Transfer and Negotiation of Commercial Paper and Rights of Holders 13

Transfer and Negotiation of Commercial Paper and Rights of Holders 13

So far, we have established that if an instrument is negotiated to a third party called a holder in due course, that party has an elevated status over an assignee. For the holder in due course to attain this elevated status, the instrument must be negotiable. This means that it must meet all six requirements, as set forth in Article 3 of the UCC (see Section 12.3 in Chapter 12). This chapter explores yet another requirement: that the instrument must be properly negotiated.

If the instrument is not properly negotiated, then the third party could be an assignee or a holder but not a holder in due course. A proper negotiation is critical to creating holder-in-due-course status. Negotiation is the actual physical transfer of the commercial paper to the third party, which we will discuss in more detail further on. First, however, let us begin with the concept of issuance.

13.1 Issuance and Negotiation

When the drawer makes a check payable to the payee and hands it to the payee, that pro-cess is called issuance. Issuance is the physical delivery of the instrument to the payee, as illustrated in Figure 13.1. Since the payee is the second person in line, he or she cannot qualify as a holder in due course.

Figure 13.1: Issuance

When the payee delivers the instrument to a third party, as in Figure 13.2, the rules regarding negotia- tion and holders in due course come into play.

Drawer 1st

Payee 2nd

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Section 13.1 Issuance and Negotiation CHAPTER 13

Figure 13.2: Issuance and negotiation

The UCC defines negotiation as “a transfer of possession, whether voluntary or involun- tary, of an instrument by a person other than the issuer to a person that thereby becomes its holder” (UCC §3[201]). A proper and effective negotiation depends on whether the paper is order paper or bearer paper.

As noted at the end of Chapter 12, all commercial paper is either order paper or bearer paper. Order paper contains language such as “Pay to the order of ___“ or “Pay to [a specific person or entity],” for example, “Pay to the order of Paul Jones” or “Pay to Mil- lennium Enterprises.” Bearer paper, on the other hand, includes the word bearer or cash, for example, “Pay to Bearer,” “Pay to the Order of Bearer,” “Pay to Cash,” or “Pay to the Order of Cash.” Why is this significant? Because order paper and bearer paper are negoti- ated differently, as we will now discuss.

Bearer Paper

Bearer paper is negotiated by physical delivery of the instrument alone. For example, if Joe made out a check “Pay to the order of cash” and handed it to Lisa, and Lisa handed the same check to Robert, a proper negotiation has taken place. Merely physically passing the check from one person to the next constitutes negotiation by physical delivery. By the same token, if Joe dropped the check on the street and Michelle picked it up, since it is payable to the order of cash, and therefore bearer paper, she could take it to the bank and cash it. After all, the transfer by delivery is to anyone who holds it. For this reason, bearer paper can create problems if not handled properly. There is a way to convert bearer paper to order paper so that it doesn’t fall into the wrong hands, but at this point be mindful that anyone who is in physical possession of bearer paper can cash it.

Order Paper

Unlike bearer paper, order paper cannot be negotiated or transferred by delivery alone but instead requires an endorsement (spelled either endorsement or indorsement).

Let’s say that Lisa made a check payable to Amelia and handed it to Amelia (recall that this is called issuance). Because on its face it says, “Pay to the order,” if Amelia now wishes to pay her telephone bill with that same check, she will need to indorse it in order to transfer it any further. She could turn it over and write her name on the back. Or she could write on the back, “Pay to the order of AT&T Telephone Co.” and sign it Amelia. In any event, on its face, the instrument payable to the order of a specific person or company can be further negotiated only by endorsement plus delivery, and not by delivery alone, as Figure 13.3 illustrates.

Third Party 3rd

Payee 2nd

Drawer 1st

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Section 13.2 Requirements of Endorsements CHAPTER 13

Figure 13.3: Issuance with endorsement and delivery

13.2 Requirements of Endorsements

The UCC provides that an endorsement must be written by the endorser (or on his behalf) either directly on the instrument or on a separate piece of paper that is per-manently attached to the instrument, called an allonge (from the French allonger, to draw out). In the event that an instrument is made payable to a person with her name misspelled or even with a mistaken name, it is lawful for the payee to indorse the instru- ment using either her correctly spelled or true name or the misspelled or incorrect name. A person accepting transfer of the instrument, however, can demand that the endorsee in such circumstances sign with both the correct and misspelled or incorrect name.

Blank Endorsements

There are four different types of endorsements that a holder can place on commercial paper. Suppose that a blank endorsement is simply the signature of the payee written on the back of the check. Suppose, for example, that Bobby issues a check that on its face says, “Pay to the order of Sarah Jessica.” He then issues the check to Sarah Jessica. On its face, the instrument is order paper because it has the language, order; therefore, it needs an endorsement plus delivery to be further transferred. Sarah Jessica turns over the check and signs just her name—by definition, a blank endorsement. By so doing, she changed the order paper into bearer paper. Now this check can be negotiated by mere physical transfer. It also has the vulnerability of being picked up and cashed by anyone in physical possession. In short, a check that is indorsed in blank is a bearer instrument and can be further negotiated merely by physically transferring it to a third party. Figure 13.4 pro- vides an example of a blank endorsement.

Issuance Endorsement + Delivery

“Pay to the order of Amelia” “Pay to the order of AT&T”

AT&TAmeliaLisa

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Section 13.2 Requirements of Endorsements CHAPTER 13

Figure 13.4: A blank endorsement

Special Endorsements

Another type of endorsement is called a special endorsement. It specifies the person or persons to whom the instrument is made payable. For example, if a check states on its face, “Pay to the Order of Sarah Jessica,” and she turns it over and writes, “Pay to the Order of Verizon Wireless,” she has endorsed to a specifically identifiable person or company, and now the instrument cannot be further negotiated without that person’s endorsement. In Figure 13.5, the front of the check signifies order paper, and the special endorsement on the back retains this characteristic. Thus, this check will need another endorsement to properly transfer it to a fourth party. Remember that order paper needs endorsement plus delivery.

May 12, 2012

Pay to the order of

DOLLARS

Sarah Jessica One Hundred and 00/ 00

Sarah Jessica

$ 00.00

BUBBA BANK Irving Mayer

BLANK ENDORSEMENT CONVERTS THE ORDER PAPER INTO BEARER PAPER

Order Paper

FRONT OF CHECK

BACK OF CHECK

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Figure 13.5: A special endorsement

Restrictive Endorsements

The third type of endorsement is called a restrictive endorsement. This places a condition on further negotiating the instrument. For example, the endorsement might say, “Pay to the Order of Robert Bradley if he receives an A in his law course.” Interestingly, a restric- tive endorsement does not affect the negotiability of the instrument. This is because nego- tiability is determined only from the front of the instrument, not the back. It also means that Robert Bradley could get a “C” in his law class and still transfer the check to another person. In other words, the named endorsee is free to further negotiate the instrument regardless of whether the restrictive condition is met or not.

The last type of endorsement is one that says, “For deposit only,” “Pay any bank,” or “For collection.” Students find this concept confusing because, here too, the check can be negotiated further. A third party could accept the check from Robert Bradley. However, if that party takes the check to the bank looking to cash it, the bank must obey the restric- tive endorsement or be held liable. The rule under the UCC is that “Such endorsements are generally valid, and any person, bank, or entity that takes the instrument for value inconsistent with the endorsement converts the instrument.” If the bank converted the instrument, it would have to recredit the account.

Pay to the Order of Verizon Wireless

Sarah Jessica

May 12, 2012

Pay to the order of

DOLLARS

Sarah Jessica One Hundred and 00/ 00

$ 00.00

BUBBA BANK Irving Mayer

SPECIAL ENDORSEMENT

FRONT OF CHECK

BACK OF CHECK

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Section 13.3 General Rules Applicable to Commercial Paper CHAPTER 13

13.3 General Rules Applicable to Commercial Paper

Numerous mistakes can occur when writing a negotiable instrument. In this section we will look at instruments that have unusual characteristics that may put the holder on notice that there is something amiss or may even affect the negotiability of the paper.

Antedating and Postdating Negotiable Instruments

The negotiability of an instrument is unaffected by postdating or antedating. If, for example, a check issued on August 1 is postdated for September 1, it is still a negotiable instrument.

Incomplete Instruments

A negotiable instrument that has not been completely filled out by the maker or drawer cannot be enforced until it is complete. However, it is permissible for the holder of an incomplete instrument to complete it by filling in missing information, as long as the completion is authorized. If a completion is unauthorized, the rules relating to material alteration apply, and the instrument is generally void. The burden of proving an unau- thorized material alteration rests with the party making the assertion that the instrument has been materially altered without authorization.

UCC Article 3 (§ 3-302) holds that good-faith additions to negotiable instruments by per- sons who have the instrument in their possession are generally lawful unless they are unauthorized. A person receiving a check on which the date has been omitted, for exam- ple, could safely insert the date on which the check was negotiated to him or her. In addi- tion, a blank check (a check that is signed by the maker but is otherwise incomplete) can be lawfully filled out by the person to whom it is given, as long as the drawer intended to authorize the person to do so.

Instruments Payable to Two or More Persons

An instrument payable to two or more alternative parties can be negotiated by any of the named parties alone. If an instrument is negotiated to two or more parties jointly, however, the signatures of both parties are necessary to effect lawful negotiation. If, for example, a check is made payable to Jane or John Doe (payable in the alternative), either John or Jane may cash the entire check. If the check is made out to John and Jane Doe (payable jointly), however, both John and Jane’s signatures would be required to negotiate the check.

Contradictory Terms of Instrument

When an instrument contains contradictory terms, the rule is that “typewritten terms prevail over preprinted terms, handwritten terms prevail over both, and words prevail over numbers” (UCC Article 3 (§ 3-114)). Consider the check in Figure 13.6. As you can see, there is a conflict between the amount of $100.00 and the written words “One Thou- sand and 00/100 Dollars.” According to the rule “words prevail over numbers,” “One

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Section 13.4 Holders in Due Course CHAPTER 13

Thousand and 00/100 Dollars” prevails over the dollar amount “$100.00.” Likewise, if the words “One Thousand” had been preprinted and “$100.00” was handwritten, then the handwritten dollar amount “$100.00” would have prevailed.

Figure 13.6: Contradictory terms of instrument

Note that the negotiability of an instrument is unaffected by postdating or antedating. If, for example, a check issued on May 12 is postdated for June 12, it is still a negotiable instrument.

13.4 Holders in Due Course

For a third party to a transaction to be a holder in due course, he or she must first be the holder of a negotiable instrument. The UCC defines a holder as “the person in possession [of a negotiable instrument] if the instrument is payable to bearer or, in the cases of an instrument payable to an identified person, if the identified person is in possession” (UCC §3[309]). Thus, the original payee of a note or draft is a holder when the instrument is delivered to him or her. Also, all persons to whom instruments are trans- ferred with special endorsements in their benefit or with blank endorsements become holders.

A holder in due course (HDC) is a very special person in the law, with attendant special rights and privileges. Attaining holder in due course status therefore requires that one meet a number of requirements.

1. The person must be the holder of a negotiable instrument. 2. The holder must give value for the instrument (usually holders pay to receive

the paper).

May 12, 2012

Pay to the order of

DOLLARS

Sarah Jessica One Thousand and 00/ 00

$ 00.00

BUBBA BANK Irving Mayer

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Section 13.4 Holders in Due Course CHAPTER 13

3. The holder must take “in good faith without notice that it is overdue or has been dishonored . . . or has an unauthorized signature or has been altered.” For exam- ple, if someone hands the holder a check with smudges, crossed-out figures, or obvious forgeries, one cannot be a holder in due course because one is “on notice” that something is wrong with the instrument.

In summary, to be a holder in due course, one must take:

1. A negotiable instrument; 2. For value; and 3. Without notice that it is “ODD”—overdue, has been dishonored, or has defenses

against it.

Significance of Being a Holder in Due Course

Suppose that the following occurred: Millennium Industries entered into a contract to purchase 1,000 units of steel from Mighty Steel Company. Millennium issued an IOU, payable in 90 days (a nonnegotiable instrument), in the amount of $10,000.00 payable to Mighty Steel Company. Millennium endorsed the IOU and delivered it to Lena, the third party, as illustrated in Figure 13.7.

Figure 13.7: Third-party contract with IOU

Is Lena a holder in due course? You should be able to discern that she is not. To be a holder in due course, one must possess a negotiable instrument, pay value, and not be on notice of any defenses against the instrument. While Lena may have paid value, and the face of the instrument may have looked good, it is not negotiable. Therefore, she is merely a holder, not a holder in due course. Nevertheless, if no other problems arose, she might still get paid and remain blissfully unaware that her non–holder in due course status had any significance.

But the story does not end there. Suppose that later a dispute arises between Mighty (the seller) and Millennium (the buyer) about the steel, which Millennium has now received and thinks is of poor quality. A non–holder in due course takes subject to that dispute; that is, if Millennium refuses to pay on the IOU in 90 days, Lena will not get paid. Notice that she won’t get paid owing to a dispute going on between two parties, one of whom she probably doesn’t even know. Nevertheless, “taking subject to” means she is stuck, with- out payment or recourse.

Now let’s assume a different and better scenario. This time, Millennium issues Mighty a negotiable note, as shown in Figure 13.8.

IOU for $10,000.00

IOU for $10,000.00

LenaMighty SteelCompanyMillennium

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Section 13.4 Holders in Due Course CHAPTER 13

Figure 13.8: Third-party contract with negotiable note

Lena has now taken a negotiable instrument, paid value, and is not aware of any problems with the note. As a result, she qualifies as a holder in due course (HDC).

Defenses to a Contract

Holders in due course take negotiable instruments free from personal defenses (between the seller and buyer) and are subject only to real defenses (between the seller and buyer). Therefore, if the dispute between the seller and the buyer is in the category of personal defenses, Lena will get paid; however, if the dispute is in the category of real defenses, she will not.

Personal defenses include:

• Breach of contract or warranty; • Lack or failure of consideration; • Fraud in the inducement; • Illegality; • Mental incapacity; • Discharge by payment or cancellation; • Unauthorized completion of an incomplete instrument; • Nondelivery of the instrument; and • Ordinary duress or undue influence.

Real defenses include:

• Infancy, to the extent that it is a defense to a simple contract; • Duress, lack of legal capacity, or illegality of the transaction that nullifies the obli-

gation of the obligor; • Misrepresentation that induces a party to sign a negotiable instrument without

understanding its character or its terms (fraud in the execution); and • Discharge in insolvency proceedings.

Negotiable Note for

$10,000.00

Negotiable Note for

$10,000.00

LenaMighty SteelCompanyMillennium

HDCPAYEEMAKER

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Key Terms CHAPTER 13

Key Terms

allonge A separate piece of paper that is permanently attached to an instrument.

antedating When a check or other instru- ment is issued on a particular date but the date written on it is earlier (it is still a negotiable instrument).

bearer paper An instrument that includes the word bearer or cash (e.g., “Pay to Bearer,” “Pay to the Order of Cash”) but names no specifically ascertainable person.

blank endorsement The signature of the payee written alone on the back of the check.

endorsement Writing on a negotiable instrument that has the effect of transfer- ring all the rights represented by that instrument to another party.

incomplete instrument A negotiable instrument that has not been completely filled out by the maker or drawer and that cannot be enforced until it is.

issuance The process wherein the drawer makes a check payable to the payee and hands it to the payee.

negotiation The physical transfer of com- mercial paper to the third party in the transaction.

order paper This type of instrument includes the word order and is payable to a specific person or entity.

personal defenses Defenses that the holder in due course takes “free from”; thus, the holder in due course still gets paid if the defense is personal.

postdating When a check or other instru- ment is issued on a particular date but the date written on it is later (it is still a nego- tiable instrument).

real defenses Defenses that the holder in due course takes “subject to”; thus, the holder in due course does not get paid if the defense is real.

restrictive endorsement Writing that places a condition on further negotiating the instrument.

special endorsement On an instrument, writing that specifies the person or persons to whom the instrument is made payable.

void No longer in force. For an instru- ment, if a completion is unauthorized, it generally becomes void.

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Critical Thinking and Discussion Questions CHAPTER 13

Critical Thinking and Discussion Questions

1. What is the difference between order paper and bearer paper? 2. What are the three requirements one must meet in order to be considered a

holder in due course? 3. Your company has received a check for services performed. The name of your

company is Millennium Enterprises. The check is made payable to Malleneum Ent. How could you go about depositing this check into your company’s account?

4. Your company receives a check that is payable “60 days from [date].” The check is dated. Is this a negotiable instrument? Why or why not? What if the check says, “Payable on June 1, 2013”? Is that a negotiable instrument?

5. A check made payable to Jane Doe has $100.00 written in figures in the box pro- vided for the amount but states “One Thousand Dollars” on the space provided beneath. Is the check valid? If so, for what amount? If not, why not?

6. Mark Maker issues a note to Percival Payee 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 is payable?

7. Peter receives a check as a birthday gift from his grandmother. The check is made out for $50 to him as payee, but the drawer neglected to write in a date on the space provided and also forgot to write in the amount in words in the space provided on the check. Peter, eager to buy two games for his new game console on sale that week for $25 each, fills out the missing date and the words “Fifty and NO/100” dollars on the check and negotiates it to his local games dealer. Is the check valid? Has Peter committed an unlawful act in completing the check?

8. Don Drawer gives a check to his friend Pamela Payee as a birthday gift. Pamela endorses the check as follows: “Pay any bank, [signed] Pam Payee.” Answer the following questions based on these facts:

a. Is Pamela a holder of the instrument when Don gives her the check? b. Is Pamela a holder in due course of the instrument? Explain. c. Is Pamela’s bank a holder in due course after it accepts the check and credits

her account? Explain.

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