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Chapter 27
Liability, Defenses, and Discharge
INTRODUCTION
This chapter examines the liability of the parties who sign the instrument and the warranty liability of those who
transfer instruments and present instruments for payment. You might explain to your students that the focus is on
liability on the instrument itself or on the warranties connected with transfer or presentment of the instrument, as
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.
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ADDITIONAL BACKGROUND—
Signature Liability
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.
An authorized agent or representative may sign for a party. Under the unrevised UCC, the courts differed
as to when signatures by agents or representatives gives rise to their personal liability. Generally, an agent or
representative was personally liable on his or her signature if the principal was not named or the agent or
representative did not sign in a representative capacity [UCC 3–403(2)]. The same was true if the instrument
named the principal but did not show that the agent or representative signed in a representative capacity, or
the principal was not named but the agent or representative indicated that he or she signed in a
representative capacity.
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
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.)
B. SECONDARY LIABILITY
Drawers and indorsers have secondary liability. On a draft, a drawer’s liability arises if the drawee fails
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1. Presentment
Presentment can be made by any commercially reasonable means, including oral, written, or
electronic communication, and is usually effective on demand for payment or acceptance.
a. Proper Presentment
A note or certificate of deposit must be presented to the maker for payment; a draft to the
drawee for acceptance, payment, or both.
b. Timely Presentment
• A holder of a check must present it for payment or collection within thirty days of its date
2. Dishonor
Dishonor can occur when acceptance or payment is refused, cannot be obtained, or is excused and
the instrument is not accepted or paid [UCC 3–502(c)].
3. 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].
C. ACCOMMODATION PARTIES
1. Accommodation Makers
If an accommodation party signs on behalf of a maker, he or she is primarily liable.
2. Accommodation Indorsers
D. AUTHORIZED AGENTS’ SIGNATURES
1. Liability of the Principal
• If an authorized agent clearly names the principal in the signature, the principal is liable.
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2. Liability of the Agent
• If an authorized agent signs only his or her own name, and does not name the principal, the
agent is liable to an HDC who has no notice that the agent was not intended to be liable. To
CASE SYNOPSIS—
Case 27.1: Envision Printing, LLC v. Evans
Red Rhino Market Group, LLC had a customer account with Envision Printing, LLC that was in arrears.
A Red Rhino employee e-mailed Envision, stating that Bernie Evans, the chief executive officer of Red
Rhino, had “full authorization under the LLC documents to sign for Red Rhino Market Group” a note for the
Notes and Questions
Suppose that “Red Rhino Market Group, LLC” had not been included on the note. Would Evans
have been personally liable for payment in that situation? Why or why not? Whether Evans would be
personally liable would depend on several factors. If he indicated in some way that he was acting as an agent
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ADDITIONAL CASES ADDRESSING THIS ISSUE—
Liability of Agents
Cases involving questions of agency and liability in the context of negotiable instruments include the
following.
• Geraldo v. First Dominion Mutual Life Insurance Co., __ Ohio App.3d __, __ N.E.2d __, 2002 Ohio 4654
(6 Dist. 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).
the authorized signature of the represented corporation).
3. Checks Signed by Agents
If the instrument is a check payable from the account of a principal who is identified on the check,
the agent is not liable [UCC 3–402(c)].
E. UNAUTHORIZED SIGNATURES
1. The General Rule
A forged or an unauthorized signature does not bind the person whose name is forged.
2. Exceptions to the General Rule
• Ratification—If the person whose name is signed ratifies the signature, he or she is bound
3. 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 3–403(a)].
F. SPECIAL RULES FOR UNAUTHORIZED INDORSEMENTS
When there is a forged or unauthorized indorsement, the burden of loss usually falls on the first party to
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1. Imposter Rules
A loss falls on a drawer or maker when an imposter induces the maker or drawer to issue an
instrument to the imposter [UCC 3–404(a)].
b. Comparative Negligence Applies
If a bank fails to exercise ordinary care in cashing a check made out to an imposter, the
drawer may be able to recover a portion of the loss from the bank.
2. Fictitious Payees
3–404(b); 3–405].
• A common context for this situation is employment—a dishonest employee deceiving his or
employer.
II. Warranty Liability
Transfer warranties arise even when a transferor does not indorse the instrument [UCC 3–416, 3–417].
ADDITIONAL BACKGROUND—
Warranty Liability
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.
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1. Parties to Whom Warranty Liability Extends
Transfer by indorsement and delivery of an order instrument extends warranty liability to any
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
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—
• The party is entitled to enforce the instrument or is authorized to obtain payment or acceptance on
behalf of a person who is entitled to enforce the instrument.
1. Protect Transferees
Liability is shifted to the party in the best position to prevent the wrongdoing.
2. Limitations
The second and third warranties do not apply to makers, acceptors, and drawers Notice of a claim
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
terms of the instrument. Important factors include the signer’s age, experience, and intelligence.
3. Material Alteration
Material alteration is only a partial defense against an HDC, who can enforce the instrument against
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4. Discharge in Bankruptcy
This is an absolute defense against all parties because the purpose of bankruptcy is to settle all of
the insolvent party’s debts [UCC 3–305(1)(a)].
5. Minority
This is a universal defense only to the extent that state law recognizes it [UCC 3–305(a)(1)(i)].
6. Illegality
7. Mental Incapacity
8. Extreme Duress [UCC 3–305(a)(1)(ii)]
B. PERSONAL DEFENSES
The text discusses briefly the following personal defenses.
1. Breach of Contract or Breach of Warranty
2. Lack or Failure of Consideration [UCC 3–303(b), 3–305(a)(2)]
CASE SYNOPSIS—
Case 27.2: Mills v. Chauvin
Gregory Mills and Robert Chauvin were friends and attorneys, and maintained a professional and
business relationship. Chauvin was an investor in Amelia Village, a real estate development project. Over
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Notes and Questions
In whose favor did the court ultimately rule? Why? The trial court in the Mills case ruled that the note
signed by Chauvin and in the possession of Mills “was valid and enforceable and that Mills was entitled to
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credibility determinations concerning witnesses, we conclude that Supreme Court’s determination that
the principal parties to the exchange of funds that the note represented.
Under what circumstances might Chauvin’s asserted defense of a lack of consideration have
succeeded? In the Mills case, the appellate court concluded that “Mills took the note as a holder in due
course.” The court also concluded that the trial court’s “determination that Chauvin failed to establish a bona
3. Fraud in the Inducement (Ordinary Fraud)
4. Illegality
If a statute makes an illegal transaction voidable, this is a personal defense
5. Mental Incapacity
Any instrument issued by a mentally incompetent person is voidable, and this defense is personal,
ADDITIONAL BACKGROUND—
Personal Defenses
In addition to the personal defenses listed in the text, a number of other personal defenses can be used
to avoid payment to an ordinary holder, but not a holder in due course (HDC), of a negotiable instrument.
These include—
• Ordinary duress or undue influence [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)].
• Nondelivery of an instrument [UCC 1–201(14), 3–105(b), 3–305(a)(2)].
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C. FEDERAL LIMITATIONS ON THE RIGHTS OF HDCS
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 proceeds of any purchase-money loan made in connection with any consumer
credit contract. Under the rule, these parties must include in the consumer contract the following
provision:
NOTICE
ANY HOLDER OF THIS CONSUMER CREDIT CONTRACT IS SUBJECT TO ALL CLAIMS
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
ADDITIONAL BACKGROUND—
Does the Notice Required by the FTC Rule Make a Note Conditional?
The FTC Rule makes it impossible for there to be an HDC of a consumer credit note. Under unrevised
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.”
For example, the FTC legend required in a note taken by a seller in a consumer sale of goods or services is
Is the result different if the phrasing of a legend or statement is different from that stated in UCC
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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
With the intent to cancel, a holder can discharge any party by cancellation [UCC 3–604]. Sufficient acts
include—
• Writing “Paid” across the face of an instrument.
C. DISCHARGE BY MATERIAL ALTERATION
Materially altering an instrument can discharge the liability of all parties [UCC 3–407(b)]. An HDC may
be able to enforce a materially altered instrument against its maker or drawer according to the
instrument’s original terms.
D. DISCHARGE BY REACQUISITION
When a party reacquires an instrument that he or she previously held, all intervening indorsers are
E. DISCHARGE BY IMPAIRMENT OF RECOURSE
Discharge can occur when a party’s right of recourse is impaired [UCC 3–605].
F. DISCHARGE BY IMPAIRMENT OF COLLATERAL
ENHANCING YOUR LECTURE—
HOW TO BUY NEGOTIABLE INSTRUMENTS
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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
have demanded payment but not received it, or a reasonable amount of time may have passed. (With
any doubt about whether a demand instrument is overdue, you should investigate.
Suppose that you wish to purchase a demand instrument as a holder in due course (HDC). By definition,
NOTICE OF DEFECTS
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
As a prospective holder, you cannot afford to ignore a defect in any negotiable instrument. A four-month-
CHECKLIST FOR THE PURCHASE OF NEGOTIABLE INSTRUMENTS
1. Make sure that a demand instrument is not overdue before purchasing it.
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
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
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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 obligation the instrument represents. Parol evidence can be used to identify the signer, and once that
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 defines a signature as “any name, including a trade or assumed name”, or “a word, mark, or symbol
3. Compare the concepts of primary and secondary liability under a contract theory of law. In a promis–
sory 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.
4. When is an instrument dishonored? An instrument is dishonored when presentment is properly made and
acceptance or payment is refused or cannot be obtained within the prescribed time, or when presentment is excused
5. How may an agent avoid becoming personally liable when signing on behalf of his or her principal?
When an authorized agent signs on behalf of his or her principal, there are three possible forms of legal liability that
6. When may a person whose forged signature appears on a negotiable instrument be liable on that in-
strument? In general, a person is not normally liable to pay on a negotiable instrument in which his signature has
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7. Who assumes the burden of loss when there is a forged or unauthorized indorsement? In general, the
burden of loss falls on the first party to take the forged indorsement because a forged indorsement does not transfer
8. What is a material alteration of a financial instrument? An alteration is material if it changes the contract
terms between any two parties in any way. Examples of material alterations include completing an instrument, adding
9. What are the ways in which an instrument may be discharged? Discharge from liability on an instrument
can come from payment, cancellation, or material alteration. Discharge can also occur if a party reacquires an
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 could have prevented it at the lowest cost. A presenting bank would be in a better position than a
ACTIVITY AND RESEARCH ASSIGNMENTS
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
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 in-
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EXPLANATION OF A SELECTED FOOTNOTE IN THE TEXT
Footnote 10: New Houston Gold Exchange, Inc. (HGE) issued a $3,500 check to Shelly McKee to buy a
purportedly genuine Rolex watch. The check was postdated. McKee indorsed the check and presented it to RR
In RR Maloan Investments, Inc. v. New HGE, Inc., a state intermediate appellate court reversed. On further
appeal, a state intermediate appellate court held the check cashing service qualified as an HDC. With respect to the
good-faith element to attain HDC status, One of the elements for a holder to attain HDC status is that the holder takes
a negotiable instrument in good faith. RR Maloan appears to have satisfied the definition of the term—“honesty in fact
Should a party’s subjective intent be considered when deciding whether to enforce a negotiable