978-1285770178 Lecture Note Unit 3

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2 INSTRUCTOR’S MANUAL FOR BUSINESS LAW: COMMERCIAL LAW FOR ACCOUNTANTS

A. CASE BACKGROUND

The text illustrates the point with an 1884 Kansas case in which a farmer who signed a note in reliance on

another’s false representations could not later avoid payment on the note to a third party who took the

note without notice of the fraud.

B. THE COURT’S DECISION

The court’s decision presaged the UCC’s position on the question. UCC 3-305(a)(1)(iii) states that fraud

is only a defense against an HDC if the injured party signed the instrument “with neither knowledge nor a

reasonable opportunity to obtain knowledge of its character or essential terms.”

C. THE REASONING OF THE HDC CONCEPT

The HDC doctrine reflects the philosophy that when two or more innocent parties are at risk, the burden

should fall on the party that was in the best position to prevent the loss.

II. Good Faith in Negotiable Instruments Law

The text discusses good faith in the context of the HDC doctrine.

A. THE IMPORTANCE OF GOOD FAITH

A 1998 Pennsylvania case, in which the court refused to apply the fictitious payee rule because a bank

did not act in good faith is offered as an example of good faith in this context.

B. HOW SHOULD GOOD FAITH BE TESTED?

The text sketches two answers to the question of how good faith should be measured—subjectively or

objectively—and how those answers might affect HDC status differently.

C. CRITICISMS OF THE OBJECTIVE STANDARD

Some observers claim the objective test that requires the “observance of reasonable commercial

standards” is to imprecise, relative, or ambiguous. A good faith argument is thus always possible, leading

to potential litigation.

D. HOW GOOD FAITH STANDARDS CAN AFFECT HDC STATUS

Whether the subjective or objective test is used can affect HDC status. The text includes an example.

III. Efficiency versus Due Care

The text highlights the problem of signature verification on the billions of checks processed every month.

Does a bank exercise ordinary care if it follows the prevailing industry practice of examining

signatures on only a few, randomly selected checks over a certain amount?

Under the unrevised Article 3, some courts held that banks do not breach their duty of care by adhering to a

practice that is cost-effective and customary within the industry. Others reasoned that banks are supposed to

verify all signatures on all checks. The revised Article 3, in UCC 3–103(a)(7), states that “[i]n the case of a

UNIT THREE: FOCUS ON ETHICS—NEGOTIABLE INSTRUMENTS 3

TEACHING SUGGESTIONS

1. Ask the class whether it is more important to protect innocent third parties from harm caused by the mis–

use of negotiable instruments or to apply the laws governing negotiable instruments so as to encourage the

free flow of commerce. To what extent do these objectives conflict? What sorts of ethical dilemmas

arise when one establishes a legal framework that is more concerned with protecting innocent third

parties than with facilitating commerce or vice versa? Would such a system compel one to favor one

value over the other or is it possible to reconcile these two arguably competing values?

2. Because the UCC places great emphasis on the need for parties to act in good faith, ask students

whether this requirement obligates people to conduct their affairs in a manner that is more ethical than that

required by law. Should people be concerned with maintaining a standard of conduct that exceeds any

legal requirements or would it be more practical to simply do what is required by law and nothing

more? A cynic might argue that most people will do only what is legally required of them and nothing more so

that it is pointless to be concerned with extraneous ethical principles.

3. To illustrate the problems associated with the signature verification of billions of checks, use the

experience of a local bank. How many checks does the bank process each day? If it were necessary to

verify all of its customers’ signatures on those checks, what would be the procedure?

Cyberlaw Link

If students were able to write with a clean slate—as the government may be able to do to some de–

gree with e-money—what laws would they draft for the regulation of negotiable instruments? In par-

ticular, what regulations would they impose to govern the use of e-money and protect those who use

it?

ADDITIONAL QUESTIONS

1. Is there an inherent ethical conflict in the UCC’s efforts to protect all individuals against harm caused

by the misuse of negotiable instruments while facilitating the free flow of commerce by providing guidelines

to govern the use of negotiable instruments? The answer to this question depends in large part on whether the

respondent believes that greater protection for innocent parties will automatically reduce the efficiency of the nation’s

financial system. Although one could argue that the economy would be even more efficient if innocent third parties

2. Is the “good faith” requirement contained in the UCC a legal or an ethical obligation? Both. Although

the good faith requirement has its roots in the common law and is a byproduct of certain normative expectations

4 INSTRUCTOR’S MANUAL FOR BUSINESS LAW: COMMERCIAL LAW FOR ACCOUNTANTS

about how we believe that people should behave, it is also of great importance in the law because the legal liability of

3. Does the UCC’s attempt to protect innocent third parties against harm caused by the misuse of nego–

tiable instruments create an incentive for parties acquiring negotiable instruments to be less vigilant in in–

vestigating its defects? The requirement that a holder in due course acquire an instrument for value in good faith

without notice of its defects does not permit one to decide not to investigate a possible problem. The person acquiring

4. Is it fair when two or more innocent parties are at risk that the burden should fall on the party in the

best position to prevent the loss? In an ethical sense, it is not fair that either innocent party should bear the risk of

loss. Yet the UCC rule is based on the practical consideration that situations do arise in which a choice will have to be

5. Should fraud always be available as a defense against a holder in due course? UCC 3–305(1)(a)(iii)

limits the extent to which fraud can be raised as a defense against a holder in due course to those situations in which

the injured party signed the instrument “with neither reasonable knowledge nor a reasonable opportunity to obtain

knowledge of its character or essential terms.” In general, those situations in which the injured party was negligent in

6. Do banks breach any ethical duties to their customers when they fail to examine the signatures on

checks below a certain threshold amount? Although it may offend our sense of fairness that banks generally

concentrate their efforts on verifying the signatures on only those checks in excess of a certain amount of money

(thus neglecting most if not all of the checks written by most small depositors), it is also true that small depositors are

the ones who are most likely not to worry about balancing their checkbooks or examining their canceled checks. In

UNIT THREE: FOCUS ON ETHICS—NEGOTIABLE INSTRUMENTS 5

ACTIVITY AND RESEARCH ASSIGNMENTS

1. Ask students to reveal whether they balance their checkbooks on a regular basis and whether they actually

examine their checks for forgeries. Do they rely on the bank to balance their checkbooks for them? The students

might also be asked to reveal whether they have ever uncovered any bookkeeping errors by the bank in their monthly

check statements and how the errors were resolved. What sorts of evidence had to be marshaled in order to

convince the bank that it had made a mistake?

2. Ask students to obtain any information from local banks regarding how disputes over unauthorized electronic

fund transfers are resolved. Do the procedures for resolving such disputes appear to be fair or are they heavily

slanted in favor of the individual banks? Ask students to devise more satisfactory procedures for resolving such

disputes short of going to court. How should a court decide who is telling the truth when a bank customer

disputes an electronic fund transfer for which there is no paper trail other than the record in the ATM? As with

any legal dispute, the resolution of this matter will depend on the way in which the court evaluates all the relevant

facts and circumstances. When a customer claims that an unauthorized electronic fund withdrawal has been made

from his or her account, then the court must consider the credibility of the injured party as well as any other witnesses

and weigh that against any evidence regarding the accuracy or inaccuracy of the ATM’s records. Consequently, there

is no single way to resolve the issue of truthfulness; each case will necessarily turn on its particular factual pattern

and any concomitant circumstances.

NEGOTIABLE INSTRUMENTS—

 ANSWERS TO THE LEGAL REASONING QUESTIONS 

1. What do you think would result if the law was changed to allow personal defenses to be

successfully raised against HDCs? Who would lose, and who would gain? How would such a change

in the law affect the flow of commerce in this country? Allowing personal defenses to be successfully

asserted against HDCs would provide more protection to arguably innocent makers and drawers, and others,

but at the cost of removing an incentive for the use of negotiable instruments by other arguably innocent

parties (HDCs). Would this shift in protection affect the nation’s flow of commerce? The laws governing the

use of negotiable instruments should be practical and reasonable to encourage the free flow of commerce. It

could be argued that the economy would be more efficient if HDCs were not given special rights under the

UCC.

But it is difficult to see how a system that did not protect the expectations of those who pay value for

instruments could be sustained. If no one could acquire the rights of an HDC, then third parties would

probably be reluctant to accept negotiable instruments in any form. This might lead to a cash-based, or even

barter-based, economy with a consequent reduction in economic activity.

6 INSTRUCTOR’S MANUAL FOR BUSINESS LAW: COMMERCIAL LAW FOR ACCOUNTANTS

2. Because the UCC offers special protection to HDCs, innocent makers of notes or drawers of

checks in fraudulent transactions often have no legal recourse. From an ethical standpoint, how

could you justify to the “losers” in such situations the provisions of the UCC that fail to protect them?

Can you think of a way in which such problems could be handled more fairly or ethically than they are

under the UCC? It may not seem fair that an innocent victim should have to suffer the consequences of

another’s fraudulent act, but the UCC assumes that it would be even less fair if an HDC could not collect

payment. The reasoning underlying this assumption is that an HDC is a third party and unlikely to have been

responsible for—or to have had an opportunity to protect against—the fraud.

The requirements for HDC status include acting in good faith and taking an instrument for value without

notice of any claims to or defenses against payment. These requirements presume innocence with respect to

fraud. It might be argued that when a maker or drawer is also innocent, the parties could split the difference of

any loss, with each suffering some determinable amount, but neither absorbing the total loss in every

circumstance.

The HDC doctrine reflects the philosophy that when two or more innocent parties are at risk, however, the

burden should fall on the party that was in the best position to prevent the loss. For businesspersons, the

doctrine means that they should exercise caution when issuing and accepting negotiable instruments to

protect against the risk of loss through fraud.

3. Do you think that the UCC’s provisions have struck an appropriate balance between the interests

of banks and those of bank customers? Why or why not? A response to this question could come from

any point on the spectrum of the UCC’s different definitions of good faith. There has long been a division of

opinion as to how good faith should be measured or tested. At one end of the spectrum of views is the

position that the test of good faith should be subjective in nature. In other words, as long as a person acts

honestly, no matter how negligent or foolish the conduct may be, that person is acting in good faith. At the

other end of the spectrum is the “objective” test of good faith. Under this test, honesty in itself is not enough. A

party must also act reasonably under the circumstances. The objective measure of good faith is incorporated

into UCC Articles 3, 4, and 4A.

A response to this question might also fall anywhere along the range of changing commercially

reasonable standards. The changes are illustrated by the evolving standard of banks’ signature verification.

If a bank fails to verify a signature on a check it receives for payment and the check turns out to be forged,

the bank will normally be held liable to its customer for the amount paid. At one time in the banking industry,

ordinary care was generally interpreted to mean that a bank had a duty to inspect all signatures on checks.

But now billions of checks are processed by the banking system each month. The banks’ solution to this

problem is simply to not examine all signatures. Instead, computers are programmed to verify signatures

only on checks exceeding a certain threshold amount. This practice, which has become an acceptable

standard in today’s banking industry, is economically efficient for banks. Some argue, however, that banks

using such procedures are not exercising due care in handling their customers’ accounts.

