Chapter 24 - Negotiable Instruments Notes

The key points in this chapter include:

1. The four types of negotiable instruments.

2. The requirements for an instrument to be
negotiable.

3. Factors that do not affect an instrument’s
negotiability.

4. The process of negotiation.

5. The types of indorsements, and the legal effect
of each.

A negotiable instrument is a signed writing that contains an unconditional promise or order to pay an exact sum of money, when demanded or at an exact future time. It is transferred more easily than a contract, and a person who acquires it is subject to less risk than the assignee of a contract. This chapter outlines types of negotiable instruments, requirements for negotiability, and the effect of indorsements.

I. ARTICLE 3 AND ITS REVISION
UCC Articles 3 applies to transactions
involving negotiable instruments. Since 1990,
most states have adopted revised versions of
these articles. This outline refers to the revised
articles.

II. THE FUNCTION OF INSTRUMENTS
A negotiable instrument can function as a
substitute for money or as an extension of
credit. To do so, it must be easily transferable
without danger of being uncollectible.

III. TYPES OF INSTRUMENTS

A. DRAFTS AND CHECKS
The person who signs or makes an order to
pay is the drawer. The person to whom the
order is made is the drawee. The person to
whom payment is ordered is the payee.

1. Draft
An unconditional written order by one person
to another to pay money. The drawee must be
obligated to the drawer either by an agreement
or through a debtor-creditor relationship to
honor the order.

a. Time Draft
Payable at a definite future time.

b. Sight Draft (Demand Draft)
Payable on sight (when presented for
payment). A draft payable at a stated time
after sight is both a time and a sight draft.

c. Trade Acceptance
A draft in which the seller is both the drawer
and the payee. The draft orders the buyer to
pay a specified sum of money to the seller, at a
stated time in the future.

d. Banker’s Acceptance
A draft drawn by a creditor against his or her
debtor, who must pay the draft at maturity.
Typically, the term is short.

2. Check
A draft drawn on a bank and payable on
demand. A cashier’s check is a draft in
which the bank is both the drawer and drawee.
A teller’s check is a draft drawn by one bank
on another bank [UCC 3–104(h)].

B. PROMISSORY NOTES AND CDS (PROMISES TO
PAY)
A person who promises to pay is a maker. A
person to whom the promise is made is a
payee. A promissory note is a written
promise by one party to pay money to another
party. A certificate of deposit (CD) is a note
made by a bank promising to repay a deposit of
funds with interest on a certain date
[UCC 3–104(j)].

IV. REQUIREMENTS FOR
NEGOTIABILITY
To be negotiable, an instrument must
[UCC 3–104(a)]—

A. IN WRITING
A writing can be on anything that is (1)
permanent and (2) has portability
[UCC 3–103(a)(6)].

B. SIGNED BY THE MAKER OR DRAWER
A signature can be any place on an instrument
and in any form (a mark or rubber stamp) that
purports to be a signature and authenticates the
writing [UCC 1–201(39), [UCC 3–401(b)].

C. AN UNCONDITIONAL PROMISE OR ORDER

1. Promise or Order
A promise must be an affirmative written
undertaking—more than a mere
acknowledgment of a debt (an I.O.U. does not qualify; use of the words “I promise” or “Pay”
qualifies) [UCC 3–103(a)(9)].

a. Certificates of Deposit
The bank’s acknowledgment of a deposit and
the other terms indicates a promise to repay a
sum of money [UCC 3–104(j)].

b. More Than One Payee
An order may be addressed to more than one
person, either jointly or alternatively (“Pay Joe
or Jan”) [UCC 3–103(a)(6)].

2. Unconditional
Payment cannot be conditional, and the
promise or order cannot be subject to or
governed by another writing, or be subject to
rights or obligations stated in another writing
UCC 3–104(a), UCC 3–106(a)]. Negotiability
is not affected by—

a. References to Other Writings [UCC 3–106(a)].

b. Payments Only out of a Particular fund or Source
[UCC 3–106(b)(ii)].

c. A Statement that an Instrument Is Secured by a
Mortgage
Destroys negotiability only if it stipulates that a
promise to pay is subject to the terms of the
mortgage [UCC 3–106(b)(ii)].

E. AN ORDER OR PROMISE TO PAY A FIXED
AMOUNT
A negotiable instrument must state a fixed
amount to be paid when the instrument is
payable.

1. References to Outside Sources
Interest may be determined with reference to
information not contained in the instrument but
readily ascertainable by reference to a source
described in the instrument
[UCC 3–112(b)].

2. Variable Interest Rate Notes Can Be Negotiable
The fixed-amount requirement applies only to
principal [UCC 3–104].

F. PAYABLE IN MONEY
Only instruments payable in money (not bonds,
stock, gold, or goods) are negotiable [UCC
3–104(a)(3)]. Money is a medium of exchange
recognized as the currency of a government
[UCC 1–201(24)].

G. PAYABLE ON DEMAND OR AT A DEFINITE TIME

1. Payable on Demand
An instrument that is payable on sight or
presentment or that does not state any time for
payment [UCC 3–108(a)]. A check is payable
on demand [UCC 3–104(f)]. Presentment
occurs when a person presents an instrument
to a person liable on it for payment or when a
person presents a draft to a drawee for
acceptance.

2. Payable at a Definite Time
Payable on or before a stated date or within a
fixed period after sight, or on a date or time
ascertainable at the time the instrument is
issued [UCC 3–108(b)].

3. Acceleration Clauses
Allows a holder to demand payment of entire
amount due if a certain event occurs. Does not
affect negotiability [UCC 3–108(b)(ii)]. A
holder is any person in possession of an
instrument drawn, issued, or indorsed to him or
her, or to his or her order, to bearer, or in blank
[UCC 1–201(20)].

4. Extension Clauses
The period of the extension must be specified if
the right to extend is given to the maker. If the
holder has the right, no period need be
specified [UCC 3–108(b)(iii), (iv)].

H. PAYABLE TO ORDER OR BEARER
When it is issued or first comes into the
possession of the holder [UCC 3–104(a)(1)].

1. Order Instrument
May be payable “to the order of an identified
person” or to “an identified person or order,”
but must identify the payee with reasonable
certainty [UCC 3–109(b)].

2. Bearer Instruments
Does not designate a specific payee (but an
instrument payable to a nonexistent entity is not
bearer paper) [UCC 3–109(a) and Comment
3]: “Payable to the order of bearer,” “Pay to
the order of cash,” “Pay cash”.

V. FACTORS NOT AFFECTING
NEGOTIABILITY

A. NO DATE
Negotiability is affected only if a date is
necessary to determine a definite time for
payment [UCC 3–113(b)].

B. POSTDATING
Postdating an instrument does not affect
negotiability [UCC 3–113(a)].

C. HANDWRITTEN WORDS
Handwritten words prevail typewritten words,
which prevail over those that are printed (such
as preprinted forms) [UCC 3–114].

D. DISCREPANCY BETWEEN WORDS AND
NUMBERS
An amount stated in words prevails over
contradictory numbers [UCC 3–114].

E. UNSPECIFIED INTEREST RATE
If a rate is unspecified, interest will be at the
judgment rate [UCC 3–112(b)].

F. NOTATION ON A CHECK THAT IT IS
NONNEGOTIABLE
This has no effect on a check, but any other
instrument is made nonnegotiable by the maker
or drawer adding such a notation
[UCC 3–104(d)].

V. TRANSFER BY ASSIGNMENT OR
NEGOTIATION

A. TRANSFER BY ASSIGNMENT
A transfer by assignment (see Chapter 18)
gives the assignee only those rights the
assignor possessed. Defenses that can be
raised against an assignor can normally be
raised against an assignee.

B. TRANSFER BY NEGOTIATION
On a transfer by negotiation, the transferee
becomes a holder and receives the rights of the
previous possessor (and possibly more)
[UCC 3–201(a), 3–202(b), 3–203(b),
3–305, 3–306]. Order paper is negotiated by
delivery with indorsement; bearer paper is
negotiated by delivery only [UCC 3–201(b)].

C. CONVERTING INSTRUMENTS
An instrument can be converted from a bearer
to an order instrument, or vice versa, by
indorsement. A check payable to “cash”
subsequently indorsed “Pay to Bob” must be
negotiated as an order instrument (by
indorsement and delivery) [UCC 3–205(a)].
An instrument payable to a named payee
(“Bob”) and indorsed in blank is a bearer
instrument [UCC 3–205(b)].

VII. INDORSEMENTS
Indorsements are required to negotiate an
order instrument. The person who
indorses an instrument is an indorser; the
person to whom the instrument is
transferred is an indorsee.

A. WHAT AN INDORSEMENT IS
A signature with or without additional words or
statements. Usually written on the back of an
instrument but can be written on a separate
piece of paper (an allonge) affixed (stapled) to
it [UCC 3–204(a)].

B. BLANK INDORSEMENT
Specifies no particular indorsee and can consist
of a mere signature [UCC 3–205(b)].
Converts an order instrument to a bearer
instrument.

C. SPECIAL INDORSEMENT
Names the indorsee [UCC 3–205(a)]. No
special words are needed. Converts a bearer
instrument into an order instrument.

D. QUALIFIED INDORSEMENT
Disclaims or limits contract liability (see
Chapter 19) (the notation “without recourse”
is commonly used) [UCC 3–415(b)]. Often
used by persons acting in a representative
capacity.

1. No Payment Guarantee
Does not guarantee payment, but does transfer
title. (Most blank and special indorsements are
unqualified, guaranteeing payment and
transferring title).

2. Further Negotiation
A special qualified indorsement makes an
instrument order paper (and requires
indorsement and delivery for negotiation). A
blank qualified indorsement creates bearer
paper (and requires only delivery).

E. RESTRICTIVE INDORSEMENTS

1. Indorsement Prohibiting Further Indorsement
Does not destroy negotiability
[UCC 3–206(a)]. Has the same effect as a
special indorsement.

2. Conditional Indorsement
Specifying an event on which payment depends
does not affect negotiability. A person paying
or taking the instrument for value can disregard
the condition [UCC 3–206(b)]. (Conditional
language on the face of an instrument,
however, does destroy negotiability.)

3. Indorsement for Deposit or Collection
Making the indorsee (usually a bank) a
collecting agent of the indorser (such as “For
deposit only”) locks the instrument into the
bank collection process [UCC 3–206(c)].

4. Trust Indorsement (Agency Indorsement)
An indorsement by one who is to hold or use
the funds for the benefit of the indorser or a
third party [UCC 3–206(d), (e)]. To the extent
the original indorsee pays or applies the
proceeds consistently with the indorsement, he
or she is a holder and can become a holder in
due course (HDC). Any subsequent purchaser
can qualify as an HDC (unless he or she
knows the instrument was negotiated in breach
of a fiduciary duty).

F. MISCELLANEOUS INDORSEMENT PROBLEMS

1. Forged or Unauthorized Indorsements
See Chapters 28 and 29.

2. Misspelled Name
An indorsement should be the same as the
name on the instrument. An indorsee whose name is misspelled can indorse with the
misspelled name, the correct name, or both
[UCC 3–204(d)].

3. Multiple Payees
An instrument payable in the alternative (“Pay
to the order of Bill or Joan”) requires the
indorsement of only one. An instrument
payable jointly (“Pay to the order of Bill and
Joan”) requires the indorsements of both. If it
is not clear how it is payable, it requires the
indorsement of only one [UCC 3–110(d)].

4. Agents or Officers
An instrument payable to an entity (“Pay to the
order of the YWCA”) can be negotiated by the
entity’s representative. An instrument payable
to a public officer (“Pay to the order of the
County Tax Collector”) can be negotiated by
whoever holds the office [UCC 3–110(c)].