665
Unit Five
Focus on Ethics:
Negotiable Instruments
See Separate Lecture Outline System
INTRODUCTION
Articles 3 and 4 of the Uniform Commercial Code (UCC) reflect two fundamental ethical principles: (1) that individuals
should be protected against harm caused by the misuse of negotiable instruments and (2) that the free flow of commerce
should be encouraged by practical and reasonable laws governing the use of negotiable instruments. This focus examines some
ethical dimensions of transactions that involve these instruments.
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ADDITIONAL RESOURCES—
VIDEO SUPPLEMENTS
The following video supplements relate to ethical issues on topics discussed in this feature—
Business Law Digital Video Library
The Business Law Digital Video Library at www.cengage.com/blaw/dvl offers a variety of videos for group or
individual review. Clips related to topics in this feature include the following.
• Ask the Instructor
Negotiability & Transferability: Indorsing Checks—I thought bearer instruments didn’t need indorsements. Why do
banks always make you indorse checks made out to cash, which are bearer instruments?—Banks require all checks,
including bearer instruments, to be indorsed because the indorsement creates indorser liability for the indorsing party.
Also, it is more efficient and safer for a bank to have a policy requiring indorsement of all checks rather than for tellers
to make individual assessments of whether checks are order or bearer instruments.
and needs to pay for booth space at a trade show. They discuss whether they can use a vendor contract as security for
a loan.
FOCUS OUTLINE
I. Ethics, the HDC Concept, and Ort v. Fowler
Before Article 3, at common law, courts often restricted the extent to which defenses such as fraud could successfully
be raised against a good faith holder of a negotiable instrument.
A. CASE BACKGROUND
The text illustrates the point with an 1884 Kansas case in which a farmer who signed a note in reliance on an-
other’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
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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.
668 INSTRUCTOR’S MANUAL TO ACCOMPANY BUSINESS LAW, TWELFTH EDITION
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 v. 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
TEACHING SUGGESTIONS
1. Ask the class whether it is more important to protect innocent third parties from harm caused by the misuse 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
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 degree with e-
UNIT FIVE: FOCUS ON ETHICS—NEGOTIABLE INSTRUMENTS 669
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
2. Is the “good faith” requirement contained in the UCC a legal or an ethical obligation? Both. Although the good faith
3. Does the UCC’s attempt to protect innocent third parties against harm caused by the misuse of negotiable instruments
create an incentive for parties acquiring negotiable instruments to be less vigilant in investigating its defects? The requirement
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
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
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 short, small depositors are more likely to be negligent
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
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
UNIT FIVE: FOCUS ON ETHICS—NEGOTIABLE INSTRUMENTS 671
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 DISCUSSION QUESTIONS
1. 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
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
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
2. 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
But it is difficult to see how a system that did not protect the expectations of those who pay value for instruments
cept negotiable instruments in any form. This might lead to a cash-based, or even barter-based, economy with a
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
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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.
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