Negotiable Instruments,
Credit and Bankruptcy
Chapter 12
Negotiable Instruments
• Functions of Negotiable Instruments
– substitute for cash (checks for example)
– provides way to extend credit (promissory
note)
• Types of Negotiable Instruments
– 3 party instruments used instead of cash and
as credit device
• Orders to Pay: Drafts
• Orders to Pay: Checks
– 2 party instruments used as credit device
• Promises to Pay: Notes
• Promises to Pay: Certificates of Deposit
Negotiable Instruments and
the Concept of Negotiability
• Can be transferred to another party
– assigned - assignee has same rights and
responsibilities as assignor
– transferred by negotiation - transferee takes
instruments free of transferor’s responsibilities
• transfer order instrument by:
– payee endorses & delivers instrument to third party
• Bearer instruments
– drawer may create “to bearer”; “to the order of
bearer”, “payable to bearer,” “to cash” etc.
– risky – if lost, finder can be cashed by finder
– transfer bearer instrument by delivery
UCC Requirements for
Negotiable Instruments
• Only negotiable instruments fall under the UCC
• If nonnegotiable, the common law applies
• To be negotiable it must:
– be written
– be an unconditional order or promise to pay
– be signed by the maker or drawer
– be payable on demand or at a specified time
– be made out “payable to order” (order paper)
or “to bearer” (bearer paper)
– must state a certain sum of money
Requirements for Holders
in Due Course
• Person in possession of negotiable
instrument may be ordinary holder or holder
in due course
• ordinary holder has same contract
responsibilities as assignee – holder in due
course does not
• to be holder in due course, transferee must:
– give value for instrument
– take instrument without knowledge it is
overdue or defective
– take instrument in good faith
Major Types of
Negotiable Instruments
• Drafts
– unconditional written promise to
pay
• drawer orders drawee to pay
$$ to payee
• time draft says at a specified
time
• sight draft gets paid upon
presentation
– sales draft – for sale of goods
– In international, called a bill of
exchange
– Bankers acceptance creates a
guarantee by a bank that draft is
good.
• Checks
– draft drawn on a bank
and payable on demand
– Checks used to be a
major method of payment
– Now credit & debit cards
have largely replaced
checks
– on a cashier’s check the
bank is both drawer and
drawee
Lor-Mar/Toto, Inc. v. 1st
Constitution Bank
• Lor-Mar had a business checking account at 1st Constitution Bank.
• Resolution between Lor-Mar & bank allowed checks to be paid if they
had a signature of either Van Middlesworth or Toto.
• Bank given samples of their stamped signatures.
• Five bogus checks for $24,350 were written against the account; paid
by bank. Lor-Mar saw problem in monthly statement.
• Bad checks had all correct information, but on different paper stock
and color used by Lor-Mar.
• Checks had different “security features” from standard checks.
• Had signatures that looked like Van Middlesworth’s stamped
signature.
• Bank allowed customers to use checks not provided by bank.
• Bank thought the signature appeared the same, so it held the
payment proper.
• Lor-Mar sued.
• Trial court held for Lor-Mar. Bank appealed.
Lor-Mar/Toto, Inc. v. 1st
Constitution Bank, cont.
• ISSUE: Whether the fraudulent checks were authorized by Lor-Mar
and were they in accordance with the agreement between Lor-Mar
and the Bank?
• In New Jersey, strict liability of bank can be shifted to the customer
as long as the bank lives up to its statutory duty of good faith.
• Parties can agree for bank to honor checks bearing a facsimile
signature that resembles the specimen on file, BUT must have
clear and unambiguous language of shifting the risk to the
customer for a forged facsimile signature resembling the specimen
on file – didn’t happen here.
• Lor-Mar did not expressly know and assume all risks in the
unauthorized use of its officer’s facsimile signature.
• No meeting of the minds modifying the customer’s rights.
• HELD: Affirmed. Bank paid improperly.
Promises to Pay
• Notes
– promise by the maker • Certificates of
to pay certain $ to
Deposit
payee
– bank is maker of
• usually called
certificate & promises
promissory notes
to repay customer
• but also have
payee
– collateral note
– most large certificates
– real estate mortgage
are negotiable which
note
allows them to be
sold, used to pay
– installment note
debts or used as
– balloon note
collateral
Credit
•
•
•
•
Creditor: lends money
Debtor: to whom money is lent
Principal: the sum of the debt owed
Equity financing: sale of stock in company or negotiable
instruments subject to securities regulation
• Debt financing: borrowing money evidenced by contract
• Credit Policy focuses on characteristics such as:
– capacity (the debtor’s ability to pay)
– capital (the debtor’s financial condition)
– character (the debtor’s reputation)
– collateral (the debtor’s assets to secure the debt)
– conditions (the economic situation affecting the
debtor’s business)
Credit Accounts
• Open Account
– must pay within fixed time
period
• Installment Account
– repay through regular
(usually monthly)
payments
• Revolving Account
– make minimum payment &
can add new debt – credit
cards work this way
Credit with Security
by
When creditor can take property of debtor to
satisfy debt – can happen by agreement or
operation of law
• By Agreement - depends if property is real or
personal
• Suretyship - promise by a third party to pay debt
if debtor doesn’t
• Defenses of Sureties - since debt falls under
contract law, there are the same defenses that the
principal (debtor) has – including, impossibility,
illegality, duress, fraud
General Electric Business
Financial Services v. Silverman
• Warren Park Partners, Ltd. borrowed $34.8 million from GE Financial.
• Bought land in Frisco, Texas. Silverman & partners signed a guaranty
“absolutely, unconditionally” guaranteeing full payment.
• Silverman also signed “Limited Joinder” guaranteeing full repayment
of loan even if Warren Park went bankrupt.
• Warren Park defaulted; went into bankruptcy.
• GE demanded payment from Silverman; he did not pay; GE sued.
• Silverman & parties claimed affirmative defenses of (1) fraud, (2)
extortion, (3) theft & (4) economic duress.
• Said hours before signing the documents, GE notified them changes
in terms of the agreement.
• They had no time to contest, as loan was needed immediately.
• He signed agreement because he was trapped.
• Claimed GE employee told him new terms would not be enforced.
• GE moved for summary judgment .
General Electric Business Financial
Services v. Silverman
•
•
•
•
•
•
•
•
•
•
•
•
HELD: Summary judgment for GE.
Breach of limited joinder (a contract claim) and breach of guaranty.
GE offered evidence of both claims that defendants did not contest.
Instead defendants asserted the 4 affirmative defenses (above).
GE argued even if affirmative defenses are true, allegations are barred
by the Credit Agreement Act (ICAA).
ICAA bars all actions or defenses by a debtor based on an oral
agreement (similar to Statute of Frauds).
Defendants didn’t dispute that they made “credit agreements”.
Defendants say ICAA does not bar their affirmative defenses.
They also argue “unclean hands” of the plaintiff, GE.
The court was not swayed, because –
Oral promises by GE would contradict the terms of the contract;
therefore the ICAA bars defendant’s affirmative defenses.
Silverman loses.
Credit with Security
Perfected Security Interest
•
•
•
Secured Transactions
– product may secure debt
– commercial sale of goods - UCC Article 9
– must create security interest - be sure it is:
– 1. attached (Attachment)
• signed by customer
• seller provided value
• customer has legal, transferable rights
in collateral
– 2. perfected (Perfection)
• filing w/proper state official (online)
Interests in Inventory
– As collateral, equipment, inventory, raw
materials (tangible property) are used as
security
“Floating Lien” Inventory
– Goods held for sale and raw materials
– Inventory is constantly changing
• Default by Debtor
– Some property my
be exempt, i.e.
homestead
exemption (when
personal assets
have been placed as
collateral
– Default is when the
buyer doesn’t repay
– creditor can take
back property and
keep or may resell it
(in a “commercially
reasonable
manner”)
– any excess from
sale of repossessed
property over debt
owed must be
returned to debtor
Fordyce Bank & Trust v.
Bean Timberland
• Bank made loans to Bean Timberland so it could buy
timber from landowners.
• Bean would cut timber and sell logs to Potlatch and Idaho
Timber (P&I). Revenue from sales would repay loans.
• Bank perfected its interest by filing UCC Financing
Statement with the Arkansas Secretary of State Office.
• Bean sold timber but failed to repay loans; went bankrupt.
• Bank sued P&I because Bank had a priority interest in
timber sale proceeds.
• Bank said P&I was negligent in its dealings for failing to do
a lien search and did not “exercise good faith” required
under the UCC.
• Trial court held for P&I, ruling they were not negligent.
• Trial court said that P&I was not required to perform a
security interest search in the “ordinary course of
business.” Bank appealed.
Fordyce Bank & Trust v. Bean Timberland
• Under Arkansas UCC 9-320, a buyer in the ordinary course
of business (P&I) “takes free of a security interest created
by the buyer’s seller [Bean], even if the security interest is
perfected [by the bank] and buyer knows of its existence.”
• If P&I were buyers in “ordinary course of business.” No
duty to perform a lien search. Even if they knew of bank’s
security interest, P&I can take free of Bank’s interest.
• HELD: Affirmed. Evidence that purchasing timber brought
to the mill’s front gate without performing a lien search is
standard timber industry practice.
• P&I’s actions were “usual or customary practices” in the
timber industry, and they were therefore “buyers in the
ordinary course of business.” No duty to the bank to
conduct a lien search.
Real Estate Financing
• Mortgage: Real estate is used to secure a debt
obligation evidence by a mortgage
• Debtor is the mortgagor
• Creditor is the mortgagee
• Mortgage is a lien in most states
• In case of default, the mortgagee has the right to
foreclose on the property
• Deficiency judgment: If proceeds from
foreclosure not sufficient, a separate legal action
against debtor is maintained
• Statutory redemption: Period of time mortgagor
has the right to redeem the property by paying
the debt (normally within 6 months after default)
Liens (Nonconsensual Lien)
Obtained by operation of law.
• Should be removed before property is sold
• Mechanic’s Lien
– party that furnished material, labor, or services for
construction or repair of building or other real property
places the lien
• Possessory or Artisan’s Lien
– party that added value to or cared for personal property
places the lien
• Court-Decreed Liens
– Attachment lien is court-ordered seizure of goods
through writ of attachment
– Judgment lien occurs when creditor has successful
action against debtor
– If debtor doesn’t pay judgment, creditor asks court for a
writ of execution
Bankruptcy
• Purpose: orderly resolution when debtor owes more
than can be paid.
• Federal Bankruptcy Code has been amended – most
recent revision was The Bankruptcy Abuse
Prevention and Consumer Protection Act of 2005.
• Most bankruptcies involve individuals.
• Chapter 7 (Liquidation)
• Chapter 13 (Reorganization of debts)
• Chapter 11 (Business wishes to remain in operation
and not be liquidated.)
Personal Bankruptcy
• Most bankruptcies involve individuals
• Means businesses do not get paid
• Dept. of Justice’s U.S. Trustee Program approves
organizations to provide mandatory credit counseling
• Credit counseling must be taken before filing bankruptcy
• Debtor education is taken after filing
• Income and Means Testing
– Income test determines if person files under Chapter 7
or Chapter 13
– People with higher income less likely to have debts
liquidated
– Test of income against expenditures – to see if person
has above average income for a given area
Bankruptcy : Chapter 7 Proceedings
• Most bankruptcies are voluntary, but
creditors may force an involuntary
proceeding
• Upon filing, there is a freeze on actions
against the debtor and the debtor’s
property
• Trustee is appointed to administer the
debtor’s estate
• Assets are liquidated and proceeds
distributed to creditors.
• Liquidation and fair distribution of debtor’s
non-exempt assets to creditors
Bankruptcy Chapter 7
• Used to be the most commonly used (now about half)
• Since 2005 reforms, many people forced into Chapter 13
• Chapter 7 means liquidation of debts and fair distribution
of debtor’s non-exempt assets
• Liquidating bankruptcy available for businesses under
Ch. 7, but only individuals can be discharged under Ch 7.
• Bankruptcy petition provides
– Statement of the financial affairs of debtor
– List of all creditors & addresses, with amounts owed
– List of properties owned by debtor
– Statement of current income & expenses of debtor
– Priority of creditors
Bankruptcy - Chapter 13
• Available only to individuals.
• Sole proprietorship may file under Chapter 13.
• Debtor files plan for payment of creditors over time
(installment repayment plan).
• Debtor keeps property and shares administration of the
bankrupt estate with court-appointed trustee.
• Trustee collects income from debtor; pays creditors.
• Payments made under approved Confirmation Plan
• Debts of those bankrupt not discharged.
• Plan usually is accomplished within 5 years.
• Long-term secured debt (i.e. house mortgage) treated
differently.
• If plan fails, possible to shift to Ch 7 for total discharge.
Bankruptcy - Chapter 7
• Priority of classes of creditors
– secured creditors
– costs of preserving and
administering debtor’s estate
– unpaid wage claims
– refund of security deposits
– alimony and child support
– taxes
– unsecured creditors
• All creditors of particular class must
be paid before going to next class
In re Darby
• After Darby filed Chapter 13 bankruptcy, Time Warner
canceled his cable service.
• Darby filed motion with bankruptcy court to compel Time
Warner to reinstate his service, with his assurances of
future payment.
• Bankruptcy Court and District Court ruled that cable
service was not a “utility” that must be provided as a
“necessity” under law. Darby appealed.
• HELD: Affirmed. Cable service is not a “necessity”.
• Bankruptcy laws give protections to debtors from cut-off
of service by a utility after they file for bankruptcy.
• Utilities are “necessities” and must be provided to
debtors.
– Include electric company, gas supplier or telephone
company.
• Cable service not a “necessity” and bankruptcy court
need not require its reinstatement to Darby.
Bankruptcy Chapter 11
• Allows businesses to keep operating,
without liquidation of assets
• “Prepackaged” bankruptcy filings: debtor &
creditors settle issues before debtor files,
and court then approves
• Reorganization
– stays further action by creditors
– debtor acts as trustee, called debtor in
possession, to run business for benefit of
all parties
– creditors are satisfied by class in order of
priority of claims
In the Matter of Kmart Corporation
• Kmart, in Chapter 11 bankruptcy, requested to pay, in full,
claims of “critical vendors.”
• Kmart said that if it didn’t pay these vendors, they would
not do business in the future and were necessary for
Kmart to stay in operation. Changed the order of unpaid
creditors (vendors).
• Bankruptcy judge agreed – granted order.
• Kmart determined the critical vendors, paying 2330
suppliers $300 million.
• 2000 unpaid vendors, and 43,000 additional unsecured
creditors received 10 cents on the dollar (mostly in stock
of reorganized company).
• Some creditors appealed. District court reversed order of
payments to critical vendors. Decision was appealed.
In the Matter of Kmart Corporation
• HELD: Affirmed.
• Kmart argued that the District Court’s reversal order was
too late – money had already changed hands.
• Too bad. To order payment of critical vendors, it is
necessary to show
– 1) disfavored creditors will be as well off with
reorganization as with liquidation (this was never
demonstrated), and
– 2) that critical vendors would cease deliveries if old
debts were left unpaid during litigation.
• #2 was not always true, i.e. some of the critical vendors
must continue business due to long-term contracts