Negotiable Instruments
Commercial Paper
WHAT IS COMMERCIAL PAPER?
• Unconditional written orders or promises
to pay money
• Demand instrument
(A substitute for money)
A negotiable instrument must:
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•
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Be in writing
Be signed by the maker or drawer
Be an unconditional promise or order to pay
State a fixed amount of money
Not require any undertaking in addition to the
payment of money
• Be payable on demand or at a definite time
• Be payable “to order” or “to bearer”
Why are banks debtors of their checking
account depositors?
The Bank – Customer Relationship
Creditor – Debtor Relationship
• Created when a customer deposits money
into the bank.
• The customer is the creditor and the bank
is the debtor (owes the money).
The Bank – Customer Relationship
(continued)
Principal – Agent Relationship
• Created if the:
– deposit is a check that the bank must collect
for the customer or the
– customer writes a check against his or her
account
• The customer is the principal and the bank is
the agent.
TYPES OF
COMMERCIAL PAPER
• Drafts
• Checks
– Honor and dishonor
– Stop-payment orders
– Precautions and care
• Promissory notes
• Certificates of deposit
Draft
• A draft is a three-party instrument that is
an unconditional written order by one party
that orders the second party to pay money
to a third party.
– Drawer of a draft
– Drawee of a draft
– Payee of a draft
Check
• A distinct form of draft drawn on a financial
institution and payable on demand.
– Drawer of a check
– Drawee of a check
– Payee of a check
Parties to a Check
• Drawer
- Customer who maintains the checking
account and writes checks against the
account
• Drawee
- Bank on which the check is drawn
• Payee
- Party to whom the check is written
Duties of Bank and Customer
• Customer must examine bank statements
and promptly notify bank of unauthorized
payments
– Liable for failure to perform duties
• Bank owes duty of ordinary care in
presenting and sending checks for
collection
– Liable for losses caused by its negligence
Promissory Notes
• A two-party negotiable instrument that is
an unconditional written promise by one
party to pay money to another party.
– Maker of a note
– Payee of a note
• Types of notes:
– Time note
– Demand note
– Installment notes
Promissory Notes (continued)
• Collateral required
– Some notes require posting security
– May be automobiles, homes, buildings,
securities, or other property
– If maker fails to repay note as due, lender can
foreclose and take collateral as payment
Certificates of Deposit (CD)
• A two-party negotiable instrument
• Special form of note created when a
depositor deposits money at a financial
institution
– Institution promises to pay back the amount of
the deposit plus an agreed-upon rate of
interest at set time.
Primary Liability
• Makers of promissory notes and
certificates of deposit have primary
liability for the instrument.
• Maker unconditionally promises to pay
the amount stipulated in the note when
due.
• Makers are absolutely liable to pay the
instrument, subject only to certain real
defenses.
Secondary Liability
• Drawers of checks and drafts and
unqualified indorsers of negotiable
instruments have secondary liability on
the instrument.
• This liability is similar to that of a
guarantor of a simple contract.
• It arises when the party primarily liable on
the instrument defaults and fails to pay the
instrument.
Secondary Liability (continued)
• Unqualified indorsers have secondary liability.
• Qualified indorsers have no secondary liability.
– They have expressly disclaimed liability.
• Secondary liability arises from an instrument
being:
– Properly presented
– Dishonored.
– Notice being timely given to person who is
secondarily liable.
SPECIALIZED TYPES OF
COMMERCIAL PAPER
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Certified checks
Teller’s check
Cashier’s check
Money orders
Traveler’s checks
Special Types of Checks
• Certified Checks
– Bank agrees to accept check when presented
– Pays out of funds set aside in special account
– Drawer is discharged from liability on check
• Cashier’s Checks
– Two party check
– Bank is both drawer and drawee
– Holder is payee
• Traveler’s Checks
– Issued without named payee
– Requires purchaser’s signature at issuance and upon
use
WHAT MAKES AN INSTRUMENT
NEGOTIABLE?
• In writing and signed by the maker or
drawer
• Unconditional promise or order
• Payable in a sum certain in money
• Payable on demand or at a definite time
• Payable to bearer or to someone’s order
• Negotiable instruments serve the following
functions:
– Substitute for money
– Credit device
– Record-keeping device
• Most purchases by businesses and many
individuals are made by negotiable
instruments instead of cash.
Additional Clauses
• Prepayment clause
– Allows maker to pay amount before due date
• Acceleration clause
– Payee or holder may accelerate payment of
principal
• Extension clause
– Allows date of maturity to be extended
Nonnegotiable Contract
• A promise or order to pay that does not
meet the requirements of a negotiable
instrument.
• It is not subject to the provisions of UCC
Article 3.
• A nonnegotiable contract can be enforced
under normal contract law.
HOW IS COMMERCIAL PAPER
TRANSFERRED?
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Indorsement
Indorser
Indorsee
Holder
Transfers
• Negotiable instruments can be transferred
to subsequent parties by negotiation.
– Done by placing endorsement on instrument
ENDORSEMENTS
AND THEIR FUNCTIONS
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Blank endorsements
Special endorsements
Qualified endorsements
Restrictive endorsements
Accommodation parties
Accommodation Party
• A party who signs an instrument and lends his or
her name (and credit) to another party to the
instrument.
• The accommodation party is obliged to pay the
instrument in the capacity in which he or she
signs.
– Accommodation Maker – primarily liable
– Accommodation Indorser – secondarily liable
• Liability of accommodation party:
– Guarantee of payment
– Guarantee of collection
BLANK INDORSEMENTS
SPECIAL INDORSEMENTS
HOW IS COMMERCIAL PAPER
DISCHARGED?
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By payment
By cancellation
By alteration
By impairment of collateral
As a contract
Impairment of the Right of
Recourse
• Certain parties (holders, indorsers,
accommodation parties) are discharged
from liability on an instrument if the holder:
1.Releases an obligor from liability, or
2.Surrenders collateral without the consent of
the parties who would benefit by it
COLLECTION OF COMMERCIAL
PAPER OBLIGATIONS
• Holder in due course
• Qualifications of an HDC
– Take in good faith and give value
– Without knowledge of defense or dishonor
Holder Versus Holder In Due
Course
Holder
• A person who is in
possession of a
negotiable instrument
that is drawn, issued,
or indorsed to him or
his order, or to
bearer, or in blank.
Holder in Due Course
(HDC)
• A person who takes a
negotiable instrument
for value, in good
faith, and without
notice that it is
defective or is
overdue.
• If the requirements of Article 3 are met, a
transferee who qualifies as a holder in due
course takes the instrument free of many
defenses that can be asserted against the
original payee.
• In addition, the document is considered an
ordinary contract that is subject to contract
law.
WHAT ARE THE LIMITED
(Personal) DEFENSES?
• Breach of contract or failure of consideration
• Fraud in the inducement
• Temporary incapacity to contract—excluding
minority
• Ordinary duress
• Prior payment or cancellation
• Conditional delivery or non-delivery
• Unauthorized completion
• Theft
Personal Defenses
Personal Defenses
Effect
1.
2.
3.
Personal defenses
cannot be raised
against a holder in due
course
4.
5.
6.
Breach of contract
Fraud in the inducement
Mental illness that makes a
contract voidable instead of void
Illegality of a contract that makes
the contract voidable instead of
void
Ordinary duress or undue
influence
Discharge of an instrument by
payment or cancellation
WHAT ARE THE UNIVERSAL
DEFENSES?
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Permanent incapacity to contract and minority
Illegality
Forgery or lack of authority
Alteration
Fraud in the execution of the paper or as to the
essential terms
• Duress depriving control
• Claims and defenses stemming from a
consumer transaction
Universal Defenses
Universal Defenses
Effect
1.
2.
3.
4.
5.
6.
7.
8.
Real defenses can be
raised against a holder in
due course
Minority
Extreme duress
Mental incapacity
Illegality
Discharge in bankruptcy
Fraud in the inception
Forgery
Material alteration
Signature Liability
• A person cannot be held contractually
liable on a negotiable instrument unless
his or her signature appears on the
instrument.
• The signatures on a negotiable
instrument identify those who are
obligated to pay it.
• If it is unclear who the signer is, parol
evidence can identify the signer.
Commercial Wire Transfers
• Fast
– Transfers usually completed within one day
• Inexpensive
Questions?
Next Week: Chapters 38 & 39