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Business Law with UCC Applications 14th Edition
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978-0077733735

978-0077733735 Chapter 16 Lecture Notes

April 10, 2019
Chapter 16 - The Nature of Negotiable Instruments
Chapter 16
The Nature of Negotiable Instruments
I. Key Terms
Acceptance (p. 384) Holder (p. 388)
Acceptor (p. 388) Holder in due course (p. 388)
Allonge (p. 392) Indorsee (p. 388)
Assignment (p. 391) Indorsement in full (p. 394)
Bank draft (p. 386) Indorser (p. 388)
Bearer (p. 388) Installment note (p. 383)
Bearer paper (p. 391) International bill of exchange (p. 384)
Bill of exchange (p. 383) Issuer (p. 388)
Blank indorsement (p. 392) Maker (p. 388)
Cashier’s check (p. 386) Money order (p. 387)
Certificate of deposit (CD) (p. 383) Negotiable instrument (p. 382)
Certified check (p. 386) Negotiation (p. 391)
Check (p. 384) Note (p. 383)
Comakers (p.388) Order paper (p. 391)
Conditional indorsement (p. 395) Payee (p. 388)
Conversion (p. 396) Qualified indorsement (p. 395)
Demand note (p. 383) Restrictive indorsement (p. 3594
Dishonored (p. 396) Sight draft (p. 384)
Domestic bill of exchange (p. 384) Special indorsement (p. 394)
Draft (p. 383) Teller’s check (p. 386)
Drawee (p. 388) Time draft (p. 384)
Drawer (p. 388) Trade acceptance (p. 384)
Foreign draft (p. 384) Traveler’s check (p. 346)
II. Learning Objectives
1. State the purpose of a negotiable instrument.
2. Explain those negotiable instruments that contain a promise to pay money.
3. Explain those negotiable instruments that contain an order to pay money.
4. Differentiate among the different types of checks and money orders.
5. Identify the requirements of a negotiable instrument.
6. Explain an assignment and a negotiation of an instrument.
7. Name and describe four kinds of indorsements.
8. Identify the implied warranties related to indorsements.
9. Explain the contract that is made when people indorse negotiable instruments.
10. Describe the legal effect of a forged indorsement.
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Chapter 16 - The Nature of Negotiable Instruments
III. Major Concepts
16-1 The Essentials of Negotiable Instruments
The law of negotiable instruments is found in Article 3 of the UCC. Under the UCC, a
negotiable instrument is a written document signed by the maker that contains an
unconditional promise or order to pay a fixed amount of money on demand or at a
definite time to the bearer or to order. There are two basic kinds of negotiable
instruments: promise instruments (including notes and certificates of deposit) and order
instruments (including drafts and checks). The following are parties to negotiable
instruments: maker or comaker; drawer; issuer; drawee; payee; bearer; holder; holder in
due course; indorser; indorsee; and acceptor. To be negotiable, instruments must: (1) be in
writing; (2) be signed by the maker or drawer; (3) contain an unconditional promise or
order to pay; (4) be made out for a fixed amount of money; (5) be payable on demand or
at a definite time; and (6) except for checks, be payable to order or to bearer.
16-2 Transferring Negotiable Instruments
When an instrument is first delivered by the maker or drawer for the purpose of giving
rights to any person, it is said to be issued. When the person to whom it is issued delivers
it to a third party, it is transferred. Instruments can be transferred by assignment or by
negotiation. An instrument is indorsed when the holder signs it, thereby indicating the
intent to transfer ownership to another. Indorsements may be written in ink, typewritten,
or stamped with a rubber stamp. There are four commonly used types of indorsements:
blank indorsements, special indorsements, restrictive indorsements, and qualified in-
dorsements. Indorsements have threefold significance. In addition to being necessary to
negotiate order paper, they create obligations on the part of the indorser. These obli-
gations come in the form of implied warranties and a contractual promise to pay
subsequent holders of the instrument. An unauthorized signature or indorsement is one
made without actual, implied, or apparent authority.
IV. Outline
I. Purpose and Types of Negotiable Instruments (16-1)
A. Introduction
1. The law of negotiable instruments developed to meet the need of transacting business
without carrying around large sums of money and to facilitate the borrowing of
money.
2. Checks, drafts, and notes are used as a substitute for money and to obtain credit.
3. Online payments are being used as a substitute for checks.
B. Promise and Order Instruments
1. The law of negotiable instruments is found in Article 3 of the UCC.
2. A negotiable instrument is a written document signed by the maker containing an
unconditional promise or order to pay a fixed amount of money on demand or at a
definite time to the bearer or to order.
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Chapter 16 - The Nature of Negotiable Instruments
3. The two basic types of negotiable instruments are promise instruments and order
instruments.
4. A note is a written promise by one party, the maker, to pay money to the order of
another party, the payee.
5. A demand note is payable whenever the payee demands payment.
6. A time note is payable at some future date, on a date named in the instrument.
7. In an installment note the principal and interest on the unpaid balance is payable in
installments at specified times.
8. A certificate of deposit, CD, is an instrument containing an acknowledgment that a
bank has received a sum of money and a promise by the bank to repay the sum of
money.
9. A CD is a note of the bank.
10. In contrast to notes, which are promises to pay money, drafts are orders to pay money.
11. The one who draws the draft is called the drawer.
12. The one who is ordered to pay the money is called the drawee.
13. The one who is to receive the money is known as the payee.
14. Drawees are liable on drafts only when they accept them; that is, agree to become
liable on them.
15. A sight draft is payable as soon as it is presented to the drawee for payment.
16. A time draft is not payable until the lapse of a particular time period stated on the
draft.
17. A domestic bill of exchange is a draft that is drawn and payable in the Untied States.
18. A draft that is drawn in one country but payable in another is called an international
bill of exchange or foreign draft.
19. A check is a draft drawn on a bank and payable on demand.
20. Ownership of a check may be transferred to another person by indorsement by the
payee.
21. A bank must honor a check when it is properly drawn against a credit balance of the
drawer, and failure to do so makes the bank liable to the drawer for damages.
22. While banks provide regular and special printed check forms, the use of a printed
form is not required.
23. A certified check is a check accepted by the bank on which it is drawn; and once a
check is certified, the drawer is discharged from liability.
24. A bank draft, sometimes called a teller’s or treasurer’s check, is a check drawn by one
bank on another bank in which it has funds on deposit in favor of a third person, the
payee.
25. A cashier’s check is a check drawn by a bank upon itself.
26. A traveler’s check is similar to a cashier’s check in that the issuing financial
institution is both the drawer and the drawee.
27. To cash a traveler’s check, the purchaser writes the name of the payee in the space
provided and countersigns it in the payee’s presence.
28. A money order is a type of draft drawn on the funds of the organization that issues it.
C. Parties to Negotiable Instruments
1. A maker is the person who signs a note.
2. A drawer is a person who signs a draft.
3. An issuer is either a maker or a drawer.
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distribution without the prior written consent of McGraw-Hill Education.
Chapter 16 - The Nature of Negotiable Instruments
4. A drawee is a person ordered in a draft to make payment.
5. A payee is a person to whom a note or draft is payable.
6. A bearer is a person who is in possession of a negotiable instrument that is payable to
bearer or to cash or that has been indorsed in blank.
7. A holder is a person who is in possession of a negotiable instrument that is issued or
indorsed to that person’s order or to bearer.
8. A holder in due course is a holder who is treated as favored and is given immunity
from certain defenses.
9. An indorser is a person who indorses a negotiable instrument.
10. An indorsee is a person to whom a draft or note is transferred by indorsement.
11. An acceptor is a drawee of a draft who has promised to honor the draft as presented
by signing it on its face.
D. Requirements of Negotiable Instruments
1. Written Instrument
a. A negotiable instrument must be in writing.
b. Under the Uniform Electronic Transactions Act, an electronic record fulfills the
requirement of a writing.
c. Article 3 of the UCC has been amended to permit electronic negotiable
instruments although not all states have adopted the amendment.
d. If forgery should happen, the person who drew the instrument would be
responsible for any loss caused by the negligent drawing of the instrument.
2. Signature of Maker or Drawer
a. The instrument must be signed by the maker or drawer.
b. Any writing, mark or symbol is accepted as a signature so long as it expresses the
writer’s intent to make a signature.
c. A signature may be made by an agent or other representative.
d. Agents who sign their own names are personally obligated if the instrument
neither names the person represented nor shows that the agent signed in a
representative capacity.
3. Unconditional Promise or Order to Pay
a. The instrument must contain no conditions that might in any way affect its
payment.
b. Statements requiring that certain things be done or that specific events take place
prior to payment make the instrument a simple contract rather than negotiable
paper.
c. In addition to being unconditional, a negotiable instrument must contain a
promise to pay or an order to pay.
4. Fixed Amount of Money
a. A negotiable instrument must be payable in a fixed amount or a sum certain of
money.
b. Money is defined as a medium of exchange adopted by a domestic or foreign
government as part of its currency.
5. Payable on Demand or at a Definite Time
a. Negotiable instruments must be made payable on demand or at a definite time.
b. An instrument is payable on demand when it so states, or when it is payable “on
sight” or “on presentation.”
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distribution without the prior written consent of McGraw-Hill Education.
Chapter 16 - The Nature of Negotiable Instruments
c. Instruments payable at a fixed period after a stated date or at a fixed period after
sight are considered payable at a definite time.
6. Payable to Order or to Bearer
a. Negotiable instruments, except for checks in states that have adopted revised
Article 3, must be payable to order or to bearer.
b. The terms to the order of and to bearer are called words of negotiability.
7. Dates and Controlling Words
a. The omission of a date does not affect the negotiability of an instrument.
b. When the date is omitted, the date on which the instrument is received is
considered to be the date of its issue.
c. Handwritten terms control typewritten and printed terms, typewritten terms
control printed terms, and words control figures except when words are
ambiguous.
II. Transferring Negotiable Instruments (16-2)
A. Introduction
1. Instruments can be transferred by assignment or by negotiation.
2. An assignment is the transfer of a contract right from one person to another.
3. Negotiable instruments are assigned either when a person whose indorsement is
required on an instrument transfers it without indorsing it or when it is transferred to
another person and does not meet the requirements of negotiability.
4. In the case of an assignment, the transferee has only the rights of an assignee and is
subject to all defenses existing against the assignor.
5. A negotiation is the transfer of an instrument in such form that the transferee becomes
a holder.
6. To be negotiated, order paper must be indorsed by the payee and delivered to the
party to whom it is transferred; but bearer paper may be negotiated by delivery alone.
B. The Concept of Negotiability
1. The person receiving a negotiable instrument is provided with additional protection
and in many cases is able to recover money on the instrument even when the person
from whom the instrument was received could not have done so.
2. Instruments that do not meet the requirements of negotiability can be transferred by
assignment which is governed by contract law.
3. People who receive instruments by assignment are not given the special protection
provided those who receive instruments by negotiation because they cannot be
holders in due course.
C. Negotiation by Indorsement (27-3)
1. Blank Indorsements
a. A blank indorsement consists of the signature alone written on the instrument.
b. When an instrument is indorsed in blank, it becomes payable to bearer and may
be transferred by delivery alone.
2. Special Indorsements
a. A special indorsement is made by writing the words pay to the order of or pay to
followed by the name of the person to whom it is to be transferred and the
signature of the indorser.
b. The instrument remains an order instrument and must be indorsed by the indorsee
before it can be further negotiated.
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distribution without the prior written consent of McGraw-Hill Education.
Chapter 16 - The Nature of Negotiable Instruments
3. Restrictive Indorsements
a. A restrictive indorsement limits the rights of the indorsee in some manner in order
to protect the rights of the indorser.
b. Indorsements for deposit or collection are restrictive indorsements designed to get
an instrument into the banking system for the purpose of deposit or collection.
c. A conditional indorsement, a type of restrictive indorsement, makes the rights of
the indorsee subject to the happening of a certain event or condition.
d. A person paying an instrument with a conditional indorsement or taking it for
value may disregard the condition.
4. Qualified Indorsements
a. A qualified indorsement occurs when words have been added to the signature
limiting the liability of the indorser.
b. By adding the words without recourse to the indorsement, the indorser is not
liable in the event the instrument is dishonored.
D. Obligations of Indorsers
1. Warranties of Indorsers
a. An indorser who receives consideration for an instrument makes five warranties
as follows to subsequent transferees of the instrument:
(a) The indorser is entitled to enforce the instrument.
(b) All signatures are authentic and authorized.
(c) The instrument has not been altered.
(d) The instrument is not subject to a defense of any party which can be asserted
against the indorser.
(e) The indorser has no knowledge of the bankruptcy of the maker, acceptor, or
drawer.
2. Contract of Indorsers
a. Unless an indorsement states otherwise, every indorser agrees to pay any
subsequent holder the face amount of the instrument if it is dishonored.
b. To enforce this obligation, it is necessary for the holder to present the instrument
for payment to the maker or drawee when it is due and notify the indorser or
indorsers of any dishonor.
c. Time limits apply to the notice requirement and vary depending on whether the
holder is a bank or other holder.
E. Multiple Payees, Missing and Forged Indorsements (27-5)
1. If an instrument is payable to either of two payees, the indorsement of only one of the
payees is necessary for negotiation.
2. If an instrument is payable to both of two payees, the indorsement of both payees is
necessary for negotiation.
F. Unauthorized or Forged Indorsements
1. An unauthorized signature or indorsement is one made without actual, implied, or
apparent authority.
2. When an instrument is paid on a forged indorsement, the tort of conversion takes
place.
3. There are three exceptions to the general rule that an unauthorized indorsement has
no effect:
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Chapter 16 - The Nature of Negotiable Instruments
a. When an instrument is issued to an imposter on the false belief that the imposter
is the payee, the indorsement by any person in the name of the payee is treated as
an effective indorsement.
b. When an agent or employee of the maker or drawer pads the payroll by supplying
the employer with fictitious names, an indorsement by any person in the name of
any fictitious payee is effective.
c. When the maker or drawer of an instrument intends the payee to have no interest
in the instrument or the payee is a fictitious person, an indorsement by any person
in the name of the payee is effective.
V. Background Information
A. Cross-Cultural Notes
1. It is a serious matter in Dubai to write a bad check because jail time may be imposed.
For a discussion from the New York Times see
http://www.nytimes.com/2009/09/12/world/middleeast/12dubai.html?_r=0.
B. Historical Notes
1. As traders at commercial fairs of the Middle Ages bought items from one another, the
amounts due were recorded in the sellers’ books and were countersigned by the
purchasers. At the end of the fair, individuals settled debts. Balances were paid in
cash at first, but eventually it became customary for a debtor to sign a document
agreeing to pay the creditor at a certain date. These documents were the forerunners
of the modern bills of exchange.
2. The first demand notes were the first series of U.S. currency put into circulation. In
1861, at the start of the Civil War, an act of Congress authorized the U.S. Treasury to
issue legal tender notes in denominations of $5, $10, and $20. They were called
demand notes because they carried the statement “The U.S. promises to pay the
bearer...on demand.” These demand notes were also known as “greenbacks” because
they were green on one side.
3. Over the years, checks have served surprising purposes. For example, in 1867, the
United States paid for the territory of Alaska with a check for $7.2 million.
4. As long ago as the thirteenth century, it was common practice for bankers and
merchants to use bills of exchange as a means of transferring funds and making
payments without having to move gold or silver.
5. Traveler’s checks were first introduced in 1891 by American Express. Once
frequently used by travelers, fewer and fewer places accept them today. They may
still be an attractive alternative if travelling to an area that has few ATMs. They are
also an idea for emergency back-up.
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distribution without the prior written consent of McGraw-Hill Education.
Chapter 16 - The Nature of Negotiable Instruments
6. Today, rubber and mechanical stamps, such as signature stamps and “for deposit
only” stamps, are vital to most business operations. However, prior to 1860, such
stamps were rarely used. The union used revenue stamps to help finance the Civil
War.
7. Before alternative systems of identifying customers were introduced, clerks at
Heywoods Bank in London wrote short descriptions of customers next to their sample
signatures. One description given is “short man; whiskers all round his face; one tooth
out in front. Looks like a coal heaver.” Additional information can be found at
http://www.martinsbank.co.uk/.
C. State Variations
1. A New York law states that it is illegal to arrest a dead man for debts.
2. Some states allow employers to require employees to accept direct deposit of payroll
checks whereas some states do not.
D. Quotations
1. A negotiable bill or note is a courier without luggage.
— John B. Gibson (1780–1853), American judge
VI. Terms
1. The word draft comes from the Middle English draught, which is akin to the Old
English dragan, meaning “to draw” or “to drag,” and the Latin trahere, “to pull” or
“to draw.”
2. The term bill is derived from the Latin billa, meaning “seal.” During the Middle
Ages, bill came to refer to any commercial document.
3. Forgery consists of making a false written instrument with the intent to defraud,
altering a genuine instrument in any way, or uttering a forged instrument. In this
sense, the word utter means “to offer” or “to pass for value in return.”
4. The word negotiable comes from the Latin verb negotiare, meaning “to carry on
business.” It is also derived from negotium, which means business and is a
combination of neg, meaning not, and otium, meaning leisure.
5. Indorse is an alternate spelling of endorse. Both terms developed from an Old French
word combining en, meaning on, and dos derived from the Latin dor-sum, which
means back. Thus, endorse means “to put on the back.” Today, under the UCC, an
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distribution without the prior written consent of McGraw-Hill Education.
Chapter 16 - The Nature of Negotiable Instruments
indorsement may be on either side of the instrument, although it is usually placed on
the back.
6. The phrase “foot the bill” comes from the practice of signing one’s name at the
bottom of a bill to indicate acceptance of payment. However, the current popular
usage of the phrase indicates an acceptance to pay, making it similar to an
indorsement.
7. If a person is required by law to pay on a negotiable instrument, he or she may be said
to have to “shell out.” This colloquialism dates to colonial America when money was
scarce, and people often paid debts in shelled corn.
VII. Related Cases
1. Duncan Savings & Loan Association issued a money order for $24,190 payable to
McAffrey Funeral Home. When the instrument was presented for payment, Duncan
Savings and Loan refused payment because McAffrey had put a stop payment on the
money order. The court ruled that a drawer bank (Duncan Savings & Loan) on a
personal money order is liable notwithstanding a stop payment order unless able to
prove a valid defense. The S&L could not assert a defense, so it was required to pay
on the order. First National Bank of Nocona v. Duncan Savings & Loan Association,
656 F.Supp. 358 (W.D. Okla. 1987).
2. Intending to make a loan, X gave Y a check for $20,000, but neglected to sign the
check. The following day Y deposited the check to his account and delivered to X a
note promising to pay back the $20,000. A year later after Y defaulted, X sued the
bank for cashing his check without his signature. The court ruled against X
recognizing that the bank was relieved from liability, since X, accepted the note and
received payment on it constituting a ratification of the bank’s payment of the
unsigned check. Spec-Cast, Inc. v. First National Bank and Trust Co. of Rockford,
538 N.E.2d 543 (Ill. 1989).
3. A husband signed his wife’s name to a promissory note without her knowledge or
permission. In a bankruptcy proceeding, the court recognized that the wife was not
liable for the note because an unauthorized signature is wholly inoperative as that of
the person whose name is signed, unless that person later ratifies it. The wife neither
signed nor ratified the note. The court ruled, however, that she continued to be liable
on a preexisting note that was cancelled in reliance on the new note containing the
signature of the husband and the forged signature of the wife. In re Grove, 73 B.R.
(D. Minn. 1987).
4. The Alabama Supreme Court in Foster v. Hacienda Nirvana, Inc. applied the UCC’s
six-year statute of limitations for negotiable instruments to bar a claim for $200,000
based on the sale of horses. The plaintiffs’ unsuccessfully argued that a 10-year
statute of limitations applied if the promissory note was a contract under seal and also
that a contract under seal could not be a negotiable instrument.
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distribution without the prior written consent of McGraw-Hill Education.
Chapter 16 - The Nature of Negotiable Instruments
VIII. Teaching Tips and Additional Resources
1. At https://www.fdic.gov/consumers/consumer/information/fdiciorn.html, the FDIC
provides an article titled “Insured or Not Insured?” noting that certificates of deposit
are a type of insured account.
2. The Federal Trade Commission provides information on fake check scams at
http://www.consumer.ftc.gov/articles/0159-fake-checks.
3. Additional information regarding check fraud, including videos, can be found at
http://fakechecks.org/prevention.html.
4. Information on the Federal Reserve’s automatic clearinghouse system is available at
http://www.federalreserve.gov/paymentsystems/fedach_about.htm.
5. At http://www.ct.gov/dob/cwp/view.asp?a=2235&q=297926 on the Internet site of the
State of Connecticut Department of Banking is an article referencing fraud involving
cashier’s checks.
6. Tips on using traveler’s checks can be found at
http://www.wlbt.com/story/684346/travelers-checks?redirected=true.
7. An article discussing traveler’s checks and other ways to obtain money while
traveling titled “Money Matters on the Road” can be found at
http://www.msnbc.msn.com/id/17009526/page/3/.
8. The Federal Deposit Insurance Corporation has a number of articles of interest to
consumers at http://www.fdic.gov/consumers/consumer/index.html.
9. A list of embezzlement warning signs is available on the web site of Findlaw.com at
http://smallbusiness.findlaw.com/business-finances/embezzlement-warning-signs.htm
l.
10. Information from the Federal Bureau of Investigation on financial institution fraud is
available at
https://www.fbi.gov/about-us/investigate/white_collar/financial-institution-fraud
11. Information on identity theft is available at the web site of the American Association
of Certified Public Accountants at
http://www.aicpa.org/interestareas/informationtechnology/resources/privacy/pages/id
entitytheft.aspx.
12. Discuss with students alternatives to checks. An article titled “Latest Scam
Highlights Risks for Debit-Card Users” is available at
http://www.smartmoney.com/borrow/credit-cards/latest-scam-highlights-debitcard-da
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distribution without the prior written consent of McGraw-Hill Education.
Chapter 16 - The Nature of Negotiable Instruments
ngers-1305329229415/. Another article from U.S. News Money titled “The Debit
Card Danger You’re Probably Forgetting” is available at
http://money.usnews.com/money/blogs/my-money/2014/09/22/the-debit-card-danger-
youre-probably-forgetting.
13. Ask students if they or their families have ever been the victims of check fraud.
Discuss steps to avoid such fraud with personal accounts and business accounts.
14. To introduce Negotiable Instruments, ask students to discuss how they manage and
use money. Have them explain how and why they conduct particular transactions
such as borrowing money and writing and cashing checks, and using debit cards.
Discuss various problems that arise when people exchange money, and ask students
to predict how such problems are addressed by the law.
15. Students may not realize that the rates of exchange among the different currencies of
the world not only vary slightly from day to day but also according to whether a
person is buying or selling the currency. Have students bring in currency exchange
rates for a full week. These may be obtained from a bank or a national newspaper.
Use these rates to show how the rates change daily. Ask students to relate examples of
monetary exchange problems encountered while traveling in a foreign country.
16. Remind students that if an instrument is indorsed in blank and is subsequently lost, it
can be cashed by anyone. If the instrument is a check, a bank will upon request, put a
“stop payment” order on the check so that an unintended holder of the instrument
cannot cash it.
17. Tell the class that “Pay to the order of” and “Pay to bearer” are the passwords of
negotiability. Without them, most instruments are not negotiable.
18. As you explain each type of indorsement, write it on the board or screen for students
to see. Emphasize the risks of a blank indorsement and the protection of special and
restrictive indorsements.
19. Emphasize that whenever anyone indorses an instrument, unless it is qualified, he or
she agrees to pay the face amount to any subsequent holder if the instrument is
dishonored and the proper notice is given.
20. Have students talk with a local bank official, police officer, and prosecuting attorney
to see what happens when a check is dishonored. What criminal ramifications are
possible? What steps will a police officer or prosecutor take before filing criminal
charges? What civil ramifications are possible? Discuss problems with proving
criminal intent in regard to post-dated checks. Results vary by state.
21. The maker or drawer of an instrument does not have to meet the impostor to be held
liable for any payments made. Fraud perpetrated through the mail is no exception to
the rule.
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distribution without the prior written consent of McGraw-Hill Education.
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