an authorized agent on the
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Section 14.1 Liability of Parties to Commercial Paper CHAPTER 14
person’s behalf. The Uniform Commercial Code, which governs negotiable instruments, is rather liberal in determining what constitutes a signature. The UCC essentially holds that any mark made by a party with the intention of having it serve as a signature is valid.
The mere fact that a person’s signature appears on commercial paper can subject the signer to incur some type of liability for the instrument. It is not necessary that the signer receive any consideration for signing or have any relationship to the instrument; instead, all that is required is that the signature be genuine and that the signer intentionally placed it on the instrument. So, for example, if Albert asks Betty to carry a check over to Charlie, who is 10 feet away, and Betty signs on the reverse of the check before giving it to Charlie, she has incurred signature liability.
Liability on a Draft
You will recall from Chapter 12 that drafts are a type of three-party paper in which the drawer (who writes the draft) orders the drawee (the entity paying the check) to pay the payee. Although the drawer signs the front of the draft, the drawer’s liability is not pri- mary but rather secondary. This means that if someone holding the check wishes to get paid, he first has to go to parties primarily liable for payment before he can go to parties secondarily liable for payment. Primary and secondary liability refers to the order in which people are liable for paying: if the party primarily liable refuses to pay, then the party secondarily liable will have to pay (see Table 14.1). The problem is that, on a check, no one is primarily liable.
As a result, people often request a certified or bank check. When this occurs, the drawee or bank becomes primarily liable. If you want to be guaranteed payment on a check, this is the best thing to do. To obtain such a check, the drawer usually goes to his or her bank and presents a personal check and requests that the bank certify the check. If the bank agrees to do so, the bank is in essence guaranteeing payment on the check, or assuming primary liability. The bank will clearly mark the front of the check with a word such as “CERTI- FIED” or “ACCEPTED.” Why would the bank assume liability? Because it will have first checked its customer’s account to determine whether the money is available to pay the check. If it is, the bank will move the money out of the customer’s account to another account, from which the bank will pay the certified check. The money is now guaranteed because the bank has set it aside. Accordingly, it will charge the customer for this service.
Liability for Unauthorized Signatures
In general, individuals are not liable to pay on negotiable instruments unless they sign them. If an unauthorized signature is placed on a negotiable instrument (forged, for exam- ple), the signature is ineffective. If a person’s checkbook is stolen during a house bur- glary, and the thief writes a check for $20,000 from the account, the bank must recredit the account. As long as the owner of the checkbook was not negligent in how she handled her checkbook (e.g., did not leave it lying around), then the bank will be liable for paying out on a forged signature. This is because when the drawer opened an account at the bank, she filled out and signed a signature card. So now, the bank has the obligation to corrobo- rate the signature when presented with a check for payment. Even if the thief presented the check to another bank, say in a different state, that bank would eventually present the check for payment and the drawer’s bank would have a duty to verify the signature.
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Liability of Agents
Similarly, if a person claiming to act as an agent on behalf of a principal signs a nego- tiable instrument on the principal’s behalf but does so without the principal’s authority, the unauthorized signature is ineffective as to the principal. Suppose an employee steals his employer’s checkbook out of his desk drawer and writes a check, signing it as the employer’s agent. Because this pseudo-agent had no authority to do so, the bank is liable for paying out on the check. To guard against this type of fraud, banks require that agents with signatory authority fill out information, including their signatures, and do not pay out on such checks without corroborating the agent’s authority and signature. And, as for liability on a forged draft, if a person’s negligence contributed to the unauthorized instrument (such as leaving a checkbook out at work, making a signature stamp available to anyone at a business, or leaving company checks lying around), then the defense of unauthorized signature may not be asserted against a holder in due course (for more on holders in due course, see Chapter 13).
Liability of Endorsers
Endorsers of negotiable instruments have secondary liability for payment of the instru- ment. This means that if the party primarily liable fails to pay on the instrument when it is presented, the holder of the instrument can then turn to the party secondarily liable for payment.
Liability of Accommodation Parties
Often, a seller will require that someone else lend good credit to the buyer. For example, a minor wishing to buy a car might have the parents cosign a note in order to get approval. Parties who cosign are referred to as accommodation parties. An accommodation party can be a codrawer, a coendorser, or a comaker. Depending on which capacity he signs in, he is either primarily or secondarily liable on the instrument. For example, a comaker has primary liability, as does a maker; in contrast, a coendorser has secondary liability, as does an endorser.
Table 14.1: Contractual liability of parties to negotiable instruments
Primary Liability Secondary Liability
Notes or CDs The maker, because he/she says, “I promise to pay . . .” The co-accommodation party because they say, “We promise to pay. . .”
Drafts No one, unless a bank (drawee) accepts a check by certifying it or issuing it as a bank check
Drawers Endorsers Accommodation Coendorsers
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Section 14.2 Warranties on Presentment and Transfer CHAPTER 14
14.2 Warranties on Presentment and Transfer
In addition to the contractual liability of parties to commercial paper discussed above, another kind of liability arises for all parties who transfer or present commercial paper, even if they never signed or endorsed the paper. These are called presentment warran- ties and transfer warranties.
Suppose that an employee receives a paycheck and endorses it to the holder in due course. The holder in due course will then present the check for payment. Note that the holder in due course probably does not know the payee’s employer. Nevertheless, when the holder presents the check to the bank, that holder is giving three promises in the simple action of presenting it for payment:
1. The holder has a “right” to payment; that is, all the endorsements are genuine; 2. The instrument has not been altered, meaning, for example, that the presenter
has not changed the monetary amount; and 3. If it is a draft, the signature of the drawer is genuine.
If the check turns out to be a fake from the employer/drawer, the bank can then “go after” the holder/presenter for payment, based on the presentment warranty.
The other type of liability one can incur when dealing with commercial paper is a trans- fer warranty. This refers to passing along the commercial paper. Sometimes, paper is endorsed down a chain of people, although statistically, this is rare. Nevertheless, every- one who touches and transfers commercial paper for consideration (as opposed to giving it as a free gift) has some sort of liability. The five transfer warranties 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 altered; 4. The instrument is not subject to a defense or claim in recoupment of any party
that can be asserted against the warrantor; and 5. The warrantor has no knowledge of any insolvency proceeding commenced with
respect to the maker or acceptor or, in the case of an unaccepted draft, the drawee.
Presentment of an instrument is a demand made by a person entitled to enforce the instrument that it be paid or accepted (an acknowledgment by a maker or drawee that the instrument is valid and will be paid when due) (see UCC §3-501(a)). Normally, pre- sentment of an instrument to the party primarily liable for acceptance is a prerequisite to invoking secondary liability on that instrument. Presentment has several criteria: it may be made at the place of payment of the instrument (if the instrument is payable at a bank in the United States, it must be made at the place of payment), may be made by any
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Key Terms CHAPTER 14
commercially reasonable means, and is effective when the demand for payment or accep- tance is received (UCC § 3-501(b)(1)).
If the party to whom presentment is made is a bank, then it may treat presentment as occurring on the next business day after the day of presentment if it has established a cutoff hour not earlier than 2:00 p.m. for the review and processing of instruments pre- sented for payment or acceptance and the presentment is made after the cutoff hour (UCC § 3-501(4)).
Notice of Dishonor
If an instrument is presented for payment, but payment is refused, we say the instrument has been dishonored. Notice of dishonor may be given by any commercially reasonable means, including written, oral, and electronic communications (UCC § 3-405(b)) to the party who is liable on that instrument or to a third party who may be compelled to pay it.
The UCC sets forth various rules for giving this notice. For example, if the notice of dis- honor is given by a bank that has taken the instrument for collection, it must give such notice by midnight of the next banking day following the banking day on which the bank itself received notice of dishonor of the instrument (UCC § 3-503(c)). Notice of dishonor given by any other person taking an instrument for collection must be given within 30 days following the day the person receives the notice of dishonor (UCC § 3-503(c)). For any other instrument (e.g., those not taken for collection), notice of dishonor must be given within 30 days following the day on which dishonor occurs (UCC § 3-5-3(c)). Note, however, that an endorser can disclaim his or her contractual liability by endorsing the instrument “without recourse” (UCC § 3-415(b)).
accommodation parties Parties who cosign a note. They can be a codrawer, a coendorser, or a comaker. Depending on their signing capacity, they are either primarily or secondarily liable on the instrument.
certified or bank check A negotiable instrument that is clearly marked “CERTI- FIED,” “ACCEPTED,” or similarly. The bank agrees to guarantee payment on the check and to assume primary liability. The bank will set aside funds from the cus- tomer’s account for this and charge the customer a convenience fee.
contractual liability The obligation that arises on a negotiable instrument because of the relationship between the parties.
dishonor Refusal to make payment on a negotiable instrument when it is presented for payment.
endorser (or indorser) Someone who lends a signature to an instrument and thereby has secondary liability for pay- ment of the instrument.
notice of dishonor Communication that an instrument presented for payment has not been honored, given by a bank or other party to the person who may be liable on the instrument or any other holder or third party.
presentment A demand, made by a per- son entitled to enforce an instrument, that it be paid or accepted.
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Critical Thinking and Discussion Questions CHAPTER 14
presentment warranty Promises made in the action of presenting a check for pay- ment. They include the right to payment, the fact that the instrument is genuine and has not been altered, and a valid signature.
primary and secondary liability The order in which people are liable for pay- ing; if the party primarily liable refuses to pay, then the party secondarily liable will have to pay.
signature liability This sort of obligation arises from the act of signing a negotiable instrument in order to create or transfer it.
transfer warranty The chain of endorse- ments for commercial paper that gives everyone who touches it some liability.
Critical Thinking and Discussion Questions
1. What are the two types of liability of parties to commercial paper? 2. Which parties to commercial paper have primary liability for its payment? 3. What two basic types of warranties are involved in commercial paper
transactions? 4. What are the three warranties of presentment, and when are they available? 5. What are the five warranties of transfer, and to whom do they apply? 6. When must presentment be made if the instrument does not specify a time for
presentment? 7. Sam Slick, a crook, finds a check made out to Pamela Payee in the amount of
$10 on Pamela’s desk at work. He steals the check, changes the amount to $100, forges Pam’s signature, and specially endorses the check to himself as endorsee. The next day, Sam negotiates the instrument to Ignacio Innocent, a coworker who does not know of the theft or alteration of the check and who proceeds to pay Sam $100 for the instrument.
a. What transfer warranties has Sam breached in negotiating the check to Ignacio?
b. What transfer warranty or warranties has Sam not breached in negotiating the instrument?
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Critical Thinking and Discussion Questions CHAPTER 14
8. Examine the sample instrument that follows and then answer the questions that relate to it.
a. What type of instrument is this? b. If Pedro deposits the check in his account and it turns out that Diane did not
have sufficient funds to cover the instrument, how long does Pedro’s bank have to notify him of the dishonor when it learns of it?
c. How may the bank notify Pedro of the dishonor?
DATE March 11, 2012
PEDRO PAYEE 100.00
One hundred and no/100 – – – – – – – – – – – – – – – – – – – – – – – – – – – –
Diana Drawer 25 Ocean View Fort Walton Beach, FL 32547
Sunny Bank of Florida One Glorious Pl. Ft. Walton Beach, FL 32549
PAY TO THE ORDER OF
⑉01234567⑆ ⑈ 8901109 ⑈ 100–0195
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