978-1285427003 Chapter 22 Lecture Note Part 1

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Suggested Additional Assignments

Writing Exercise

Ask students to write their own mystery story modeled on the vignette that opens the chapter. This

exercise will help them consolidate their grasp of the material in the chapter. In class, ask them to break

into groups and share their stories with the group. They will then select the best story from their group to

read aloud to the class.

Research: Indorsements

Ask students to look at the checks that have been returned with their bank statements and find as many

different types of indorsements as they can: blank, special, or restrictive. Ask them to bring photocopies

of the indorsements to class.

Research: Biometric Authentication

Have students research biometric authentication of check cashing and other financial transactions. What is

biometric authentication? What technologies does it use? How is it being used to authenticate financial

transactions? How much does it cost to implement? What are its advantages? Is anyone critical of it?

Why? Students could present their findings during class.

Field Work: Completing Checks

Ask students to bring in an original or photocopy of a check that they or someone else has filled out. (The

purpose is to determine if there is a standard method for filling out checks.)

Chapter Overview

Chapter Theme

This chapter lays the foundation for the three chapters on negotiable instruments. Students will learn the

important fundamentals: the types of negotiable instruments, the concept of negotiability, and the rights of

a holder in due course.

This chapter could also be entitled, “When Bad Things Happen to Good Instruments.” It deals with

liability when a person who ought to be paid on an instrument is not and also when a person who ought

not to be paid is.

Commercial Paper

Commercial paper is a contract to pay money. It is used as a substitute for money or a loan of money.

There are two kinds of commercial paper: negotiable and non-negotiable instruments. Article 3 of the

Uniform Commercial Code (UCC) covers only negotiable instruments; non-negotiable instruments are

governed by ordinary contract law.

The Role of Commercial Paper

Students use commercial paper all the time, without realizing its legal name. Everyone in the class will

have written or received a check at some point.

Question: What types of commercial paper have you used in the last month?

Question: Have you ever signed a promissory note? For what purpose?

Types of Negotiable Instruments

Notes vs. Drafts

It is important for students to be clear on the difference between a note and a draft.

Question: What is the difference between a note and a draft? Who are the players?

Question: How many players are involved in a note and draft, respectively?

The Fundamental “Rule” of

Commercial Paper

The possessor of a piece of commercial paper has an unconditional right to be paid, as long as

(1) the paper is negotiable;

(2) it has been negotiated to the possessor;

(3) the possessor is a holder in due course; and

(4) the issuer cannot claim any of a limited number of “real” defenses.

Negotiable

Fundamental Rule Part (1): The paper is negotiable

What is the legal effect of commercial paper not being negotiable? Simply this: the possessor of

non-negotiable paper has the same rights as the person who made the original contract, and the exercise of

those rights is conditional on the rights of the original party to the contract. If the original payee loses his

rights to be paid, the holder of non-negotiable commercial paper also loses his rights to be paid.

The possessor of negotiable commercial paper has more rights than the person who made the original

contract. If the possessor is a holder in due course, his exercise of those rights is not conditional on the

rights of the original party to the contract.

Question: What does the Code require to create a negotiable instrument?

Answer: UCC §3-104(a) states that to be negotiable an instrument must:

Be in writing

Be signed by the maker or drawer

Contain an unconditional promise or order to pay

State a definite amount of money

Be payable on demand or at a definite time, and

Be payable to order or to bearer.

Question: Why are these requirements essential for negotiability?

Question: Why is a negotiable instrument like a courier without luggage?

Answer: The possessor of non-negotiable commercial paper has the same rights as the person who

Question: Is the quote completely accurate?

Answer: No, because the holder of a negotiable bill is subject to both personal and real defenses

Interpretation of Ambiguities

When the terms in a negotiable instrument contradict each other, three rules apply:

Words take precedence over numbers.

Handwritten terms prevail over typed and printed terms.

Typed terms win over printed terms.

You Be the Judge: Blasco v. Money Services Center1

Facts: Christina Blasco entered into a “payday loan” with Money Services Center (MSC). MSC loaned

Blasco $500 and return Blasco left MSC with a signed check for $587.50 which it promised not to cash

for two weeks. (Note that Blasco is paying 17.5% interest for a two-week loan, which is an annual

compounded rate of 6500%.)

Before MSC could cash the check, Blasco filed for bankruptcy. Although MSC knew this, it deposited

the check. It is illegal for creditors to attempt to collect a debt once a debtor has filed for bankruptcy, but

creditors are entitled to payment on negotiable instruments.

The numerical amount on Blasco’s check was $587.50, but the amount written in words was “five

eighty-seven and 50/100 dollars.” Did the words mean “five hundred eighty-seven” or “five thousand

eighty-seven”? Was the check negotiable despite this ambiguity?

You Be The Judge: Was this check a negotiable instrument? Was it for a definite amount?

Holding: Yes, the note was negotiable, it was for a definite amount. According to the court, to determine

whether the check was a negotiable instrument, it must state a promise to pay a definite amount of money.

The numerical amount of the check was “$ 587.50,” but the amount stated in words was “five

eighty-seven and 50/100 dollars.” For the words to prevail over the numbers, the two have to be

contradictory. The words “five eighty-seven and 50/100 dollars” did not contradict the numbers $587.50;

the numbers clarified the ambiguity in the words.

Question: Was this note in writing?

Question: Was it signed by Blasco?

Question: Did it contain an unconditional promise or order to pay?

Question: Presumably Blasco knew the amount of the check, after all she wrote it. Why then did she

sue saying the check was not negotiable?

1 2006 Bankr. LEXIS 2899, United Stated Bankruptcy Court for the Northern District of Alabama, 2006.

Negotiated

Fundamental Rule Part (2): The paper has been negotiated to the

possessor

Negotiation is the transfer of an instrument to a holder by someone other than the issuer. (Remember that

“issuer” means both the maker of a note and the drawer of a draft.) To be negotiable, order paper must be

indorsed and then delivered to the transferee, and bearer paper must be delivered to the transferee.

An indorsement is the signature of a payee.

NEGOTIATED PAPER CONSEQUENCES

Issuer (maker or

drawer)

Payee or drawee Holder (possessor)

Note or draft

Received from issuer,

later transferred to

Issuer liable to holder

regardless of any

claims it has against

payee or drawee

NON-NEGOTIATED PAPER

Issuer (maker or

drawer)

Payee or drawee

Note or draft Received from issuer

Issuer’s liability

subject to any claims

it has against payee or

drawee

To be negotiated, order paper must first be indorsed and then delivered to the transferee by someone other

than the issuer. Bearer paper must simply be delivered to the transferee; no indorsement is required.

Question: What are the differences between order paper and bearer paper?

Answer: Bearer paper is like cash. No indorsement is necessary and any holder is eligible to be a

Research: Indorsements

If students undertook the indorsements research, copy some samples on the board and ask students to

identify the different types.

Holder in Due Course

Fundamental Rule Part (3): The possessor is a holder in due course

A holder in due course has an automatic right to receive payment for a negotiable instrument unless the

issuer can claim a limited number of real defenses. In other words, a holder in due course has a greater

probability of being paid than a mere holder—a fact that gives negotiable instruments tremendous value

and fuels market demand for them.

Question: What are the requirements for a holder in due course?

Answer: A holder in due course is a holder who has given value for the instrument, in good faith,

without notice of outstanding claims or other defects.

Question: Why are holders in due course entitled to this special treatment?

Answer: The theme throughout this chapter is that an instrument has little value unless the holder can

be reasonably sure she will be paid. An innocent holder, who has no reason to believe there is any

underlying problem with the instrument, deserves to be paid. However, someone who took the

Case: Buckeye Check Cashing, Inc. v. Camp2

Facts: On October 12, Shawn Sheth and James Camp agreed that Camp would provide services to Sheth

by October 15. In payment, Sheth gave Camp a check for $1,300 that was postdated October 15. On

October 13, Camp sold the check to Buckeye Check Cashing for $1,261.31. On October 14, fearing that

Camp would violate the contract, Sheth stopped payment on the check. Also, on October 14, Buckeye

deposited the check with its bank, believing that the check would reach Sheth’s bank on October 15.

Buckeye was unaware of the stop payment order. Sheth’s bank refused to pay the check. Buckeye filed

suit against Sheth.

The trial court ruled that, because Buckeye was a holder in due course, the check was valid and Sheth

had to pay Buckeye. Sheth appealed.

Issues: Was Buckeye a holder in due course? Must Sheth pay Buckeye?

Excerpts from Justice Donovan’s Decision: At issue is whether Buckeye acted in “good faith” when it

chose to honor the postdated check originally drawn by Sheth. “Honesty in fact” is defined as the absence

of bad faith or dishonesty with respect to a party’s conduct within a commercial transaction. Under that

standard, absent fraudulent behavior, an otherwise innocent party was assumed to have acted in

good faith. The “honesty in fact” requirement, also known as the “pure heart and empty head” doctrine, is

a subjective test under which a holder had to subjectively believe he was negotiating an instrument in

good faith for him to become a holder in due course.

[H]owever, the Ohio legislature amended the definition of “good faith” to include not only the

subjective “honesty in fact” test, but also an objective test: “the observance of reasonable commercial

standards of fair dealing.” A holder in due course must now satisfy both a subjective and an objective test

of good faith.

Check cashing is an unlicensed and unregulated business in Ohio. Thus, there are no concrete

commercial standards by which check cashing businesses must operate. Buckeye argues that its own

internal operating policies do not require that it verify the availability of funds, nor does Buckeye

apparently have any guidelines with respect to the acceptance of postdated checks.

Under a purely subjective “honesty in fact” analysis, it is clear that Buckeye accepted the check from

Camp in good faith and would therefore achieve holder in due course status. When the objective prong of

the good faith test is applied, however, we find that Buckeye did not conduct itself in a commercially

reasonable manner. [T]he presentation of a postdated check should put the check cashing entity on notice

that the check might not be good. Some attempt at verification should be made before a check cashing

business cashes a postdated check. Such a failure to act does not constitute taking an instrument in

good faith under the current objective test of “reasonable commercial standards.”

This court in no way seeks to curtail the free negotiability of commercial instruments. [However,

without] taking any steps to discover whether the postdated check issued by Sheth was valid, Buckeye

failed to act in a commercially reasonable manner and therefore was not a holder in due course.

Judgment reversed, and cause remanded.

Question: Where did Buckeye go wrong?

2 159 Ohio App. 3d 784; 825 N.E.2d 644; 2005 Ohio App. LEXIS 929 COURT OF APPEALS OF OHIO, 2005.

Question: Was Buckeye a holder in due course?

Additional Case: Rosenbaum v. Bulow3

Facts: Maude Rosenbaum wanted to post bail to get out of prison. Harvey Bowen agreed to post bail of

$7,500 in return for a $7,500 promissory note signed by Rosenbaum and secured by her house. Bowen

was not a licensed bondsman and therefore, under state law, was not entitled to any payment for posting

bail. To solve this problem, Bowen asked Rosenbaum to sign a second note to his niece’s husband, W. F.

Bulow (who was not a bondsman, either).

Issues: Did Bulow give value for the promissory note? Did he act in good faith?

Holding: Bulow cannot collect on the note. At best, Bowen was trying to make a gift to Bulow of his

illegally obtained profit. Bulow did not give value to Rosenbaum. Nor did Bulow act in good faith. He

could not have believed that Rosenbaum simply wanted to make a gift to him of $7,500. If he did not

already know why she was signing the note to him, he should have investigated.

Question: What did Rosenbaum and Bowen agree to do?

Question: What does “secured by her house” mean?

Question: Is this arrangement fair?

Answer: No. As long as Rosenbaum returns to prison when ordered by the court, Bowen will get his

Question: Is this arrangement with Rosenbaum legal?

Question: Why did Rosenbaum agree to Bowen’s deal?

Question: Why did Bowen ask Rosenbaum to sign a second note to Bulow?

Question: Could Bulow enforce the second note?

Question: Why hadn’t he given value?

Question: Why hadn’t he acted in good faith?

Question: Both Bowen and Rosenbaum were wrong. She reneged on the deal; he illegally accepted a

bond fee. Why should Rosenbaum win?

3 1997 Bankr. LEXIS 555 United States Bankruptcy Court for the Eastern District of North Carolina,

1997.

Notice of Outstanding Claims or Other Defects

In certain circumstances, a holder is on notice that an instrument has an outstanding claim or other defect:

The instrument is overdue

The instrument is dishonored

The instrument is altered, forged, or incomplete

The holder has notice of certain claims or disputes

Additional Case: Hartford Accident & Indemnity Co. v. American

Express Co.4

Facts: Stratford Skalkos was a manager at Avon Products. He issued Avon checks to pay his personal

debts. So that no one in the company would know what he was doing, he disguised the name of the

payees. For example, to pay his American Express bill, he issued an Avon check to “Amerex Corp.”

Avon sued the recipients of the checks, demanding that the funds be returned. The trial court ruled against

Avon and granted defendants’ motion for summary judgment, concluding that defendants were holders in

due course and thus took the checks free of any claims or defenses. Avon appealed.

Issue: Were the defendants holders in due course?

Holding: American Express and the others were holders in due course. There was no reason why they

should have been suspicious simply because Skalkos was paying his bills with company checks. Many

companies pay entertainment and other expenses for their employees. Therefore, American Express was

not “on notice of any claims or disputes.”

Question: Is this a fair result?

Answer: As the court observed, Avon was the company that (1) had hired a dishonest employee and

Question: Should American Express have been on notice when it received checks payable to

Amerex? Similarly, should the Metropolitan Opera Company have wondered why it got checks made

out to “Metropolitan Oprtg. Co.”?

Additional Example

A financial columnist for the Chicago Tribune received this question from a reader:

I received a promissory note and accompanying letter (copies enclosed). The letter attests to the

legitimacy and negotiability of the note, which is for $1 million. Is this really a valid document? Can I

convert this to cash before the maturity date? 5

The note was for one million dollars, payable 20 years later.

Question: If you received such a promissory note in the mail, what difficulties might you have in

enforcing it? Are you a millionaire?

4 74 N.Y.2d 153, 542 N.E.2d 1090, 1989 N.Y. LEXIS 881 New York Court of Appeals, 1989.

5 “Promises, Promises! But Will They Make You a Millionaire?” by Phil Vettel, Chicago Tribune, Feb.

24, 1985, p. 2.

Second, you have not given consideration. This is a personal defense, which is valid against you as a

holder. Therefore, you cannot enforce the note.

Third, suppose you sell the note to a third party. The buyer would argue that she can enforce the note

because she has given value and is, therefore, a holder in due course. The maker of the note would claim,

however, that no one would pay real money for such a note without investigating. If the buyer finds out

the truth, she could not pass the objective test, because the transaction did not appear to be commercially

reasonable. If the buyer does not investigate, a court might also hold that she has not taken it in good

faith.