Business Law Chapter 26 Homework Federal Trade Commission Rule 16 Cfr Part

617

Chapter 26

Liability, Defenses, and Discharge

 See Separate Lecture Outline System

INTRODUCTION

618 INSTRUCTOR’S MANUAL TO ACCOMPANY BUSINESS LAW, TWELFTH EDITION

ADDITIONAL RESOURCES—

 VIDEO SUPPLEMENTS 

The following video supplements relate to topics discussed in this chapter—

PowerPoint Slides

To highlight some of this chapter’s key points, you might use the Lecture Review PowerPoint slides compiled for

Chapter 26.

CHAPTER OUTLINE

I. Signature Liability

Every party—except a qualified indorser—who signs a negotiable instrument is either primarily or secondarily liable for

payment of the instrument when it comes due.

ADDITIONAL BACKGROUND—

Signature Liability—Revised

Signature liability is the essence of negotiable instrument law. Once it is established that a party signed an

instrument, the UCC defines that party’s liability.

was personally liable on his or her signature if the principal was not named or the agent or representative did not sign

that the agent or representative signed in a representative capacity, or the principal was not named but the agent or

Basically, revised Article 3 retains the same principles when a holder in due course (HDC) is involved. That is, an

agent or representative is liable on an instrument to an HDC who had no notice that the agent or representative was

not intended to be liable. As to others, however, an agent or representative can escape liability if he or she can prove

that the original parties did not intend the agent or representative to be liable on the instrument [UCC 3–402(b)(2)].

status. Organizations that require more than one signature on a check should be alerted that the signature of the

organization is considered unauthorized if one of the required signatures is lacking [UCC 3–403(b)].

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A. PRIMARY LIABILITY

A person who is primarily liable is required to pay the instrument, subject to certain defenses [UCC 3–305]. Only

makers, issuers, and acceptors are primarily liable.

1. Makers

2. Acceptors

An acceptor is a drawee who has, by signing an instrument, agreed to pay it when it is presented for

payment [UCC 3–409(a)]. (A drawee who does not accept dishonors the instrument.) On certification of a

B. SECONDARY LIABILITY

Drawers and indorsers have secondary liability. On a draft, a drawer’s liability arises if the drawee fails to pay or

to accept the instrument. On a note, an indorser’s liability arises if the maker defaults [UCC 3–412, 3–415]. To

trigger this liability—

• The instrument must be properly and timely presented.

• It must be dishonored.

• Notice of dishonor must be given in a timely manner to the secondarily liable party.

1. Proper Presentment

A note or certificate of deposit must be presented to the maker for payment; a draft to the drawee for

2. Timely Presentment

Failure to present on time is the most common reason for the discharge of unqualified indorsers.

3. Dishonor

4. Proper Notice

Notice, which may be given in any reasonable manner, must be given by a bank before its midnight deadline

and by all others within thirty days [UCC 3–503].

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D. AUTHORIZED AGENTS’ SIGNATURES

1. Liability of the Principal

2. Liability of the Agent

3–402(a), (b)(2)].

CASE SYNOPSIS—

Case 26.1: Jeanmarie v. Peoples

Anthony and Alcibia Jeanmarie sold property in New Orleans to Melanie Murphy. Encore Credit Corp. loaned

$104,000 and $26,000 to Murphy to pay the Jeanmaries with the funds to be deposited in an escrow account

maintained by Pyramid Title, LLC. Mark Peoples, who owned Pyramid, handled the closing and drew a check on its

account payable to the Jeanmaries. When the check was returned for “insufficient funds,” the Jeanmaries filed a suit

in a Louisiana state court to recover the funds from Pyramid and Peoples. Peoples argued that he had signed the

check in his representative capacity and thus should not be liable. From a judgment in the Jeanmaries’ favor, Peoples

appealed.

A state intermediate appellate court vacated the decision and remanded. Under UCC 3–402, if a check identifies

the principal, the agent who signs it does not have to indicate his or her agency status to avoid liability. In this case,

the check clearly identified Pyramid as the principal, and the line on which Peoples signed was entitled “Authorized

Signature.” “It is patent on the face of the check that Mark Peoples signed as the authorized signatory for Pyramid

Title and not in his personal capacity.”

Notes and Questions

What might the parties in this case have done to avoid the situation that instigated this litigation? Pyramid and

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in time to pay the Jeanmaries the full amount due to them at the closing. Peoples stated elsewhere in the opinion that

Furthermore, residents of New Orleans, including the parties in this case, were contending with Hurricane Katrina’s

personal or business circumstances affect its decision on whether Peoples should be held personally liable on the check

to the Jeanmaries. If courts did take such factors into account when determining liability on negotiable instruments, it

the free transferability of instruments in the marketplace so that they may serve as substitutes for cash or extensions

of credit.

Peoples might have more closely monitored its account and kept the others apprised as to whether the loan checks

had been deposited and cleared. The Jeanmaries might have verified the validity of the check at the time of the

closing. Murphy might have contacted Encore for assurance that the loan had been issued. All of these steps could

have been taken before or at the time of the closing. After the closing, under the facts as stated, the Jeanmaries

might have resubmitted the check after its return. The Jeanmaries might have begun an action to retake possession

of the property from Murphy, who might then have pressured Encore to fully fund her loan or who might have found

another source for the funds.

ANSWER TO “WHAT IF THE FACTS WERE DIFFERENT?” IN CASE 26.1

Suppose that the name Pyramid Title, LLC, had not been included on the face of the check. Would Peoples be

personally liable for payment of the check in that situation? Why or why not? Whether Peoples would be personally

liable would depend on several factors. If he indicated in some way that he was acting as an agent for Pyramid (by

signing Mark Peoples, as agent for Pyramid Title, LLC, for example), he would not be personally liable on the

instrument. If he had signed his name and indicated that he was acting as an agent, but did not give the name of the

principal (by signing Mark Peoples, Agent, for example), he might also be held personally liable on the instrument.

Because this signature is ambiguous, however, parol evidence would be admissible to prove the agency relationship. If

he had simply signed his name, then, according to the provisions of UCC 3–402, he would be liable to a holder in due

course who had no notice of the agency status. He would not be liable to an ordinary holder, however, if he could

prove that the original parties to the instrument did not intend him to be liable.

ANSWER TO “THE ECONOMIC DIMENSION” QUESTION IN CASE 26.1

Should Encore Credit Corporation’s failure to “timely fund” the $26,000 loan be taken into consideration by the

court when determining whether Peoples could be held personally liable on the check to the Jeanmaries? Discuss fully.

2002) (the inclusion of “c/o” after a payee’s name on a check, followed by the name of an individual who allegedly

stole money from the payee’s account, did not make that individual payable as the payee’s representative, agent, or

fiduciary).

representative status and the check is payable from an account of the represented corporation that was identified on

1. Exceptions to the General Rule

2. When the Holder is a Holder in Due Course

An unauthorized signature operates as the signature of the unauthorized signer in favor of an HDC [UCC 3–

1. The Imposter Rule

2. Fictitious Payee Rule

A loss falls on a drawer or maker when a person causes an instrument to be issued to a payee who has no

interest in it [UCC 3–404(b); 3–405]. A common context for this situation is employment—a dishonest

employee deceiving his or employer. The text provides examples.

II. Warranty Liability

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Transfer warranties arise even when a transferor does not indorse the instrument [UCC 3–416, 3–417].

ADDITIONAL BACKGROUND—

Warranty Liability—Revised

Transfer and presentment warranties are implied warranties that transferors make regarding the instruments they

negotiate. Article 3 sets out the warranties in UCC 3–416 and 3–417.

A. TRANSFER WARRANTIES

Any person who transfers an instrument for consideration warrants to all subsequent transferees and holders

who take the instrument in good faith—

• The transferor is entitled to enforce the instrument.

• All signatures are authentic and authorized.

• The instrument has not been altered.

• The instrument is not subject to the defense or claim of any party that can be asserted against the

transferor.

• The transferor has no knowledge of any insolvency proceedings against the maker, the acceptor, or the

drawer.

1. Parties to Whom Warranty Liability Extends

2. Recovery for Breach of Warranty

Notice of a claim for breach of warranty must be given within thirty days” [UCC 3–416(c)]. These warranties

can be disclaimed on any instrument except a check.

B. PRESENTMENT WARRANTIES

Any person who seeks payment or acceptance of an instrument impliedly warrants to any other person who in

good faith pays or accepts the instrument that—

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• The party has no knowledge that the issuer’s signature is unauthorized [UCC 3–417(a), (d)].

III. Defenses and Limitations

A. UNIVERSAL DEFENSES

Universal defenses, which are good against all holders, including HDCs and holders who take through HDCs,

include—

1. Forgery of a Maker’s or Drawer’s Signature [UCC 3–403(a)]

2. Fraud in the Execution

3. Material Alteration

Material alteration is only a partial defense against an HDC, who can enforce the instrument against the

maker or drawer according to the original terms. If the instrument was originally incomplete, the HDC can

enforce it as completed [UCC 3–407(b)].

CASE SYNOPSIS—

Case 26.2: Keesling v. T.F.K. Partners, LLC.

Heritage/M.G. LLC signed a note payable to Peoples Bank and Trust Co., custodian for the James Henke, I.R.A., for

$300,000. The signatories included Thomas McMullen on behalf of Heritage/M.G., and Larry and Vivian Keesling.

Without the knowledge or consent of the Keeslings, Heritage/M.G. executed a second note in the amount of $102,000.

The first note was not paid in full, and no payments were made on the second note. The Henke I.R.A. assigned the notes

to T.E.K. Partners, LLC, which pursued a suit in an Indiana state court against the Keeslings to collect. The court ruled in

T.E.K.’s favor. The Keeslings appealed, contending that the second note was a material alteration of the first note,

effectively discharging their liability as accommodation parties.

converting interest due on the first note to principal under the second note.

Notes and Questions

Could the second note have been construed to operate as a novation of the original note? No. The court held

that “the second note was not a novation of the original note because there was no agreement of all of the parties to

a new contract. Thus, the Keeslings and Heritage Land are not chargeable with the second note, a new agreement

which did not include their signatures.”

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The original note was secured in part by a mortgage from Heritage Land to the Henke I.R.A. on a thirty-six acre

tract. Could T.E.K. have collected the unpaid balance of the original note through this security? Yes. The court in the

Keesling case remanded the case to the lower court with instructions to “enter an in rem judgment against Heritage

Land’s thirty-six acre tract in the amount of $48,229.69, plus interest and a pro rata share of attorney’s fees.”

ANSWERS TO QUESTIONS AT THE END OF CASE 26.2

1. If the court had affirmed the judgment in favor of T.E.K., against whom might the Keeslings have had a right of

recourse? If an accommodation party pays an instrument, under UCC 3–419(e) he or she has a right of recourse against

2. What might the parties who executed the second note have done at the time to avoid the outcome in this case? To

agree.

4. Discharge in Bankruptcy

6. Illegality

7. Mental Incapacity

8. Extreme Duress [UCC 3–305(a)(1)(ii)]

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The text discusses briefly the following personal defenses.

1. Breach of Contract or Breach of Warranty

3. Fraud in the Inducement (Ordinary Fraud)

5. Mental Incapacity

6. Other Personal Defenses

Ordinary duress [UCC 3–305(a)(1)(ii)], discharge by payment or cancellation [UCC 3–601(b), 3–602(a), 3–

603, 3–604], unauthorized completion of an incomplete instrument [UCC 3–115, 3–302, 3–407, 4–

401(d)(2)], and nondelivery [UCC 1–201(14), 3–105(b), 3–305(a)(2)].

C. FEDERAL LIMITATIONS ON HDC RIGHTS

A Federal Trade Commission (FTC) rule (16 C.F.R. Part 433)—”Rule 433”—effectively abolished the HDC doctrine

in consumer transactions.

1. FTC Rule 433

The rule applies to any seller or lessor of goods or services who takes or receives a consumer credit contract.

The rule also applies to a seller or lessor who accepts as full or partial payment for a sale or lease the

2. Effect of the Rule

A consumer who is party to a transaction that includes a contract with this notice can bring any defense he

or she has against the seller against any subsequent holder. An instrument that contains this notice or a

similar statement required by law may be negotiable, but there cannot be an HDC [UCC 3–106(d)].

ADDITIONAL BACKGROUND—

Does the Notice Required by the FTC Rule Make a Note Conditional?

required statement does not make a note conditional [UCC 3–106(d)]. There cannot be a holder in due course of the

UCC 3–106(d) applies only if such a statement is required by statutory or administrative law. Comment 3 to UCC

3–106(d) explains, “The prime example is the Federal Trade Commission Rule (16 C.F.R. Part 433) . . . . Subsection (d)

is designed to make it possible to preclude the possibility of a holder in due course without excluding the instrument

from Article 3. Most of the provisions of Article 3 are not affected by the holder-in-due-course doctrine and there is no

reason why Article 3 should not apply to a note bearing the FTC legend if holder-in-due-course rights are not involved.”

Is the result different if the phrasing of a legend or statement is different from that stated in UCC 3–106(d)? No.

Comment 3 states, “No particular form of legend or statement is required by subsection (d). The form of a particular

required in a note taken by a seller in a consumer sale of goods or services is tailored to that particular transaction and

therefore uses language that is somewhat different from that stated in subsection (d), but the difference in expression

IV. Discharge

A. DISCHARGE BY PAYMENT OF TENDER OF PAYMENT

All parties to an instrument are discharged when the party primarily liable on it pays to a holder the amount due

in full [UCC 3–602, 3–603]. Payment by any other party discharges only that party and subsequent parties.

B. DISCHARGE BY CANCELLATION OR SURRENDER

A holder can discharge any party by cancellation [UCC 3–604]. Crossing out a party’s indorsement cancels that

party’s liability and the liability of subsequent indorsers who have already indorsed the instrument.

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C. DISCHARGE BY REACQUISITION

When a party reacquires an instrument that he or she previously held, all intervening indorsers are discharged

against subsequent holders who do not qualify as HDCs [UCC 3–207].

D. DISCHARGE BY IMPAIRMENT OF RECOURSE

Discharge can occur when a party’s right of recourse is impaired [UCC 3–605].

ENHANCING YOUR LECTURE—

  HOW TO

PURCHASE NEGOTIABLE INSTRUMENTS

 

Negotiable instruments are transferred every business day of the year. Most purchasers of negotiable instruments

do not encounter any problems in further negotiating and transferring the instruments or in collecting payment on

them if they are time instruments. Potential problems exist, however, and purchasers should take precautions against

them.

OVERDUE INSTRUMENTS

instrument has no stated time for payment and therefore may be overdue—that is, the payee may have demanded

time is presumed to be ninety days from the date on the check.) If you have any doubt about whether a demand

instrument is overdue, you should investigate.

NOTICE OF DEFECTS

As a prospective holder, you cannot afford to ignore a defect in any negotiable instrument. A four-month-old date

on a check, for example, constitutes notice that the instrument is overdue. Generally, whenever an instrument has a

defect, you will not qualify as an HDC, and you may be unable to obtain payment. In other words, it is prudent to

determine whether the instrument is complete and, in some situations, whether the transfer will qualify you for HDC

status.

CHECKLIST FOR THE PURCHASE OF NEGOTIABLE INSTRUMENTS

1. Make sure that a demand instrument is not overdue before purchasing it.

2. Make sure that the negotiable instrument has no obvious defects—look for indications that the maker or drawer

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of the instrument might have a valid reason for refusing to pay.

TEACHING SUGGESTIONS

1. Because agency relationships permeate commercial law, ask the class to discuss some of the ways in which agency

relationships may be created and destroyed. How can an agent avoid incurring personal liability while acting on behalf

of his principal, especially if the principal is either unknown or insists on remaining anonymous? Conversely, a principal

2. To help keep the material in this chapter understandable to the majority of your students, emphasize only those

points that you think are most important for them to know and remember—the points that you will test them on or

the points that those who will take the CPA examination will need to remember for that test.

Cyberlaw Link

What effect might the existence of banking on the Internet have on the legal principles discussed in this chapter?

DISCUSSION QUESTIONS

1. Why must a negotiable instrument be signed? The requirement of a signature is based on the need to know whose

2. Must a party sign his or her name in full in order to be bound by the terms of a negotiable instrument? No. The UCC

3. Compare the concepts of primary and secondary liability under a contract theory of law. In a promissory note, the

maker directly promises to pay the payee or holder of the note a certain sum of money. Similarly, when a bank accepts a

negotiable instrument, it engages or promises unconditionally to pay the holder of the instrument. This primary obligation of a

4. When is an instrument dishonored? An instrument is dishonored when presentment is properly made and acceptance

5. How may an agent avoid becoming personally liable when signing on behalf of his or her principal? When an

6. When may a person whose forged signature appears on a negotiable instrument be liable on that instrument? In

general, a person is not normally liable to pay on a negotiable instrument in which his signature has been forged. But there are

exceptions to this rule. A signature made by an agent exceeding the scope of his or her authority can be ratified by the

7. Who assumes the burden of loss when there is a forged or unauthorized indorsement? In general, the burden of loss

8. What is a material alteration of a financial instrument? An alteration is material if it changes the contract terms

9. What are the ways in which an instrument may be discharged? Discharge from liability on an instrument can come

10. What is the practical reason for the warranty that a check presented for payment has not been altered since its

issuance? The practical basis for this rule is to impose the liability for a loss in this circumstance on the party that most likely

1. Students sometimes find it difficult to understand why a person whose signature has been forged should have to pay

on the instrument in any situation. Ask students to review the exceptions found in UCC 3–403(a) ] and to call local banks and

2. There are a number of defenses that may be raised when the holder of a negotiable instrument makes a demand for

payment. Real defenses may be raised to avoid payment to all holders of a negotiable instrument including an HDC or one who

holds through an HDC. Personal defenses, by contrast, may be used to avoid payment only to ordinary holders—not HDCs.

Because real and personal defenses are often confused with each other, ask each student in the class to prepare two charts—

one listing real defenses and one listing personal defenses. Each of these defenses should be defined and each chart should

have a heading explaining the concepts of real defenses or personal defenses as appropriate.

EXPLANATION OF A SELECTED FOOTNOTE IN THE TEXT

Footnote 7: Hugh Caraway was president of Internacional Realty, Inc, when Realty hired Land Design Studio to

landscape an apartment complex. The parties executed a note: “In consideration of design services rendered, I(We) Hugh

Carraway [sic], Internacional Realty, Inc. . . . do hereby promise to pay Land Design Studio . . . , the amount of $42,639.82.”

The note was signed by Caraway. No payment was made. Land Design filed a suit in a Texas state court against Caraway, who

denied that he was personally liable on the note, arguing in part that he had intended to sign it in a representative capacity. The

Caraway offered to prove his assertion by offering into evidence an unsigned contract, created two and a half years

earlier, show that the parties understood he acted only as an agent of Realty when he signed the note. Was this contract

admissible? No, because “[i]f an instrument sued on clearly shows on its face that it is the obligation of the person who signed

it, parol evidence is not allowed to exempt him from liability, on the ground that he meant to bind only his principal.” The court

added that “[t]he creation of the note was a wholly separate transaction from the creation of the unsigned contract, with two

years separating the events. What their intentions may have been at that time of the creation of the contract are irrelevant for

the purpose of establishing the intent of the parties at the time of the creation of the note.”

ANSWERS TO ESSAY QUESTIONS IN

STUDY GUIDE TO ACCOMPANY BUSINESS LAW, TWELFTH EDITION

BY HOLLOWELL & MILLER

1. What are the similarities and differences between transfer and presentment warranties? Transfer warranties. When a

person transfers an instrument by indorsement and delivery, he or she warrants to any subsequent holder who takes the

instrument in good faith that: (1) the transferor is entitled to enforce the instrument; (2) all signatures are authentic and

authorized; (3) the instrument has not been altered; (4) the instrument is not subject to a defense or claim of any party that can

be asserted against the transferor; and (5) he or she has no knowledge of any insolvency proceedings instituted against the

maker, drawer, or acceptor. A transferee or holder who takes an instrument in good faith can sue on the basis of a breach of a

2. What are the two situations in which, when there is a forged or unauthorized indorsement, the burden of loss falls on

the maker or drawer? Imposters. An imposter is one who, by use of the mails, telephone, or personal appearance, induces a

maker or drawer to issue an instrument in the name of an impersonated payee. If the maker or drawer believes the imposter to

be the named payee at the time of issue, the indorsement by the imposter is not treated as unauthorized when the instrument

is transferred to an innocent party. This is because the maker or drawer intended the imposter to receive the instrument. In

these situations, the unauthorized indorsement of a payee’s name can be as effective as if the real payee had signed. Under the

imposter rule, an imposter’s indorsement will be effective—that is, not a forgery—as far as the drawer is concerned. The

comparative negligence standard mentioned in connection with the liability of banks paying over forged signatures also applies

REVIEWING—

 LIABILITY, DEFENSES, AND DISCHARGE 

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a suit against Mahar, Star Bank, and others to recover the funds. Ask your students to answer the following questions,

1. With regard to signature liability, which UCC provision discussed in this chapter applies to this scenario? The

2. What is the rule set forth by that provision? In most circumstances, an unauthorized indorsement will not bind the

behalf of a maker or drawer, intending that the payee will have no interest in the instrument, or when an agent or

employee of the maker or drawer has supplied him or her with the name of the payee, also intending the payee to

3. Under the UCC, which party, Golden Years or Star Bank, must bear the loss in this situation? Why? Under the

authority to issue certain checks and issued checks in the names of other employees who had not requested them, for

the specific purpose of embezzling money without intending that the employees have an interest in the checks, Golden

4. Based on these facts, describe any transfer or presentment warranties that Mahar may have violated. Any person

who transfers an instrument for consideration warrants in part to all subsequent transferees and holders who take the

instrument in good faith that all signatures are authentic and authorized and that the instrument is not subject to a

defense or claim of any party that can be asserted against the transferor. Mahar violated these transfer warranties. As

to enforce the instrument, or be authorized to obtain payment or acceptance on behalf of a person who is so entitled

 DEBATE THIS: 

Because signature stamps create so many opportunities for embezzlement, they should be banned. It is much

harder to engage in embezzlement with checks when some real person has to sign physically each check. Therefore, if

we banned the use of check-signing devices, we would reduce the amount of embezzlement in all sizes of businesses.

Businesses use check-signing devices for a reason: in so doing, these businesses save human resources and

thereby increase profits. To be sure, such devices create more opportunities for embezzlement, but we should look at

the net benefits of using devices, which are clearly positive.

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