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REGULATION 6

Commercial Paper, Secured Transactions, and Suretyship & Creditors' Rights


1. Commercial paper 3
2. Documents of title 27
3. Secured transactions 32
4. Suretyship &creditor's rights 47
5. Money laundering 57
6. Task-based simulations 65
7. Class questions 69
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Regulation 6
R6-2
NOTES
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I. IN GENERAL
A. Introduction
Regulation 6
COMMERCIAL
Note/CD
2.
1.
3.
It is often inconvenient to use cash as payment in certain transactions (e.g., those
involving large sums of money), but ordinary promises to pay are unsuitable as a
substitute for cash because contract defenses may apply. The commercial paper laws
arose, in part, to provide a convenient and safe substitute for cash in such situations.
To facilitate a freely transferable substitute for cash, a central theme of the Negotiable
Instrument Article (Article 3) is the holder in due course rule.
a. Alholder in due courselis a person who takes a negotiable instrument for value,
in good faith, and without notice of any defenses on or claims to the instrument.
b. Holder in due course rule: If a negotiable instrument is negotiated to a holder in
due course, the holder in due course will take the instrument subject to very few
defenses. "ot
The text and the examiners use the terms "commercial paper" and IIl:!!I!Il!mI
"negotiable instrument" interchangeably. Article 3 of the UCC is properly entitled
Negotiable Instruments.
B. Terminology
Article 3 governs "commercial paper," a type of "negotiable instrument." Other UCC Articles
govern other types of negotiable instruments.
Article 7 governs documents oftit/e (e.g., bills of lading and warehouse receipts). Article 8
governs investment securities (e.g., corporate stocks and bonds).
PASS KEY
Past questions have required examinees to recognize that warehouse receipts, bills of lading, stocks, and
bonds are not within Article 3, while any type of note or draft (e.g., a check, an installment note, etc.) is within
the article.
1. Notes-Promise to Pay
,: A "note" isltwo-partY)commercial paper. It is simply a promise by one party
(the "maker') to pay money to another party (the "payee" or to bearer).
lYfe o-P fc:l\fe
v
,------ -------,
EXAMPLE
The following is a promissory note because it is two party paper-a promise to pay.
Max Maker Markets, Inc.
123 Market Street
Erehwon, NY DATE
No. 123
On demand the
undersigned promises n
t::.:.o-",pa::.:.y::.:.to-=:.th::.:.e",-or::.:de-,-,r0::.:.1_---=-f>-=e-'-'''''v--=e::.:.v_--'r--=,c:l\=--=-Jyc..:e'''''-''e''-----_-----.JI $ I 1,200.00
"Twelve v."".J-ve.J- """.J- 001100 - - - - - - - - - - - - - - - - - - - dollars
Max Maker Markets, Inc.
memo _
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a.
Regulation 6
11&1
2.
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Certificates of Deposit-Bank Promissory Note
A certificate of deposit (CD) also involves two parties (a bank and a payee). A
CD is a negotiable instrument issued by a bank that acknowledges receipt of
money and promises to repay at a future date.
Drafts-Order for a Third Party to Pay
A draft is generally{fhree-parMcommercial paper. It is an(ordei)by one person (the
drawer) to another person (the drawee) demanding that the drawee pay money to a
third person (the payee).
EXAMPLE
(To: Dan Duke) DVc:l\wee (vecetves No. 124
P.O. Box 37
Denver, Colorado DATE 1.20 1\
Pay to the
order of $ I '-,000.00
five 'l'\OIJ,S",,,,,,l. ",,,,,,l. 00/ I 00 - - - - - - - - - - - - - - - - - - - - - dollars
memo _
b.
IBIII
R6-4
a. Checks-Drawee Must be a Bank and Must be Payable on Demand
A check is a type of draft with two particular characteristics, namely drawn on a
bank and payable on demand. Checks have one other special characteristic. As
will be discussed later, other drafts and notes must state that they are payable "to
order" or "to bearer" (sometimes these words are called "the magic words of
negotiability"); checks do not need to include such language to be negotiable.
Trade Acceptances
A trade acceptance is a(drafQdrawn by the payee (usually the seller of goods) on
the drawee (usually the buyer of the seller's goods) and accepted by the drawee
(accepting liability on the instrument).
EXAMPLE
Alex is purchasing 500 widgets from Becky for $50,000. The widgets will be delivered in 90
days. Becky needs money to buy materials to make the widgets, and so draws a draft payable
to the order of herself 90 days after sight and gets Alex to accept (sign). This is a trade
acceptance.
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ANCILLARY MATERIAL (for Independent Review)
Regulation 6
c. Remotely Created Item
A number of jurisdictions recognize an additional type of draft, analogous to a
trade acceptance, called a "remotely created item." It is a draft, created by a
third party with authority from, but not signed by, the person indicated as the
drawer so that the third party (usually the seller in a telephone or Internet
transaction) can get paid from the drawer's account. Each transferor of such a
draft makes a warranty that it was created with authority from the person
identified as the drawer.
END OF ANCILLARY MATERIAL
3. Demand vs. Time Instruments
Commercial paper (a note or a draft) can be payable either on demand or
at a specified future date. An instrument payable on demand is a
"demand" (sight) note or draft. An instrument payable at a future date is a
"time" note or draft.
~ o + - c:l\ Ilcl-\ec\::,1
becc:l\l.\se ~ O +
fc:l\Yc:l\ble O ~
~ e 'Mc:l\~ ~
EXAMPLE
The instrument below is a time draft since it is three party paper payable on a certain date
(November 1).
To: N.Y. Bank DVc:l\Wee
No. 125
New York, NY
DATE
actobev 2 ~ , 20\ 1
Pay to the
order of Pl-lil P"'yee $ I 1,000.00 I
I
O"e "Tl-IOL\S.,.,,,,A .,.,,,,,A 00/100 - - - - - - - - - - - - - - - - - - - - - dollars
on November 1, 2011
memo f,ivt-l-I,A.,.,y fvese"t- By /s/ De.,.,,,,,,.,., Dv.,.,wev
PASS KEY
The examiners often simply ask you to name the type of instrument involved. Remember, for an
instrument to be a note, there can be only two parties (a maker promises to pay a payee). If there are
three parties (a drawer orders a drawee to pay a payee), the instrument is a draft.
4. Money
The UCC does not apply to money.
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<Step 2: Is
II. FORMAL REQUISITES OF NEGOTIABILITY
A. Negotiability Defined
I I
Whether an instrument is negotiable depends on its form; it must meet the very technical
- formal requirements listed in the UCC for negotiable instruments. Therefore, the following
definition must be memorized for the CPA exam. The meaning of the individual terms will be
discussed below.
To be a negotiable instrument within Article 3, the instrument must:
(i)
(ii)
(iii)
MelMOVlz.e! (iv)
(v)
(vi)
(vii)
Be in writing;
Be signed by the maker (note) or drawer (draft);
Contain an unconditional promise (note) or order (draft) to pay;
Be for a fixed amount of money;
Be payable on demand or at a definite time;
Be payable to order or to bearer; with the exception of checks; and
Contain no additional undertaking or instruction not authorized by the UCC.
EXAMPLE
Max Maker Markets, Inc. No. 123
123 Market Street
Erehwon, NY DATE
On demand
lVj
the
undersigned promises
to pay(iii) to the order of

I $ I 1,200.00 I
"-welve \,;IA,,"'-ve"'- ",,,,,,- 00/100 - - - - - - - - - - - - - - - - - - -
Max Maker Markets, Inc.
memo By /5/ M",,.: M",\:.:evj
The above is a negotiable note since it (i) is in writing and (ii) signed by the maker (Max
Maker), (iii) contains an unconditional promise to pay ("the undersigned promises to
pay"), (iv) a fixed amount of money ($1,200), (v) on demand (since no time is stated for
payment, it is considered to be payable on demand), (vi) to bearer, and (vii) contains no
unauthorized undertaking or instruction.
EXAMPLE
To: Dan Duke No. 124
P.O. Box 37
Denver, Colorado DATE ]&'\,.... '-''-'''l.vy 1.20\ I
Pay!iii) to the
order
1iV
) of
p",,,, P",yee
I $ I <;,000.00
I
Five "-\';01A5"'''''' "',,'" 00/100 - - - - - - - - - - - - - - - - - - - - - dollars
l
")
memo By /5/ De't>'t>ie D",,,t-e1i;j
The above is a negotiable draft since it (i) is in writing and (ii) signed by the drawer (Debbie
Dante), (iii) contains an unconditional order to pay ("To: Dan Duke... Pay"), (iv) a fixed amount
of money ($5,000), (v) on demand, (vi) to order ("to the order of Pam Payee"), and (vii)
contains no unauthorized undertaking or instruction.
R6-6
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DVc:l\-Pt - fowev o-P lS ok
B. Maker or Drawer IIMfflIt!li1
1. The UCC is very liberal about what constitutes a writing. It may be printing, typing, or
any other intentional reduction to tangible form.
2. A note must be signed by the maker and a draft must be signed by the drawer. l'o!bM;1
3. The UCC is very liberal as to what constitutes a signature. A signature may be made
by the use of any trade name or assumed name or by any mark intended to be a
signature. For example, a signature stamp may be a sufficient mark.
C. Unconditional Promise or Order /' tl-\e
An instrument generally is not negotiable if it states that payment is conditional. The purpose
of commercial paper is to provide a freely transferable substitute for cash. If conditions to
payment were allowed, the instrument would not be freely transferable. Conditions can be
spotted by such words as "subject to" and "contingent upon."
1. No Terms in Separate Instrument-Subject to Another Agreement
The terms of the promise or order must be determinable from the face of the
instrument. Thus, if an instrument states that it is subject to or governed by another
agreement, it is not negotiable.
2. No Express Conditions
The promise or order must not be subject to any express condition (e.g., "I will pay if
the Bears win the Super Bowl"). Such a writing is not negotiable regardless of whether
the condition has been fulfilled. Implied conditions (e.g., an implied promise to obey
the laws of the state), however, do not destroy negotiability.
3. Permissible Conditions
The UCC does allow inclusion of certain conditions. A promise or order will not be
made conditional merely because the instrument:
a. Is subject to implied conditions (implied in the law or that consideration was
given);
Do


b.
c.
States its consideration ("this instrument is given in exchange for a car");
Refers to the transaction out of which the instrument arose or states that the
instrument was made in accordance with or as per the transaction; or refers to
another writing for a statement of rights regarding collateral, prepayment, or
acceleration; or
d. Limits payment to a particular source or fund (e.g., "I promise to payout of the
funds from my next wheat crop").
D. Fixed Amount of Money
1. Amount Must be Fixed - OV SeVVlCeS
The amount must be fixed on the face of the instrument and must be a specifically
ascertainable amount. A sum is not rendered uncertain if:
a. It is payable with interest-This will not render the sum uncertain since the sum
due on any particular day can be calculated with accuracy. If an instrument is
ok payable "with interest" but the rate is not stated, it still is negotiable. The state's
judgment rate-the rate implied by courts on judgments-will be implied.
Variable interest rates are also acceptable.
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It is payable with a stated discount or addition if paid before or after the date
fixed for payment; or
It is payable with the cost of collection attorney's fees upon default.
2. Must Be Payable in Money-Legal Tender
Commercial paper must be payable in money and only money.
a. Currency is Money
It is proper for an instrument to state that it is payable in "currency" or in "current
funds." A promise to pay "an ounce of gold" is not a promise to pay money.
Similarly, a promise to pay in specific property as an alternative to money (e.g.,
"$500 or an ounce of gold") also renders the instrument nonnegotiable.
b. Foreign Money-Permissible
Money includes any currency recognized by the issuing government. It is
permissible to require that the instrument be paid in foreign currency.
PASS KEY
To be negotiable, an instrument must be payable in money and only money. An instrument is not
negotiable if it is payable in "money or goods," "money or stock" or "money or land."
E. On Demand or at a Definite Time
To be negotiable, an instrument must be payable on demand or at a definite time.
1. Demand - Chec\c.s Ao "oi- hel\ve i-o be AeI\i-eA
An instrument is payable on demand if it specifically states that it is payable "on
demand," "at sight," "on presentation," or most commonly when it does not say
anything at all about the time for payment.
2. Definite Time
a. Instrument Must Reveal When Obligation is Due
An instrument can be negotiable only if it can be determined from the face of the
instrument when the obligation will become due.
(1) What Constitutes a Definite Time?
An instrument is payable at a definite time if, by its terms, it is payable (i)
on or before a stated date (e.g., "payable December 1, 2011 "), or (ii) at a
fixed period after the stated date ("payable 90 days after date"), (iii) at
tw\L\si- be AeI\i-eA ~ some time readily ascertainable at the time the instrument is issued, or (iv)
at a definite period of time after sight or acceptance
(2) Events Not Certain to Happen-Not Negotiable
An instrument is not payable at a definite time if it is payable only upon an
event that is not certain to happen.
EXAMPLE
A note payable "when I am able to obtain a bank loan" is not negotiable because "I"
might not be able to obtain a bank loan.
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(3) Events Certain to Happen but Uncertain as to Time-Not Negotiable
If an instrument is payable at a stated time after an event certain to happen
but uncertain as to time, it is not payable at a definite time and so cannot
be negotiable.
EXAMPLE
"Payable 30 days after my Uncle Joe's death" is not negotiable. No one knows when
Uncle Joe will die.
b. Acceleration Clauses Do Not Destroy Negotiability I_I
A clause that accelerates the time of payment upon a stated event
or at the option of the maker or holder does not destroy negotiability. As long as
the latest date that the instrument can be paid is determinable from the
instrument, it can be negotiable. Thus, a note "payable on May 1, 2050-
accelerated by the death of my Uncle John," can be negotiable because the
latest date for payment is known.
EXAMPLE
The following instrument is negotiable even though the payment date can be accelerated by the
maker.
No. 130
The undersigned
promises to pay
to the order of
PlAll P",-yee
DATE 1....1y\,2010
$ I 1,000.00
O,,-e llAalAS"'-"-"," ",-"-,,," 00/100 - - - - - - - - - - - - - - - - - - - - - dollars
fifty days after sight or sooner
memo _
To Order or to Bearer F.
c. Extension Clauses Do Not Destroy Negotiability
Clauses that extend the time for payment to a further definite time stated in the
instrument at the option of the maker or holder or upon the happening of an
event will not destroy negotiability. Rationale: The latest date that payment will
be due can be determined from the face of the instrument.
d. Undated, Postdated, and Antedated-Permissible
The failure to date an instrument will not destroy negotiability. An undated
instrument is payable on demand. Equally, neither antedating nor postdating an
instrument will destroy negotiability.
[1;1
To be negotiable, an instrument must be payable to "order" or to "bearer" with the exception
of checks.
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Regulation 6
1.
2.
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Order-Payablecto the Order oOa Specified Party
Order paper must state that it is payable to the order of an identified person (e.g., "Pay
to the order of John Smith") or payable to an identified person or order (e.g., "Pay John
Smith or order"). If a note or draft simply says ''pay John Smith" without one of the
"magic words" above, it will not be negotiable, unless the instrument is a check.
Bearer-Payable to Anyone Who Possesses It
Bearer paper is payable to anyone who has possession of it. An instrument is payable
to bearer if it is payable: "to bearer," "to the order of bearer," to a named person "or
bearer" (e.g., "pay John Smith or bearer"), to a named person "and bearer" or to
"cash," or to the order of "cash."
Note: If an instrument is payable to bearer, it need not include the word "order" (i.e., an instrument
that says "pay bearer" can be negotiable; it need not say "pay to the order of bearer").
EXAMPLE
No. 125
DATE "'"we" I, 2.0 II
Pay to the
order of Phil P"'"yee
The bearer of this instrument
$ I \,000.00
O"e ,hovs","",A ","",A 00/100 - - - - - - - - - - - - - - - - - - - - - dollars
memo' _
3.
R6-10
The above instrument is not negotiable because it does not contain the "magic words" of negotiability
("to bearer").
Checks-Do Not Need to be Payable to Order of Bearer
A check is negotiable even if it does not have the "magic words" of negotiability. Thus,
a check that states "Pay Phil Payee," is negotiable even though it is not payable to the
"order of Phil Payee."
G. No Unauthorized Promises
An instrument will not be negotiable if it contains any promises in addition to the promise to
pay except for the following authorized promises:
1. An authorization to give, maintain, or protect collateral;
2. A term authorizing confession of judgment or disposition of the collateral if the
instrument is not paid when due; and
3. A term that waives the benefit of laws intended for the benefit of the obligor (e.g.,
waivers of rights to trial by jury, homestead allowances, and the like).
PASS KEY
Remember these authorized promises do not destroy negotiability and neither do the additional terms set out
earlier, regarding interest, prepayment penalties, and attorneys' fees. The examiners often use promises
regarding the collateral, promises to pay legal fees, waivers of the right to jury trial, and promises to pay a
prepayment penalty as answer choices. These will not destroy negotiability.
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H. Rules of Construction
1. Type of Writing
Typewritten terms control over printed terms. Handwritten terms control both.
2. Words Control Figures
Words control figures, unless the words are ambiguous. Thus, where a sum is
expressed in words and figures and there is a discrepancy between the two, the sum
denoted by the words is the sum payable. For example, "Pay five hundred dollars
($5,000)" is construed as an order to pay $500.
PASS KEY
The examiners often ask negotiability questions. They use two formats.
In the first format, the examiners will give you an instrument and ask you to identify its type (e.g., a
negotiable time note). Although you should go through the list of requirements for negotiability, sometimes
you can shortcut the list because three choices will be three party paper (drafts) and only one choice will be
two party paper. Look at the instrument to see how many parties are involved. If there are only two, your
choice is easy.
In the second format, examiners will ask you what will destroy negotiability. Favorite wrong choices that do
not destroy negotiability: (i) the instrument may be paid off early (an acceleration clause); (ii) the instrument
includes a promise to maintain collateral or a statement indicating the instrument is secured; and (iii) a
promise to pay collection costs. Often the right answer is a promise to pay "in cash or" something else (e.g.,
goods or services) .
.;:I. Example
$10,000 -


J

OV
H'Me J
OV
'oec:l\vevJ
Calumet City, Illinois
! January 1, 2010
For value received, six years after date, I, 1v\0\)< 1v\00\:.ev, promise to pay to the order of
Pete's Plants, Inc., ONE HUNDRED THOUSAND DOLLARS. This instrument arises out of
the sale of land located in Illinois. This instrument is secured by a first mortgage on the
land conveyed. It is agreed that: 'Wl-\y ok Collc:l\tevc:l\l ok
1. Maker will pay the costs of collection, including attorneys' fees upon default. ok
2. Maker will repay the amount outstanding on any anniversary date of this note. ok
memo _
lWO fc:l\vry
fVO'MlSe to fc:l\Y
The preceding instrument is a negotiable time note. It is two party paper since there is only a
promise to pay. It is negotiable because it is (i) in writing and (ii) signed by the maker (Max
Maker), (iii) contains an unconditional promise to pay (statement that it arose out of another
transaction does not make it conditional) (iv) a fixed amount of money ($100,000 since the
words control over the number in the left top corner; sum not rendered uncertain by
agreement to pay costs of collection or attorneys' fees), (v) at a definite time ("six years after
date"), (vi) to order ("to the order of Pete's Plants"), and (vii) contains no unauthorized
promises (the fact that it is secured does not destroy negotiability, and neither does the blank
memo line).
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';:J. If the Instrument is Not Negotiable
If an instrument is not negotiable, there can be no holder in due course and the holder in due
course rule cannot apply. Thus, transferees of the instrument will take the instrument subject
to@defense against payment that a party might have. A nonnegotiable instrument is
treated as an ordinary contract.
1. Look Only at Face of Instrument
Whether an instrument is negotiable depends on whether the instrument has the above
elements on its face when created. As will be discussed below, endorsements cannot
destroy negotiability or create negotiability.
<Step ~
III. NEGOTIATION-BECOMING A HOLDER IN DUE COURSE
A. Introduction ~
IMMifuNl
B.
R6-12
To gain the protection provided by Article 3 (i.e., freedom from many defenses that a maker
or drawer might have against payment), it is not enough that an instrument merely is
negotiable. The instrument must also have been transferred in a proper way. The process
by which commercial paper is transferred is called "negotiation." and the persons whom the
UCC seeks to protect are "holders in due course" (HDCs) and most transferees of holders in
due course. <See sl-\eltev ~ o C + V l ~ e Pc:l\8e 1g
Becoming a Holder-Negotiation Process
The first step in becoming an HDC is becoming a holder. A holder can be thought of as a
person with good title to the commercial paper. One becomes a holder through proper
negotiation of the paper. What is required for proper negotiation depends on whether the
commercial paper is bearer paper or order paper.
1. Bearer Paper Requires Mere Delivery
Bearer paper is negotiated simply by delivering the instrument to a transferee.
EXAMPLE
Drawer writes a check payable to "cash," which makes the check a bearer instrument. The check can
be negotiated by delivery alone. Thus, any person who acquires possession of the instrument will be a
holder.
2. Order Paper Requires Delivery and Endorsement
Negotiation of order paper (i.e., commercial paper payable to a specific person)
requires delivery to that person, and any subsequent transfer requires the specified
payee's endorsement (signature) plus delivery.
EXAMPLE
Dan Drawer draws a check payable to the order of Paula Payee. Upon delivery of the check to her,
Paula becomes a holder. If Paula subsequently wants to negotiate the check, she must endorse it and
it must be delivered to the transferee, who will then qualify as a holder.
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3. Last Endorsement Controls Order vs. Bearer
11
o 0 0
IV ec:l\VeV
EXAMPLE
John Smith has a check in his possession made payable "to the order of cash." The back of the
check is as follows:

Pay John Smith ]<Sfeclc:l\l-
veq to IMl.\st
becc:l\l.\se
/s/ Rv.Ay od'\o<'\
to -
fc:l\fev

--
The order vs. bearer nature of commercial paper can be changed through the use of
certain types of endorsements (signatures). Each endorsement has three qualities: (i)
special or blank, (ii) restrictive or unrestrictive, and (iii) qualified or unqualified. The first
quality determines whether the instrument will be order or bearer paper after
endorsement. You must always look at the last endorsement to determine what is
necessary for further negotiation.
a. Names a Specific Party-Order Paper
A special endorsement is one that names a particular person as the endorsee
and always makes the instrument order paper. Further negotiation requires the
signature of the special endorsee plus delivery.
c:l\ l.\ c:l\ 1M l (lI 0 ev ov ev
EXAMPLE
-
Dan Drawer writes a check payable "to the order of Paula Payee." The back of the check is as
follows:
I I -
/s/ P<'\v.l<'\ It's
bec:l\vev fc:l\fev
-
This check was bearer paper when drawn since it was payable to cash. Rudy
Ochoa turned it into order paper by putting the special endorsement ("Pay John
Smith") on it. Thus, the check can be negotiated further only if it is endorsed by
John Smith and delivered.
(1) Magic Words of Negotiability8Required for Endorsements Bc:l\c\::.
To make commercial paper negotiable, the paper must be payable "to
bearer" or "to the order of" a specific payee. The "magic words" of
negotiability (Le., "to the order of') are not needed for endorsements. An
endorsement "Pay John Smith" is effective even though the magic words of
negotiability are missing from the endorsement.
b. Does Not Name a New Endorsee-Bearer I_I
A blank endorsement does not name a special endorsee. This makes the
instrument bearer paper. It can be negotiated by delivery alone.
p 1 to ttv .p
This check was order paper when drawn since it named a specific payee. It
could be negotiated only if delivered and Paula endorses. Since Paula endorsed
in blank (Le., did not name a new endorsee), the check is now bearer paper and
can be negotiated by delivery alone.
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Regulation 6

c.
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Breaking the Chain of Title
A holder can be thought of as someone with good title to commercial paper. To
have good title, it is not enough that the paper was properly negotiated under the
last endorsement. Every prior negotiation must also have been proper. !U!
necessary endorsement (i.e., the payee's or a special endorsee's signature) is
missing or is forged, the chain of title is broken and no subsequent transferee
can become a holder. - -rl-\l.\S sl.\bject to
EXAMPLE
Harry has in his possession a check that was drawn payable "to the order of Paula Payee." The
back of the instrument is as follows:
Pe88Y'S

lS
R6-14
Harry cannot qualify as a holder of the check because there was a break in the
chain of title. As originally drawn, the check was order paper ("pay to the order of
Paula Payee"). When Paula endorsed, she named a specific payee (John Smith)
and so the paper remained order paper (requiring Smith's signature for
negotiation).
Smith signed in blank (he did not name a new special endorsee) and so the
check was converted to bearer paper and could be negotiated by delivery alone.
At some point, the paper was negotiated to Fred Farmer, who changed the check
back into order paper by naming a new special endorsee (Peggy Lee). Further
negotiation required Peggy Lee's endorsement plus delivery.
The check apparently was delivered to Delta Dawn, but there was no
endorsement by Peggy Lee. Thus, the chain of title was broken. Delta Dawn
signed in blank and the paper was delivered to Harry.
Harry does not qualify as a holder because of the break in the chain of title.
(1) Compare-Forged Drawer's or Maker's Signature
If the drawer's or maker's signature is forged, this does not constitute a
break in the chain of title because the UCC treats the forgery as the
genuine signature of the forger. Thus, transferees are holders of the
forger's instrument.
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d.
e.
i-P fvi\o\o\4l'\vy f4l'\vry
Qualified Endorsements-Without Recourse
(1) An endorsement that adds the words "without recourse" is a
qualified endorsement.
(2) "Without recourse" means there is no guarantee of payment by the
endorser (no contract liability). The "without recourse" endorser still has
warranty liability. Contract and warranty liability will be discussed later.
Restrictive Endorsements-Do Not Prevent Further Negotiatiop 1 1
0", H\e b4l'\c\C.
(1) Any other language added to an endorsement creates a
"restrictive" endorsement.
(2) Examples include conditions (e.g., "pay Paula Payee only if she has
mowed my lawn"), trust endorsements (e.g., "pay Tim Trustee in trust for
Benny Beneficiary"), and restricting further negotiation to the check
collection system (e.g., "for deposit only").
(3) Restrictive endorsements generally have no effect on negotiability.
(4) However, if an endorsement limits the check to the check collection
process (e.g., "for deposit" or "for collection"), a person or the bank into
which the instrument is deposited must pay the instrument consistently
with the endorsement or be liable for conversion.
';:TYPES OF ENDORSEMENTS
Last endorsement always governs negotiability (whether instrument is "bearer" paper, or "order" paper).
I I
/5/ Jo\'-'", Bl",,,,\c
Pay J. Smith
/5/ Jevvy P"'yee
Pay J.
/5/ J. Res1-vlcHve
Without Recourse
/5/ P.L. Q",,,,ll-Ple"'\
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Blank = Mere Signature of Holder. Instrument becomes
bearer paper and may be further negotiated by mere delivery
without further endorsement.

Pay to Specific Person. Words specifying the person
to be paid precede signature. Endorsement need not contain
words such as "order" or "bearer." Holder can convert blank
to a special endorsement.

Only, or "For Deposit" or "For Collection."
Specifies use of instrument (e.g., for deposit only) or
conditions use of instrument (e.g., pay J. Smith only). Does
not prevent further negotiation.
Be4l'\vev
iualifie$= "Without Recourse." Skip me if "instrument"
(e.g., promissory note) "bounces." This negates the
endorser's contractual liability for payment (no guarantee of
payment), but the endorser is still liable on warranties.
R6-15
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Regulation 6 Becker Professional Education I CPA Exam Review
I-P 4lI\"'y o",e o-P these
----------.,
veql.\ive"",e",ts is
is 4lI\
""'eve thl.\s
"'0 bettev
th4ll\'" h4ll\",s-Pevov
In good faith; and
For value;
Without notice of any defenses to or claims of ownership on the instrument.
Value
-+C.
I-I
Becoming a Holder in Due Course (HDC)- 11'Sl.\peviov to h4ll\"'s-Pevov
ll
Article 3 limits the defenses that can be raised against an HOC. The first step in becoming
an HOC is becoming a holder, which requires proper negotiation. The second step in
becoming an HOC is to obtain the paper "in due course." A holder will take commercial paper
in due course to the extent that he takes the paper:


Me"",oviz.e! (ii)
(iii)
1.
What constitutes value is somewhat different from what constitutes consideration for a
contract. Value includes:
(i) Performance of the agreed consideration (e.g., paying for the paper);
(ii) Acquisition of a lien or a security interest in the instrument;
(iii) Taking the instrument as payment or security for an antecedent debt;
(iv) Giving a negotiable instrument for the instrument; and
(v) Making an irrevocable commitment to third parties (e.g., letters of credit).
PASS KEY
An antecedent debt (i.e., a past debt) is not consideration, but it does constitute value for HOC
purposes.
a. Executory Promise is Not Value
An executory promise (i.e., a promise to give value in the future) does not qualify
as value (though it does qualify as contract consideration). Thus, if all that a
holder gave in exchange for commercial paper is an executory promise, the
holder cannot qualify as an HOC because no value was given. This is another
way that "value" differs from consideration.
b. Value Need Not be Equivalent to Face Value
It is not necessary that the value given be equivalent to the face value of the
instrument. An instrument purchased for less than face value is said to be
purchased "at a discount."
EXAMPLE
A offers to sell B a $20,000 promissory note in exchange for $16,000. B agrees and gives A
$16,000 in cash. B is an HOC for the full $20,000 because B paid all that he agreed to pay.
R6-16
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c. Compare-Partial HDCs
One may be a partial HOC if part of the agreed upon value is executory (i.e., has
not yet been given). Here, HOC status is proportional to the percentage of the
agreed upon value that was paid.
EXAMPLE
A endorses a $20,000 promissory note, due in one year, to B in exchange for $12,000 and B's
promise to give A $4,000 the following week. Before B pays the additional $4,000, he is a
partial HDC in proportion to the percent of the agreed upon value that was paid (12/16 x
$20,000 = $15,000).
d. Time of Payment Important
If part of the consideration is still executory and the holder obtains notice of a
defense on, or claim to, the instrument before performing the executory promise,
the holder can be only a partial HOC.
EXAMPLE
In the example above, if B obtained notice of a claim or defense before paying A the remaining
$4,000, Bwill remain a partial HDC, even if he pays the remaining $4,000.
2. Good Faith-Honesty in Fact
To be an HOC, the holder must take the instrument in good faith. Good faith means
honesty in fact.
3. Notice to Purchaser
The holder must purchase the instrument!ithout n o t i c ~ o r knowledge that it is
overdue, or has been dishonored, or of any defense or claim against the instrument.
This is measured objectively-what a reasonable person would have known in similar
circumstances.
a. Facts Constituting Notice
A purchaser has notice if:
(1) The purchaser knows that any part of the principal is overdue, acceleration
has been made, or the instrument is a demand instrument and demand
has been made or more than a reasonable time has passed since the
instrument was issued (reasonable time for a check is 30 days);
(2) The instrument is irregular (e.g., it bears visible evidence of forgery or
alteration or is so incomplete that its validity is questionable);
(3) The purchaser knows that the obligation of any party is voidable in whole
or in part (i.e., knowledge that the obligor has some valid defense to
payment, such as breach of contract, fraud, failure of consideration, or that
all parties have been discharged).
b. Facts Not Constituting Notice
Other than the above situations, little else will constitute notice. Most importantly,
remember the following two non-notice situations:
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Regulation 6 Becker Professional Education I CPA Exam Review
(1) Antedated or Postdated ok
The fact that an instrument is antedated or postdated of itself does not give
rise to notice of a claim or defense.
D.

(2) Purchase at a Discount ok


That the holder purchased the instrument at a "discount" does not of itself
give rise to notice of a defense or claim (and neither does it mean that the
holder has not given full value). However, a large discount together with
suspicious circumstances may lead a court to find a lack of good faith.
4. Transactions Precluding HDC Status
A holder will not become an HOC if the instrument is purchased at a judicial sale,
acquired in taking over an estate, or is purchased as part of a bulk transaction not in
the regular course of the transferor's business.
The Shelter H,wOl.\8l-\ HDC"
In order to assure free transferability of commercial paper, Article 3 provides that most
subsequent transferees of an HOC can "succeed to" or "take shelter in" the rights of the HOC.
';:This means that even though the transferee himself might not qualify as an HOC, he can
claim the rights of an HOC who held the commercial paper before him. Thus, transferees of
HOCs generally will not be subject to most defenses against payment of the instrument.
P ,.Mc:l\\::.ev ExAMP L E ,.Pc:l\Vee
sl.\bjeC+
to ...

Fred1fraudulently inducedlMar(to make a note payable to Fr{d. Fred endorses the note and delivers it to
Pam, who qualifies as an HOC. After the note is overdue, Pam negotiates it to her nephew, Ned, as a@
Even though Ned cannot qualify as an HOC himself (because he took the note with knowledge that it was
overdue and he did not give value), he succeeds to or takes shelter in Pam's HOC rights. Thus, as will be
discussed in the next section, Ned will not be subject to Mary's defense of fraud.
<sl-\eltev
R6-18
1. Limitation-No Washing Through
The shelter doctrine protects only innocent parties; a person who was a party to fraud
or the like relating to the instrument cannot take shelter in an HOC's rights.
2. Transferees of Fraudulent Holders
Once a person qualifies as an HOC, all subsequent transferees will acquire the HOC's
rights no matter how far down the chain of transferees they are. Transferees of a
holder who did not obtain HOC rights because he was a party to the fraud affecting the
instrument do not acquire HOC rights.
PASS KEY
You probably will see a question regarding an HOC on your exam. Approach such questions in four steps:
Was the holder a holder of a negotiable instrument? If the instrument was not negotiable, the holder
cannot be an HOC. The party must also be a holder. To be a holder of bearer paper requires mere
possession. To be a holder of order paper requires possession plus a proper endorsement.
Did the holder give present value?
Did the holder take the instrument in good faith?
Did the holder take the instrument without notice of any defenses to or claims of ownership?
To be an HOC all four questions must be answered affirmatively.
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<Step 4 - Does lMc:l\\:.ev/ l-\c:l\ve c:l\ vec:l\l ov
IV. CLAIMS AND DEFENSES ON THE INSTRUMENT
A. Overview
1. The Holder in Due Course Rule
The heart of Article 3 is the HOC rule-if a negotiable instrument is negotiated to a
u ., holder in due course, the HOC takes free from personal defenses and claims and is
...,elMOvlz,e. b' tit I d f
su lec on V 0 rea e enses,
-+8.

2. Application
The rule comes into play when a holder of an instrument attempts to collect on it and
the maker or drawer refuses to pay, claiming that he has a defense to payment
Whether the maker or drawer will be forced to pay depends on whether the holder has
the rights of an HOC and the nature of the defense.
a, If the holder does@have the rights of an HOC, the maker or drawer can
successfully assertny defense)that an obligor could successfully assert against
a transferee in a simple contract action (e,g" failure of consideration, fraud,
nonperformance of conditions, etc.),
b, If the holder has the rights of an HOC, the maker's or drawer's defenses to
payment are limited to what are commonly called "real defenses,"
Real Defenses Mc:l\\:.ev/ l-\c:l\Ve to Pc:l\Y
The following defenses are "real defenses" that may be asserted against both HOC and non-
HOC transferees: "FAID<S"
(i) Fraud in the execution-where a person is tricked into signing something that he does
not know is a negotiable instrument (e,g" where a ball player signs what he thinks is a
fan's autograph book but is in fact a cleverly concealed promissory note), Note that all
other types of fraud (where the defrauded person knows he is issuing commercial
paper but does so due to a fraudulent inducement) are personal defenses and will not
succeed against an HOG.
(ii) Forgery of a necessary signature, such as the drawer's or maker's signature or the
endorsement of any named payee or special endorsee,
(iii)
(iv)
CD { (v)
(vi)
{
(vii)
(viii)
Adjudicated insanity such that under state law the contract is void from its inception
rather than merely voidable,
Material Alteration of the instrument, to the extent of the alteration (e,g" thief changes
the amount of a check from $10,00 to $1,000 by removing the decimal point and
altering the written amount; the maker or drawer is not liable for the altered amount, but
is liable for the original amount),
Infancy to the extent that it renders a contract voidable under state law,
Ilegality that renders the underlying contract void (e,g" a check given in exchange for a
promise to murder),
Duress that will render an obligation void (i.e" extreme duress, such as a check written
at the point of a gun but not that the check was written after a threat to prosecute the
drawer's son for theft),
Discharge in bankruptcy and other discharges known to the HOC (e,g" a release
written on the face of the instrument),
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Regulation 6
@{(ix)
(X)
Becker Professional Education I CPA Exam Review
Suretyship defenses, to the extent the HOC knew prior to acquiring the instrument that
the party was signing as a surety or "accommodation party" (see V.F., below) and other
defenses known to the HOC (see VI.B. below).
Statute of limitations has run (generally three years after dishonor or acceptance on
drafts and six years after demand or other due date on notes).
PASS KEY
R6-20
The typical method of testing real V5. personal defenses on the exam is very straightforward. Typically the
examiners simply ask, "An HDC will take a negotiable instrument subject to which of the following defenses?"
If you have the 10 real defenses memorized, the answer is simple since an HDC takes subject only to the real
defenses and takes free of any personal defenses. The best way to remember the real defenses is with the
acronym "FAIDS"-Forgery, Fraud in the execution, Alteration, Adjudicated insanity, Infancy, Illegality, Duress,
Discharge in bankruptcy, Suretyship if status known, Statute of limitations.
C. Personal Defenses-Cannot be Raised Against an HDC Ov tl-\elv
1. Examples of Personal Defenses- FAID'S
Personal defenses cannot be raised against one having the rights of an HOC, and may
be viewed as all defenses other than the real defenses discussed above. These
include every defense available in ordinary contract actions (e.g., fraud in the
inducement, failure of consideration, theft of an instrument after it was signed, breach
of contract, mistake, impossibility, etc.).
2. Unauthorized Completion-Personal Defense
Unauthorized completion is a personal defense (and so cannot be used against one
with the rights of an HOC). Unauthorized completion occurs when an issuer leaves
part of an instrument blank and a later holder fills in the missing information, either
without authority or beyond the authority granted.
EXAMPLE
Alex drew a check payable to the order of Becky but left the amount blank. The price depended on a future
delivery of fuel to Alex from Becky and the exact price was not yet known. Becky never delivered the fuel, but
filled the check out for $800 and negotiated it to Cindy, an HDC, for $600. If Cindy presents the check to Alex,
Alex will be liable to Cindy for the full $800 because unauthorized completion is a personal defense.
PASS KEY
Although the list of personal defenses (which are not good against an HDC) is nearly endless, the examiners'
favorite appears to be unauthorized completion (giving a party an instrument with the amount left blank),
probably because the examiners hope you'll confuse this with material alteration (changing the amount
written on an instrument without permission). The examiners' second favorite personal defense is failure of
consideration.
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Becker Professional Education I CPA Exam Review Regulation 6
v.
<
1)
<
t-{ote/CD 2)
LIABILITY OF THE PARTIES 1) D ." LI. L
Vc:l\wee lot" rney c:l\CCepr
A. Introduction DVc:l\-Pt/cl-\ec\::. <2) DVc:l\wev
As a general rule, anyone whose signature appears on commercial paper potentially has
liability on the paper (i.e., anyone who signs commercial paper potentially could be forced to
pay by a later holder). However, liability and prerequisites to liability depend on the status of
the signatory. The liability of a(n) maker, drawer, drawee, endorser, and a few others will be
discussed below.
PASS KEY
The examiners have rarely tested party liability directly, except for the effect of acceptance. However, liability
choices often appear as wrong answers. Moreover, these issues could easily be tested in the future. Thus,
general familiarity with party liability could be important.
B. Maker-Primarily Liable
When a maker signs a note, the maker enters into a contract to pay the note when due
according to its terms (most importantly the amount) when signed. Makers are primarily
liable.
C. Drawer-Secondarily Liable
The drawer of a draft or check also enters into a contract, but the drawer's contract is a
contract of secondary liability. The drawer agrees to pay the draft according to its terms if:
the draft is presented to the drawee for payment, the drawee refuses to pay (i.e., "dishonors"
the draft) and the holder informs the drawer of the dishonor.
D. Drawee-Primarily Liable After Acceptance
1. Not Liable on Instrument Unless Drawee Signs
Since the general rule is that only a person whose signature appears on an instrument
can be liable on the instrument, it follows that a drawee cannot be held liable on a
negotiable instrument until the drawee signs the instrument.
a. If Drawee Signs, Liable as Acceptor-Discharges All Prior Parties
If a drawee signs a draft, the drawee becomes an "acceptor" and is primarily
liable. An acceptor enters into a contract that it will honor a draft as presented.
Acceptance discharges all prior endorsers.
b. Certification of a Check-Discharges All Prior Parties
Certification of a check is equivalent to acceptance-it is acceptance of a check
by the drawee bank. Certification discharges all prior endorsers and, in most
states, the drawer as well. A bank does not have to certify a check if it does not
want to, but if it does it puts its own credit on the line, which is why certified
checks are widely accepted.
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Regulation 6
ANCILLARY MATERIAL (for Independent Review)
Becker Professional Education I CPA Exam Review
2. Liability between Drawer and Drawee
A holder cannot force a drawee to payout on a draft. However, the drawee may be
liable to the drawer for refusing to pay.
a. Duties of Drawee Bank to Honor Draft
The bank is contractually obligated to honor the customer's draft as drawn if
there are sufficient funds on deposit to cover the draft.
b. Stop Payment Orders
Under the UCC, an oral stop payment order is binding on a bank for 14 days. A
written stop payment order is binding for six months. The bank must be given
reasonable time to act and is under no obligation to honor a stop payment order
on a cashier's check.
END OF ANCILLARY MATERIAL
E. Liability
An endorser is one who signs his name, usually on the back of an instrument, for the purpose
of either negotiating the instrument to another or making himself secondarily liable on the
instrument. An endorser can be liable in either of two entirely independent ways: contract
and warranty.
1. Liability ess --------------,
An endorser is secondarily liable. The contract that results from merely signing one's
name on the back of commercial paper is that the endorser will pay a subsequent
holder of the instrument, according to its terms,@)
(i) The holder presents the instrument to the maker or drawee for payment;
(ii) The maker or drawee dishonors (refuses to pay); and
(iii) The endorser is given proper notice of the dishonor.
a. When Presentment Must be Made
In the case of a check, presentment must be made within 30 days to preserve
the liability of an endorser.
b. Notice of Dishonor
Once proper presentment is made and the maker or drawee refuses to pay, the
holder must give notice of the dishonor. This can be done orally-all that is
necessary is that the notice identify the instrument and state that it has been
dishonored.
R6-22
c. Endorsement without Recourse-No Contract Liability
An endorser can negate his contract liability simply by endorsing "without
recourse." For example, if John Smith endorses a check: "John Smith without
recourse," he incurs no contract liability (i.e., no guarantee of payment).
However, John Smith would still make the transfer warrantees listed below.
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2. E)Clsts eve", l-P Y0l.\ ",ot ov wlthol.\t vecol.\vSe
a. Transfer Warranties Made by Transferors
An endorser can also be liable for transfer warranties. Any person who transfers
an instrument for consideration makes the five warranties listed in b., below.
b.
Me\o\o\oVlz.e!
c.
d.
(i) If the transferor does not endorse the instrument, the warranties run only to
the immediate transferee and not to subsequent holders;
(ii) If the transferor endorses, the warranties run to all subsequent holders.
Five Transfer Warranties of Those Transferring for Consideration
(i) The transferor is entitled to enforce the instrument (i.e., has good title) or is
authorized to act for one who is entitled to enforce;
(ii) All signatures are genuine or authorized;
(iii) The instrument has not been materially altered;
(iv) No defense of any party is good against the transferor; and
(v) The transferor has no knowledge of any insolvency proceeding that has
been instituted against the maker, acceptor, or drawer of an unaccepted
instrument.
Presentment and Notice of Dishonor Irrelevant
Presentment and notice of dishonor are irrelevant to warranty liability.
Limiting Warranty Liability
Except on checks, transfer warranties may be disclaimed by language indicating
such an intent (e.g., "the transferor makes no warranties").
ANCILLARY MATERIAL (for Independent Review)
F. Accommodation Party
An accommodation party is one who signs an instrument for the purpose of lending her name
and credit to another party. In essence, she is a surety.
EXAMPLE
Alex wants to buy a car from Becky and wants to pay with a promissory note. Becky agrees to take a note
only if Alex can get Cindy to sign the note as co-maker. If Alex gets Cindy to sign, Cindy is an accommodation
party.
1. Liable in Capacity in Which Signed
An accommodation party is liable in the capacity in which she signed. Thus, in the
example above, Cindy is liable as a maker.
2. Never Liable to Person Accommodated
An accommodation party is never liable to the person accommodated. This is true
regardless of the parties' positions on the instrument.
EXAMPLE
Same facts as above, but Cindy signs the note as maker and Alex signs as an endorser. If Becky seeks
payment from Alex-the party accommodated-Alex cannot hold Cindy liable even though endorsers
can usually hold makers liable.
Note: If the accommodation party pays, she can seek payment from the accommodated party.
END OF ANCILLARY MATERIAL
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Regulation 6 Becker Professional Education I CPA Exam Review
NEGOTIABLE INSTRUMENTS HDC FLOWCHART
keep o-P pc:l\vHes
Because your defense is
personal, you cannot raise it
against Saloon Keeper because
he is a holder in due course. You
must pay him.
Beer Distributor asks Saloon
Keeper to pay on his
endorsement.
Saloon Keeper pays Beer
Distributor and takes check.
Can't find Gardener and so
asks you to pay.
The bank gives the check back to
the Beer Distributor.
BEER DISTRIBUTOR "PRESENTS" THE CHECK TO THE
BANK FOR COLLECTION
GARDENER "NEGOTIATES" THE CHECK TO A SALOON
KEEPER,
an innocent 3
rd
party who gives value (cash and
beer) for the check without notice or knowledge of
the failure of consideration (thus Saloon Keeper is a
"holder in due course").
in partial payment. The Beer Distributor is an
innocent 3 rd party who gives value (beer) for the
check (also a "holder in due course").
SALOON KEEPER "NEGOTIATES" THE CHECK TO THE
BEER DISTRIBUTOR
for the purpose of mowing your lawn, but the
gardener does not mow the lawn. Thus, there is a
"failure of consideration" for your check.
-c::;;------= DRAWN BY YOU
"ISSUED" BY YOU TO YOUR GARDENER
R6-24
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ANCILLARY MATERIAL (for Independent Review)
Regulation 6
G. Effect of Agent Signing
The general rule is that only a person whose signature appears on an instrument can be
liable on the instrument. However, a principal can be held liable on an instrument by the
signature of an authorized agent, even though the principal's signature does not appear.
H. Effect of Forgery
In a forgery situation, the forger is always liable. Examiners rarely test this rule. A more
difficult question is "who is liable if the forger is missing?" The answer to the question
depends on which party's signature is forged.
1. Forgery of Drawer's Name-Drawee Liable Upon Acceptance
If a drawer's signature is forged and the forger is missing, the drawee (e.g., the Bank)
is liable upon acceptance (e.g., if it pays out on the draft). The rationale for this rule is
that the drawee should know its own customer's signature.
2. Forgery of the Payee's Name-Does Not Usually Pass Good Title
Forgery of the payee's name generally does not pass good title. Under Article 3 an
unauthorized signature is not deemed to be that of the person whose name is signed.
Absent the forger, the person who will ultimately be liable is the first person the forger
passed the instrument to.
3. Exceptions: Impostor Rule and Fictitious Payee Rule
There are two cases where forgery of a payee's name does pass good title: the
imposter rule and the fictitious payee rule.
a. Impostor Rule-Forgery of Payee's Name Effective
An impostor is someone who pretends to be someone else. If a maker or drawer
issues an instrument to an impostor, any resulting forgery of the payee's name
will be effective.
EXAMPLE
Alex tells Barb that he is Carl, from Carl's Plumbing, to whom Barb owes $500. Barb has never
met Carl, believes Alex's story, and issues a check to Alex payable to the order of Carl. Alex
signs Carl's name and cashes the check at the drawee bank. Barb will be stopped from denying
the validity of Alex's forgery of Carl's signature since she was in the best position to prevent
this fraud.
b. Fictitious Payee Rule-Forgery of Payee's Name Effective
If the drawer or maker issues commercial paper to a payee whom he does not
actually intend to have any interest in the instrument, a resulting forgery of the
payee's name is effective to pass good title to later transferees.
EXAMPLE
The treasurer of Big Corp. draws 50 checks payable to phony employees, forges the names of
the payees, and cashes the checks, which make their way to the drawee bank through the
check collection system. The drawee bank pays out on the checks and charges Big Corp.'s
account. Big Corp. is stopped from denying the validity of the signatures since it was in the
best position to prevent the fraud.
END OF ANCILLARY MATERIAL
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Regulation 6 Becker Professional Education I CPA Exam Review
VI. DISCHARGE
A. Introduction
An instrument itself is never discharged, although, it can become unenforceable because of
the statute of limitations. However, parties can be discharged from their liability on
instruments.
B. Methods of Discharge
Parties can be discharged from their obligation on commercial paper in a number of ways,
including the following:
1. By payment, satisfaction, or tender of payment to a holder;
2. By cancellation or renunciation;
a. All parties are discharged if a holder intentionally destroys the instrument;
b. Individuals can be discharged by lining through their signatures or the like;
c. Oral renunciation is not effective;
3. By impairing recourse or collateral (e.g., by releasing a party that a subsequent party
could have looked to for payment-such as the maker or drawer-or by releasing a
security interest in collateral);
4. By delay in presentment or failure to give notice of dishonor; and
5. By acceptance or certification of a draft by a bank.
C. Discharge is Personal Defense
You might recall that discharge is not one of the "real defenses" unless the HOC has notice of
the discharge. That is, an HOC will take free of the defense of discharge unless the HOC
knows of the discharge. Thus, to ensure that discharge will be effective against an HOC, it is
best to note all discharges on the face of the instrument (e.g., by stamping "paid" on the
instrument).
R6-26
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Becker Professional Education I CPA Exam Review Regulation 6
DOCUMENTS OF TITLE
P ~ s . 27-> 1

General Background
Documents of title are governed by Article 7, and many of the rules governing documents of
title are analogous to the Article 3 rules governing commercial paper.
OVERVIEW
A.
ANCILLARY MATERIAL (for Independent Review)
I.
1. Article 7 is concerned with two types of documents of title: warehouse receipts and bills
of lading.
a. Warehouse receipts represent goods stored in a warehouse,
b. Bills of lading represent goods that are being transported by a carrier.
2. Both serve a purpose similar to the purpose of commercial paper:
a. While commercial paper provides a convenient and safe way to transfer cash,
warehouse receipts and bills of lading provide a convenient and safe way to
transfer title to goods that are stored or being transported.
b. The person who holds a document of title has the right to have the goods
represented by the document delivered to him or her by the issuer of the
document.
3. Conversely, an issuer who delivers goods pursuant to a document of title is not liable
for misdelivery if it is subsequently discovered that the person to whom the goods were
delivered was not actually authorized to receive them (e.g., because the document was
stolen).
B. General Characteristics
1. Issuance
a. The issuer of a document of title is the bailee (a bailee is a person who holds
goods belonging to another-the bailor).
b. A warehouse receipt may be issued by any warehouseman.
c. A bill of lading may be issued by any carrier.
d. There is no requirement that the issuer be licensed or bonded.
2. Negotiability-Negotiable if Goods are Delivered to Order or Bearer
a. A document of title is negotiable if by its terms goods are to be delivered to
"bearer" or "to the order of' a named person.
b. As with commercial paper, there is an advantage to holding negotiable
documents of title: a holder of a duly negotiated document of title (a person
similar to an HOC) is subject to only a few defenses. To be a holder of a duly
negotiated document of title one must:
(1) Give present value for the document of title;
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b.
Regulation 6 Becker Professional Education I CPA Exam Review
(2) Take the document of title in good faith;
(3) Without any notice of an adverse claim or defense; and
(4) The purchaser must obtain it in the regular course of business or financing.
PASS KEY
What it takes to make a document of title negotiable has been the key to a number of past questions.
It is simple: it is negotiable if by its terms goods are to be delivered to bearer or to the order of a
named person.
3. Negotiation - Depends on Whether it is an Order or Bearer Document
a. Like commercial paper, the procedure for negotiating a document of title
depends on whether the document is a bearer or order document.
(1) A bearer document of title is negotiated by delivery alone.
(2) An order document requires delivery of the document plus a valid signature
of the person named in the document.
b. A forgery of the named person's signature is not a proper negotiation. The
warehouseman or carrier is liable to the true owner if the goods are delivered to
one who presented a document with a forgery.
4. Effect of Negotiation
a. A holder to whom a document of title has been duly negotiated acquires title to
both the document and the goods represented by the document.
b. The holder also acquires the right to have the goods delivered to him or her free
of any defense not on the face of the document.
5. Transfer Warranties
A person who transfers a document of title, like a person transferring commercial
paper, makes warranties, specifically:
a. That the document is genuine;
b. That he or she has no knowledge of any fact that would impair the document's
validity or value; and
c. That the negotiation or transfer is rightful and effective.
6. Negotiable Document of Title Delivery Requirements
a. The issuer is required to deliver the goods to whoever is legally in possession of
the document or to a party designated by the holder.
(1) With bearer documents, the goods must be delivered only to the party
possessing the bearer document or one designated by him.
(2) With order documents, the goods must be delivered only to the order of
that party or to one holding a document properly endorsed by that party.
The warehouser or carrier must obtain possession of the original document.
Delivery of goods to a party with a missing document of title (absent a court
order) makes the warehouser or carrier liable to any party damaged by the
misdelivery.
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Becker Professional Education I CPA Exam Review Regulation 6
I-I
II.
7. Non-negotiable Document of Title Delivery Requirements
a. With non-negotiable documents of title, goods must be delivered to the party
named in the document (not the one possessing the document).
b. The party named in the document is called the consignee.
c. The carrier or warehouse need not take possession of the document.
WAREHOUSE RECEIPT
A. Definition
A warehouse receipt is a document of title issued by a warehouseman entitling a named
person, or his order, or the bearer of the receipt to delivery of stored goods.
B. Essential Terms
Warehouse receipts must include the following:
Where the goods are being stored (the location of the goods);
The date the receipt was issued;
The number of the receipt;
Who is to receive the goods (negotiable if to bearer or to the order of a named person;
nonnegotiable if simply to a specified person);
The fees and storage rates;
A description of the goods or the packages containing them; and
The warehouseman's signature or that of an authorized agent.
If any of these terms is missing, the warehouseman is liable for any loss caused by the
missing information.
1. Note also that warehouse receipts may contain other terms as long as they do not
impair the warehouseman's duty of delivery and due care.
2. Finally, note that as a bailee, a warehouseman owes a duty of at least ordinary care
and can be held liable for damage caused by negligence.
PASS KEY
The essential terms of a warehouse receipt can be learned by the following:
Who - who is to receive the goods?
What - a description of the goods and the number of the receipt must be included.
When - the date the receipt was issued.
Where - where the goods are being stored.
How much - the fees and storage rates must be stated.
Signed - the signature of the warehouseman or agent must be included.
C. Liability for Alterations of Warehouse Receipts
1. If a blank in a warehouse receipt is filled out without authority, a purchaser of the
receipt who gives value and does not know of the unauthorized completion is entitled to
enforce the receipt as completed.
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Regulation 6 Becker Professional Education I CPA Exam Review
2. Other alterations are ineffective. The issuer is liable only for the original terms of the
receipt.
D. Warehouseman's Lien
1. A warehouseman has a lien on the stored goods for storage charges, insurance, labor,
and other expenses reasonably incurred in storage.
2. However, if a negotiable receipt has been issued, the warehouseman's lien is limited
against a person to whom the receipt has been duly negotiated to charges set in the
receipt or to reasonable storage fees.
3. The lien is lost if the warehouseman voluntarily delivers the goods.
E. Enforcement - Sale
1. A warehouseman may enforce his or her lien by selling the stored goods at a public or
private sale.
2. Notice of the charges owed and details of the sale must first be given to the all
interested parties. The sale must be commercially reasonable.
III. BILL OF LADING
A. Defined - Document of Title Issued by a Carrier
II:fiilfflijmI 1. A bill of lading is a document of title issued by a carrier.
2. It must identify the goods being shipped and must also include a destination to which
the goods are being shipped.
3. It must also include the name of the person from whom the goods were received by the
carrier (the "consignor") and the name of the person to whom, or to whose order, the
goods will be delivered (the "consignee").
B. Duty of Care
1. At common law, a common carrier has a high standard of care. It is treated as an
insurer of the goods and is liable for all damages to the goods that occur during
shipment, regardless of cause (e.g., the carrier is liable for vandalism and other willful,
harmful acts by third persons).
2. However, Article 7 provides that a carrier may limit its common law liability by inserting
in the bill of lading a provision limiting liability to a certain amount (e.g., "the carrier's
liability shall not exceed $500 per package") or requiring that claims be presented
within a certain time.
C. Alterations
If an unauthorized person fills in a blank on a bill of lading or otherwise alters it without
authority, it is enforceable only according to its original terms.
D. Carrier's Lien
R6-30
1.
2.
A carrier has a lien on the goods covered by the bill for storage and transportation
charges and for expenses incurred in storing the goods.
However, against a purchaser for value of a negotiable bill of lading, the lien is limited
to the charges set in the bill, or to reasonable charges.
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Becker Professional Education I CPA Exam Review Regulation 6
3. The lien can be enforced in the same manner as the warehouseman's lien discussed
above and lost by delivery.
E. Liability for Misdating, Misdescription, and Nonreceipt of Goods
1. A holder to whom a negotiable bill of lading has been duly negotiated (or a consignee
of a nonnegotiable bill who has given value in good faith) may recover damages from
the issuer:
a. If the holder or consignee relies on the bill's erroneous description of the goods
or an erroneous date on the bill, or
b. If the goods are not delivered.
2. An exception exists to the extent the bill indicates that the issuer truthfully did not know
this information (e.g., if Red Ball Express loads 10 boxes of widgets and does not
check the contents of the boxes, in issuing a bill of lading it may rely on the shipper's
description, as long as it so indicates by a term such as "shipper's count").
3. The shipper is deemed to have guaranteed its description of the goods it delivered to
the carrier/issuer of the bill of lading and must indemnify the carrier/issuer for losses
caused by errors in this information.
PASS KEY
Documents of title as a whole is not heavily tested. When it is tested, there are four areas that examiners like
to test:
What does it take to make a document of title negotiable?
What are the delivery requirements for documents of title?
What are the three warranties of transferees?
What is the liability of carriers and warehousers?
END OF ANCILLARY MATERIAL
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Regulation 6
I. INTRODUCTION
Becker Professional Education I CPA Exam Review
SECURED TRANSACTIONS
A. Overview of Statutory Scheme
This general overview introduces you to the statutory scheme and terminology of Article 9,
which governs secured transactions.
1. Secured Transactions-Debt Secured by Collateral
Secured transactions questions generally involve credit transactions. A debtor buys
something from a creditor or secured party on credit. The creditor wants to be able to
rely on something other than the debtor's promise to ensure payment. A security
interest or collateral is that something.
2. Security Interest-Right of Creditor to Repossess Upon Default
A security interest is a limited right in specific personal property (the collateral) of the
debtor that allows the creditor to take the property (commonly referred to as
repossessing) if the debtor fails to fulfill the credit obligation.
3. Effective Between Creditor and Debtor Upon Attachment
A security interest is effective between the parties as soon as certain steps are taken to
"attach" the interest. Once the interest attaches, if the debtor defaults the creditor has
some right to take the collateral to satisfy the debt.
4. Effective Against Third Parties Upon Perfection
a. Attachment does not provide the creditor with rights against third parties who
might also have an interest in the collateral. To gain rights over third parties, a
creditor must take added steps to "perfect" the security interest.
b. Perfection basically serves as a form of notice that the creditor has a security
interest in the collateral, and because of this notice, gives the creditor rights in
the collateral superior to certain third parties.
A TYPICAL SECURED
TRANSACTION SCENARIO
Creditor lends debtor money to buy Debtor buys the furniture and the
office furniture and has debtor sign a security interest attaches - the parties
Creditor perfects the security interest
security agreement describing the 1- agreed to create a security interest as
-
by filing a financing statement.
furniture to be purchased as the evidenced by the security agreement,
collateral. creditor gave value (the loan), and
j
debtor had an interest (ownership) in
the collateral.
+
If debtor defaults, creditor can take
If debtor defaults, creditor will have
the collateral and sell it, but probably
rights to the collateral against both
not if third parties have rights in the
the debtor and most third parties.
same collateral.
R6-32
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B. Scope of Article 9
Article 9, with certain exceptions, applies to most contractual security interests in personal
property or fixtures (personal property so attached to real property as to become part of the
real property) and outright sales of accounts receivable.
c. Exceptions
Article 9 does not apply to security interests in land (i.e., mortgages), wage claims, and
statutory liens, such as mechanic's liens.
.(-0. Purchase Money Security Interests (PMSI)
There is a special type of security interest-a purchase money security interest (PMSI)-that
has priority over all other types of security interests in the same collateral, if the PMSI is
properly perfected. A PMSI arises when:
(i)
Ov
(ii)
A creditor sells the collateral to the debtor on credit, retaining a security interest for the
purchase price; or 111I ..'. I
The creditor advances funds used by the debtor to purchase the collateral.
Notice that the creditor may, but need not, be the seller of the collateral.
EXAMPLE
~ Becky purchases a $1,000 stereo on credit from Radio Hut and signs a security agreement giving Radio
Hut a security interest in the stereo. Radio Hut has a PMSI in the stereo since it supplied the credit that
enabled A to purchase the collateral.
Becky goes to Bank and asks Bank for $1,000 to purchase a stereo. Bank gives Becky the money, Becky
signs a security agreement giving Bank a security interest in the stereo, and Becky buys the stereo from
Radio Hut. Bank has a PMSI in the stereo because it advanced the money that was used to purchase the
collateral.
(3) Becky goes to Bank and asks Bank for $1,000 to purchase a stereo. Bank gives Becky the money, and
Becky signs a security agreement giving Bank a security interest in the stereo to be purchased. Becky
gambles away the $1,000. Becky then goes to Radio Hut and buys a $1,000 stereo on credit. Radio Hut
can have a PMSI in the stereo but Bank does not because Radio Hut provided the credit used to pay for
the stereo.
Becky wants to borrow $1,000 from Bank. Bank agrees to give Becky the money if Becky will give Bank a
security interest in a stereo that Becky already owns. Although Bank has a security interest, it will not
have a PMSI in the stereo. Becky already owned the stereo (Bank did not advance funds used to
purchase the collateral).
Note: A good rule of thumb to determine whether a PMSI exists under Article 9 is to determine whether the
debtor, at the time of the creation of the security interest in the collateral, was involved in purchasing the
collateral; and if so, whether the price or credit was advanced by the secured party for the purchase. If
either one of these factors is missing, there is no PMSI.
PASS KEY
Examiners frequently ask questions involving PMSI creditors. You must be able to spot PMSI creditors on the
exam. Remember, a PMSI creditor exists if:
(i) A creditor sells the collateral on credit, retaining a security interest; or
(ii) The creditor advances funds used by the debtor to purchase the collateral.
Simply ask: did the debtor receive the collateral with the creditor's money or creditor's credit?
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Regulation 6 Becker Professional Education I CPA Exam Review
E. Types of Collateral
IRi$Miil Collateral is the property subject to a security interest. Under Article 9, there are four broad
categories of collateral: goods, intangible and semi-intangible collateral, investment property,
and proceeds. It is important to know the type of collateral you are dealing with because
certain rules (e.g., how to perfect, where to perfect, and priority) depend on the type of
collateral involved.
1. Goods Include lipe v s ( ) \ \ ~ l lASeII
a. Consumer goods-Goods used for personal, family or household purposes (e.g.,
a tractor used to mow the grass at home).
b. Inventory-Goods held for sale or lease (e.g., a tractor at a farm implement
store) or goods used up quickly in business, such as raw materials used in
manufacturing, goods to be furnished under a service contract, and work in
progress (e.g., a partially built tractor).
c. Equipment-Goods that do not fit into another category, including durable goods
used or bought for use primarily in business (e.g., a tractor used to mow the lawn
at a gardening store).
Note: Whether goods are consumer goods, inventory or equipment is determined by how the debtor(uses)
them, not by the nature of the goods.
EXAMPLE
If a debtor uses a car as a delivery vehicle for his business, it is equipment. If he uses a car for household
purposes, it is consumer goods. If he buys a car to sell at his auto dealership, it is inventory.
R6-34
F.
2. Intangible Collateral Accounts
An account is any right to payment for goods, services, real property, or use of a credit
card, not evidenced by an instrument or chattel paper (for example, the money you owe
your doctor after a checkup).
3. Investment Property
Investment property includes stocks, bonds, mutual funds, and brokerage accounts
containing such items. Although most investment property could be described as
intangibles, the Code deals with them separately.
4. Proceeds
Proceeds include whatever is received upon the sale, exchange, collection, or other
disposition of collateral. Proceeds differ from other types of collateral in that they
constitute any collateral that has changed in form from a previous category. For
example, if a farmer borrows money and gives a creditor a security interest in wool
from his sheep, the wool is the collateral. If the farmer exchanges the wool for a tractor
or money, the tractor or money is proceeds of the wool.
Duties of Secured Party
A secured party has a duty to file or send the debtor a termination statement when the debt is
paid, confirm for the debtor the unpaid amount left on the secured debt, and to use
reasonable care to preserve any collateral in the secured party's possession.
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II. CREATION (ATTACHMENT) OF THE SECURITY INTEREST
A. Introduction
i. The parties must have an agreement creating the security interest evidenced by either:
(i) An authenticated record of the security agreement (see below for a definition);
I'.""IIImB' I
CveAltov vs. Aebtov
Three Requisites for{AttachmenO
Article 9 concerns the secured party's rights against both the debtor and third parties. The
former involves a process called attachment and the latter involves a process called
perfection. This section covers attachment. A security interest is not enforceable unless it
has attached to the collateral.
B.
cstep #1
(ii) The creditor's taking possession or control of the collateral (a "pledge").
ii. Value must be given by the secured party in exchange for the security interest (e.g.,
the creditor gives the debtor a loan in exchange for a security interest in the debtor's
equipment-the loan is value; note that this is true even if the loan was made earlier-
an antecedent debt is value too); and
iii. The debtor must have rights in the collateral (usually outright ownership, but it could be
something less, such as a possessory right under a rental agreement).
These three elements must coexist for the security interest to attach. Attachment will be
effective when all three requisites are satisfied.
EXAMPLE
On May 1, Alex fills out a loan application, including a security agreement, from Bank to borrow $1,000 to buy
a stereo. Bank tells Alex it will take five days to process the loan. On May 6, Alex obtains the money from
Bank. On May 7, Alex buys the stereo. The security interest attaches on May 7 because that is the earliest
date on which all three requirements for attachment were met. The agreement was made on May 1, value
was given on May 6, and Alex obtained rights in the collateral on May 7.
1. What is an Authenticated Record? - by Aebtov
Article 9 was revised to embrace the use of computers in obtaining security interests.
Before the revision, security agreements had to be in writing and signed by the debtor.
As revised, Article 9 requires an "authenticated record."
a. A "record" includes not only old-fashioned written security agreements, but also
intangible records such as computer files.
b. A record can be authenticated by a written signature or by any electronic mark
made with the intent to identify the authenticating person and adopt the
agreement.
2. What is Control?
A security interest in investment property, nonconsumer deposit accounts and
electronic chattel paper may be evidenced by "control." Generally, a creditor has
"control" over an item if the creditor has power to make or prevent dispositions of the
collateral. For example, the bank in which a nonconsumer deposit account is
maintained has control over the deposit account.
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Regulation 6
PASS KEY
Becker Professional Education I CPA Exam Review
A frequently tested secured transaction issue on the CPA exam is what is or is not a requirement of attachment. There are
several key points to remember:
Since the creditor must either take possession or control of the collateral or obtain an authenticated record of a
security agreement, neither is specifically required (either one will do, but one or the other must be present).
If there is a record of the security agreement, it must be authenticated by the debtor not the creditor.
The debtor must have rights in the collateral, but need not necessarily own the collateral.
A financing statement is not required. It is related to perfection, not attachment.
C.

. "-
Property in Which Debtor Acquires Interest in Future (After Acquired Property)
1. After Acquired Property-Permissible
A secured party will sometimes want to obtain a security interest not only in a debtor's
present property, but also in property that the debtor will obtain in the future. This is
permissible. COL\lA be CO\\SL\lMev
2. Most Often Used with Inventory and Equipment wen
After acquired property clauses are most often used with inventory and equipment.
The security interest attaches to the property as soon as the debtor acquires an interest
in the property.
EXAMPLE
ABC Hardware Store borrows $10,000 from Bank to make an improvement in the store. ABC signs a security agreement and
gives Bank a security interest "in all of ABC's present inventory and all inventory after acquired." Bank has a valid security
interest in ABC's present inventory. Bank has a security interest in future inventory as soon as ABC acquires an interest in
the inventory.
III. (PERFECTION):>F THE SECURITY INTEREST CveAH...ov VS. i-hlvA
2 A. In General
I'mmmi
Attachment establishes the secured party's rights to the collateral vis-a-vis the debtor.
However, other parties may also have rights in the collateral (e.g., subsequent purchasers of
the collateral, unsecured creditors, and other priority creditors). To acquire the maximum
priority in the collateral over most such third parties, the secured party must also "perfect."
There are five methods of perfection: (i) filing; (ii) taking possession of the collateral; (iii)
control; (iv) automatic perfection; and (v) temporary perfection.
1. Timing of Perfection t
-t-- A security interest is not enforceable against any party until it has(attached)o the
collateral. Thus, perfection of a security interest cannot be completed until it has
attached. In some circumstances, however, a party may complete all of the other steps
necessary for perfection (e.g., filing) before the security interest has attached (e.g.,
where an after acquired property clause is used). In such a case, the security interest
will become perfected at the time that it attaches (i.e., as soon as the debtor obtains an
interest in the collateral).
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Becker Professional Education I CPA Exam Review
EXAMPLE
Regulation 6
CD B.
On May 1, Becky fills out a loan application, including a security agreement, from Bank to borrow
$1,000 to buy a stereo. Bank tells Becky that it will take five days to process the loan and Becky can
pick up the money on May 6. On May 2, Bank files a financing statement covering the stereo. On May
6, Becky obtains the money from Bank. On May 7, Becky buys the stereo. Perfection occurs on May 7
because that is when attachment occurred.
PASS KEY
The examiners like to ask about the relationship between perfection and attachment. A key point to
remember is that a security interest cannot be perfected before it attaches to the collateral, but
attachment and perfection can occur at the same time (e.g., by taking possession of the collateral).
Perfection b#iling) CO\\stvtACT-lVe \\OT-lCe
A security interest may be petiected as to all kinds of collateral except deposit accounts and
money by filing a financing statement.
ANCILLARY MATERIAL (for Independent Review)
1. Documents to be Filed (the financing statement)
The Code simply requires "notice" filing-it does not require a filing of a copy of the
security agreement. "Notice" is given by the filing of a "financing statement," which
contains the following elements:
(i) The name and mailing address of the debtor and secured party;
(ii) An indication of the collateral covered by the financing statement; and
(iii) If the financing statement covers collateral related to real property (such as
minerals, crops, or fixtures), a description of that real property.
Note carefully that a general description of the type of collateral (e.g., "inventory" or
"equipment") is sufficient in the financing statement. A description of particular
collateral is not necessary.
2. Debtor Must Authorize Filing
The debtor must authorize the filing of a financing statement in an "authenticated
record" (i.e., the authorization cannot be oral). A debtor will be deemed to have
authorized the filing if the debtor authenticates a security agreement covering the
collateral that is covered by the financing statement.
3. Place of Filing
Generally, financing statements are filed centrally, with the Secretary of State.
END OF ANCILLARY MATERIAL
4. Period for Which Filing is Effective-5 Years and it Can be Renewed
A financing statement is effective for five years. A financing statement can be renewed
for an additional five year period by filing a continuation statement.
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Regulation 6
C.
Becker Professional Education I CPA Exam Review
Ml.\st be
Perfection by Taking Possession (pledge) - OVt:'\l \\OW ok
A secured party may perfect a security interest in most types of collateral simply by taking
possession of the collateral. This is similar to when a pawn shop takes an item in exchange
for a loan of money. The property owner can redeem the pledged item by paying back the
amount borrowed.
ANCILLARY MATERIAL (for Independent Review)
1. Collateral that Cannot be Pledged-Intangible Property
A security interest in accounts, deposit accounts, nonnegotiable documents, or general
intangibles (e.g., a patent), cannot be perfected by possession, even if the collateral is
tangibly represented (e.g., by a ledger book).
2. Rights and Duties of Secured Party in Possession
The secured party must use reasonable care in storing and preserving the collateral,
but may charge the debtor for any reasonable expenses incurred in preservation of the
collateral, including the cost of insurance.
D. Perfection by Control
Security interests in investment property may be perfected by "control." Basically, a secured
party (or other purchaser) has control of an item of investment property when the secured
party has taken whatever steps are necessary to be able to have the investment property
sold without further action from the owner.
1. Stock Certificates and Bonds-Certificated and Uncertificated
a. Certificated Securities-Must Take Possession
If the stock or bond is represented by a certificate, the secured party must take
possession of the certificate to obtain control. If the certificate is not in "bearer"
form (i.e., certificate says it is payable only to a specific person), the secured
party must also have the specific person endorse the certificate over to him.
EXAMPLE
Alex borrows $10,000 from Becky and agrees to give her a security interest in 200 shares of
Levco stock. The stock is certificated and payable to bearer. Becky will have control if she
takes possession of the certificates.
b. Uncertificated Securities-Owner Contacts Issuer
If the stock or bond is not represented by a certificate, to obtain control the
secured party must have the owner notify the issuer to reregister the securities in
the name of the secured party or have the issuer agree to follow the secured
party's instructions regarding the security.
2. Securities Accounts
R6-38
a. Few people actually physically possess the stocks or bonds they own. They
instruct brokers or mutual fund companies to purchase stocks, bonds, or mutual
fund shares on their behalf and hold them in a securities account.
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b. A creditor can perfect a security interest in such an account in much the same
way a secured party would gain control over an uncertificated security. The
owner of the account must contact the broker or mutual fund company and
instruct the broker that the secured party now has whatever right in the account
the owner has or that the broker is to comply with the secured party's orders
without further consent of the owner.
EXAMPLE
Alex borrows $100,000 from Bank. As security, Bank requires Alex to give it a security interest
in his Squabb brokerage account, which has a current market value of $200,000. Bank can
perfect this interest through control by having Alex instruct Squabb to follow Bank's orders
regarding the account.
END OF ANCILLARY MATERIAL
@ E. Automatic Perfection
Article 9 provides that a security interest can be perfected simply by the attachment of the
security interest without any added requirements. This is called an automatic perfection.
Historically, only two types of automatic perfection have appeared on the exam: (i) small
scale assignment of accounts and (ii) a purchase money security interest (PMSI) in consumer
goods.
-ta 1. PMSI in Consumer Goods - Pevso\\eI\l lASe
A PMSI arises where the creditor either sells the collateral to the debtor on credit and
reserves a security interest or advances the funds that are used to purchase the
collateral and reserves a security interest. The only type of PMSI that is automatically
perfected is a PMSI in consumer goods. A PMSI in inventory or equipment collateral
must be filed to be valid.
2. Small Scale Assignment of Accounts
A small scale assignment of accounts (e.g., assignment of a few accounts receivable)
is automatically perfected.
Temporary Perfection
1. ITwenty-Daylperiod for Proceeds
A security interest in proceeds from original collateral is continuously perfected for 20
days from the debtor's receipt of the proceeds.
EXAMPLE
Sally trades in her old stereo, which is collateral for Bank's loan, for a new stereo. Bank's security
interest in the new stereo is continuously perfected for 20 days from Sally's receipt of the new stereo.
2. Interstate Shipments-fFour-Month Grace Period I
Where collateral is taken from one state to another, perfection in the first state
generally is valid for four months after the collateral is brought into the second state.
To maintain its priority, the creditor must perfect in the new state within this four-month
period.
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EXAMPLE
.(a
IV.
Vista, a wholesaler, sold 50 microwave ovens to Davis Appliance for $50,000. Davis paid $5,000 down
and signed a promissory note for the balance. Davis also executed a security agreement giving Vista a
security interest in Davis' inventory, including the ovens. Vista perfected by properly filing a financing
statement in Maine. Six months later, Davis moved its business to Vermont, taking the ovens. On
arriving in Vermont, Davis secured a loan with Friendly Bank and signed a security agreement putting
up all inventory including the ovens as collateral. Friendly perfected by properly filing a financing
statement in Vermont. Two months after arriving in Vermont, Davis defaulted on both debts. Vista
would have priority over Friendly because the four-month grace period to file had not expired.
PRIORITIES
A. Introduction
The heart of Article 9 is its allocation of rights or priorities between conflicting interests in
collateral. Conflicts can arise, for example, between a secured creditor and a buyer of the
collateral, between creditors with a security interest in the same collateral, etc. Priorities are
discussed below in the order of highest priority to lowest priority. In brief, the priority ranking
is:
(i)
(ii)
MetMov'iz.e!
(iii)
(iv)
(v)
A buyer in the ordinary course of business of inventory that serves as collateral for a
security agreement created by the seller; holders in due course of negotiable
instruments; and holders of possessory liens;
The holder of a properly perfected PMSI in the collateral;
The holder of a perfected security interest in, or a judicial lien that has attached to, the
collateral (including the lien of a trustee in bankruptcy);
The holder of an unperfected security interest in the collateral; and
The debtor.
B. Buyers in the Ordinary Course, Holders in Due Course
II
R6-40
1. Buyers in the Ordinary Course
A buyer who buys goods from a merchant's inventory in the ordinary course of the
seller's business has the highest priority in collateral. Such a buyer takes free of a
perfected security interest in the inventory, even if he knows of the security interest,
unless he knows that the sale is in violation of the security agreement. The buyer need
not be purchasing for consumer use. A buyer in the ordinary course of business of
equipment also takes free of perfected security interests.
EXAMPLE
Steve, an appliance retailer, borrowed money from Friendly Bank (FB) to purchase a new line of
refrigerators to sell in his store. To secure the loan, Steve gave FB a security interest in his inventory.
If Becky buys a refrigerator from Steve's store, Becky takes free of FB's security interest. If Steve fails
to pay FB, FB cannot repossess the refrigerator from Becky. Note that it does not matter for what
purpose Becky bought the refrigerator-the buyer can be buying for personal or business use.
PASS KEY
Drafters of examination questions frequently ask questions involving buyers in the ordinary course of
business. Remember that a buyer in the ordinary course will always prevail over a perfected creditor,
even if the buyer had knowledge of the security interest, unless the buyer knows that the sale violates
the creditor's security interest.
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2. Holders in Due Course and the Like
Like a buyer in the ordinary course, a holder in due course of a negotiable instrument,
or a holder to whom a negotiable document of title has been negotiated, takes priority
over an earlier perfected security interest. Thus, the best way to perfect a security
interest in such items is to take possession of them. Taking possession of negotiable
instruments generally prevents other persons from gaining status as a holder in due
course or the like.
C. Holders of Possessory Liens-Mechanic's Liens
In most states, a repairer who does not get paid for repairing goods can place a mechanic's
lien on the goods (i.e., the repairer can keep possession of the goods to ensure payment).
The mechanic's lien is valid as long as the repairer keeps possession of the goods. Such
possessory liens generally have priority over existing perfected security interests.
(i) D. Properly Perfected PMSI
The person with the next highest priority in collateral is a holder of a properly perfected PMSI.
Proper perfection depends on the nature of the collateral. D IL I. L "-1
/ O ~ r V\{}/\ve rO "t"l e
1. PMSI in Consumer Goods Automatically Perfected b\.\t 0\.\ sl'\o\.\lA
As already mentioned, a PMSI in consumer goods is automatically Y I_I
perfected. . .
2. (Exception}-Second-hand Consumer Purchaser Without Notice ..
If a buyer of consumer goods resells the goods to another consumer buyer, the
second-hand buyer will take free of an automatically perfected PMSI in consumer
goods as long as the second-hand consumer buyer had no notice of the security
interest. This is often called the "garage sale" rule. Note: If the secured party filed to
perfect, the second-hand buyer is subject to the security interest. Filing would give the
second-hand buyer notice of the security interest.
-ta EXAMPLE - , P M ~ I
/
Becky buys a stereo for home use on credit from Steve and gives Steve a security interest in the stereo. Steve
does not file a financing statement, but still has a perfected PMSI in the stereo through automatic perfection.
Becky sells the stereo to her neighbor, Cindy, for use in her home. Becky stops making payments to Steve.
Steve cannot repossess the stereo from Cindy. However, if Steve had filed a financing statement, he could
repossess the stereo from Cindy. Even if Steve had not filed, if Cindy was using the stereo in her office, Steve
could repossess. Only consumer purchasers take free of automatically perfected security interests.
PASS KEY
Examiners know that you know the basic garage sale rule-a second-hand consumer purchaser usually will
take free of an automatically perfected security interest in the collateral. Therefore, when they ask about this
topic they usually try to trick you by telling you that the secured party filed a financing statement.
Remember, if the secured party filed, the second-hand purchaser is subject to the security interest. The
secured party can repossess from the second-hand purchaser because the second-hand purchaser had notice.
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Regulation 6
3.
Becker Professional Education I CPA Exam Review
PMSI ir(lnventory}-Prior Perfection and Notice Required for Priority
A PMSI in inventory has priority over a prior perfected security interest in the same
inventory collateral only if:
a. The PMSI is perfected when the debtor gets possession of the collateral (filing
must occur before the inventory is delivered to debtor); and
b. Any secured party who has filed a security interest in the same collateral is given
notice of the PMSI before the debtor receives the inventory.
EXAMPLE
4.
On March 1, First Bank (FB) loans Acme Feed Store money and takes a security interest in Acme's
inventory, now owned and after acquired. FB files a financing statement in the proper place. On April
1, Second Bank (SB) promises to loan Acme $10,000 to purchase cattle feed. For SB to have priority
over FB, SB must file a financing statement and notify FB before Acme gets the feed.
if Filing Within al20-Day Grace Periodl
A PMSI in noninventory collateral (e.g., equipment) has priority over conflicting security
interests in the same collateral as long as the PMSI is perfected within 20 days after
the debtor receives possession of the collateral.
a. If perfected within the 20-day grace period, perfection relates back to the day the
debtor got possession (which means that the PMSI is superior to security
interests created during the 20-day grace period).
b. There is no requirement that the secured party notify other secured parties as
must be done with an inventory PMSI.
EXAMPLE
(1) As of January 2, Bank holds a perfected security interest in all of Debtor's equipment and after acquired equipment. On
July 16, Dealer sells and delivers to Debtor a new piece of equipment, retaining a security interest in the equipment.
On July 25, Dealer files a financing statement perfecting a security interest in the equipment. Even though Dealer knew
of Bank's after acquired property security interest, Dealer has priority as to the new piece of equipment because Dealer
filed within the 20-day grace period.
(2) On July 16, Dealer sells and delivers to Debtor a new piece o1{equipment)retaining a security interest in the equipment.
On July 20, Bank loans Debtor $10,000, taking a security interest in all of Debtor's equipment, and files a financing
statement covering the equipment. On July 25, Dealer files a financing statement perfecting a security interest in the
new piece of equipment it sold to Debtor. Dealer has priority in the equipment it sold, because Dealer filed within the
statutory 20-day period.
PASS KEY
The examiners like to ask about PMSls. There are several key points to remember:
A PMSI in consumer goods is automatically perfected. Perfection of a security interest in other goods collateral
requires filing.
A PMSI in equipment has priority over other perfected security interests if filed anytime within 20 days of the debtor
getting possession of the collateral. The perfection relates back to the date of possession.
There is no 20-day grace period for a PMSI in inventory. To have priority it must be perfected before the debtor gets
possession and notice must be given to other perfected parties in the same collateral.
GR: pev-PecteA pev-PecteA
R6-42
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Perfected Security Interests
Perfected security interests and judicial liens that have attached have the next highest priority
after properly perfected PMSls. If there are conflicting perfected security interests or liens in
the same collateral the following rules apply:
1. Conflicting Perfected Security Interests-First to File or Perfect
When there are conflicting perfected security interests in the same collateral, priority
goes to the creditor who was first to either file or perfect.
a. Thus, if both secured parties perfected by filing, the one who filed first has
priority, even if perfection was not completed upon filing.
b. If one party perfected by filing and the other party perfected by some other
method (e.g., by taking possession), the party who filed will have priority if he
filed before the other party perfected.
......
EXAMPLE
-rw" "",,-Pt--\CSls
cveAH.."vs
(1) Frank and Sam both claim a security interest in the same collateral. Frank's security interest
attached on January 1 and was perfected by filing on March 1. Sam's security interest attached
on February 1 and was perfected by possession on February 15. Sam's security interest is
superior to Frank's interest because Sam perfected (by taking possession) before Frank filed or
perfected. Note that the dates of attachment are irrelevant.
(2) On May 1, First Bank (FB) took a loan application from Debtor Corp. seeking a $10,000 loan and
had Debtor Inc. sign a security agreement and financing statement covering Debtor Inc.'s
equipment. On May 2, FB filed a financing statement covering the transaction. On May 3,
Second Bank (SB) loaned Debtor $5,000 and took possession of Debtor's bulldozer to serve as
collateral. On May 4, FB loaned Debtor the requested $10,000. If Debtor defaults in paying FB,
FB has priority over SB in the bulldozer because FB filed before SB perfected (by taking
possession). Note that SB was the first to perfect, since its perfection was effective upon taking
possession of the machine. FB's interest was not perfected until it gave Debtor Corp. the money.
The first to file or perfect has priority.
PASS KEY
The examiners often ask which of two perfected security interests have priority. Remember filing or
perfection dates are the dates to look at. Dates of attachment generally are irrelevant.
2. Conflict between Perfected Security Interest and Judicial Lien
A judicial lien will have priority if it attached (i.e., the sheriff seized the property) before
the security interest was perfected. If the security interest was perfected before the
judicial lien attached, it has priority.
3. Trustee in Bankruptcy-Lien Creditor as of the Date of Filing
a. A trustee in bankruptcy is treated as a hypothetical lien creditor on all of the
debtor's property as of the date the bankruptcy petition is filed.
b. Thus, the bankruptcy trustee is subordinate to all prior perfected security
interests but has priority over subsequently perfected security interests unless
they have retroactive effect (e.g., PMSls in equipment collateral).
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Regulation 6
@ F.
Lt:'\st G.
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EXAMPLE
(1) On June 15, Debtor borrowed $50,000 from Creditor and gave Creditor a security interest in its factory
equipment. Creditor perfected by filing on June 16. On June 17, Debtor borrowed $50,000 from Bank
and gave Bank a security interest in its factory equipment. On June 18, Debtor was involuntarily
petitioned into bankruptcy. On June 19, Bank filed a financing statement covering Debtor's equipment.
Creditor has priority over the trustee in bankruptcy because Creditor perfected before the bankruptcy
petition was filed. Bank's security interest is subordinate to the trustee in bankruptcy because Bank
perfected after the bankruptcy petition was filed.
(2) On June 15, Debtor purchased on credit from Creditor $50,000 worth of equipment for use in Debtor's
factory. Debtor gave Creditor a security interest in the equipment. On June 21, Debtor was involuntarily
petitioned into bankruptcy. On June 23, Creditor filed a financing statement covering the equipment.
Creditor has priority in the equipment over the bankruptcy trustee because Creditor's PMSI was
perfected within 20 days of when Debtor got possession of the equipment and so will relate back.
Unperfected Security Interest-Unprotected
Unperfected security interests have priority only over the debtor. If there are two unperfected
security interests in the same collateral, the first to attach has priority.
Debtor loP t ~ e v e 'is t:'\ s\.\vpl \.\S
After default, the debtor has the lowest priority in the collateral.
PASS KEY
The examiners often ask what party will have the highest priority in collateral. The order of priority is:
Buyer in the ordinary course of business, HDCs and the like;
A properly perfected PMSI holder, except in the case of a second-hand consumer purchaser of consumer
goods subject to an automatically perfected PMSI;
Perfected security interest holders and judicial lien holders once the lien has attached; and finally
Unperfected security interests.
ANCILLARY MATERIAL (for Independent Review)
H. Priority Rules may be Modified Contractually
Although Article 9 provides rules for priority, parties entitled to priority under Article 9 may
contractually subordinate their rights to the rights of other parties. Thus, if a client wishes to
lend money to a debtor but all of the debtor's assets are subject to a security interest that
would be superior to the client's security interest, all is not lost; the client can negotiate with
the other secured creditor for a subordination agreement.
END OF ANCILLARY MATERIAL
R6-44
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v. RIGHTS ON(OEFAULT)
A. Right to Take Possession of and Sell Collateral
The right to take possession of and sell the collateral on default is the most
important and most used of the rights on default.
1. Taking Possession
a. Self-help-No Requirement for Judicial Action
The secured party may take possession by self-help without judicial process if
she can do so without a breach of the peace.
b. Collection Rights of Secured Party
With collateral such as accounts and instruments, upon default where agreed,
the secured party is entitled to notify the account debtor to make payment to her,
rather than to the debtor who is in default.
EXAMPLE
Bank has a security interest in Doctor's accounts receivable. If Doctor defaults on the secured
obligation, Bank may inform patients with outstanding account balances to make payments to
Bank.
c. Replevin Action
The secured party may always take possession of the collateral by replevy (a
judicial action seeking the transfer of personal property).
2. Sale
After default and repossession, the secured party may sell or lease the collateral, either
in its condition when taken or after reasonable preparation or processing. Disposition
may be by either public (auction) or private sale.
a. The sale or lease must be commercially reasonable in all respects: method,
manner, time, place, and terms.
b. The debtor and others parties must generally be given notice of the sale.
c. The sale wipes out all subordinate interests, such as the interest of secured
parties with lower priority, lien creditors, and the debtor's interest. A good faith
purchaser of the collateral at the sale takes free of all subordinate interests, but
is subject to superior interests.
d. The debtor has the right to redeem by paying off the indebtedness and costs
before the sale, but this right is cut off by the sale.
PASS KEY
The examiners often ask about the effect of a sale of the collateral. Remember that all subordinate
claims are wiped out and there is no right of redemption by subordinate security interest holders or
the debtor.
~ e.
Proceeds
Proceeds of a default sale are distributed in the following order:
(1) First, to pay the expenses of repossession and sale;
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(2) Second, to pay creditors with a security interest in the collateral in order of
priority; the creditor with the highest priority must be paid in full before any
proceeds can go to the secured creditor with the next highest priority;
(3) Finally, any surplus is paid to the debtor.
f. Proceeds Insufficient to Pay Expenses of Sale and Debt
If sale of the collateral does not bring in enough money to pay the expenses of
the sale and the debt, the secured party may bring a court action to recover the
deficiency from the debtor.
ANCILLARY MATERIAL (for Independent Review)
B. Retention of Collateral in Satisfaction of Debt GR: yes
1. Transactions Not Involving Consumers
After default, a secured party may keep the collateral in full or partial satisfaction of the
debt (i.e., the secured party may keep the collateral, offset its value against the debt,
and seek to recover the difference from the debtor).
2. Transactions Involving Consumers
With consumers, the secured party may keep the collateral only in full satisfaction of
the debt (i.e., no deficiency may be recovered).
3. Notice Must Be Given in Full or Partial Satisfaction Cases
In either case, the secured party must give notice of its intent to keep the collateral to
the debtor and other secured parties.
4. Compulsory Disposition of Consumer Goods (60% rule)
In consumer goods cases where the debtor has paid at least 60% of the loan, the
secured party must sell the collateral within 90 days after repossession, unless the
debtor waives this right.
END OF ANCILLARY MATERIAL
C.
1.',,'1
.,.: ..
D.
R6-46
Debtor's Right of Redemption-Pay All Creditors in Full
Until the sale or discharge of the debt through retention of the collateral, the debtor may
redeem the collateral by paying all of the obligations secured by the collateral plus all
reasonable expenses incurred relating to the repossession.
Judicial Action against Debtor
Instead of using self-help, on default, the secured party may bring an ordinary judicial action
for the amounts due and levy on the collateral after judgment. The secured party may have
the collateral seized at the same time that he or she begins the judicial action.
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SURETYSHIP & CREDITOR'S RIGHTS
I. THE SURETYSHIP UNDERTAKING
A. Defined

A suretyship transaction involves three parties: the creditor (i.e., the obligee), the
principal (i.e., the debtor or obligor), and the surety.
Broadly speaking, a(suretYJis one who is liable for the debt or obligation of another.
1. The Parties
2. Surety vs. Guarantor IKifftlNI
A(surety)in the narrow sense of the term is directly liable on his contract and is
distinguished from a(Quarantor)who is liable to the creditor only if the debtor does not
perform his duty to the creditor. IIMlfl.!thil
EXAMPLE
(1) Alex loans Becky $10,000 with a June 1 due date. Cindy is surety on the note evidencing the
indebtedness. On June 1, A the creditor-obligee, may demand performance directly from Cindy.
Cindy is liable even though Alex has not made demand upon Becky or placed Becky in default.
(2) Alex loans Becky $10,000 with a June 1 due date. Cindy guarantees Becky's performance on the
note evidencing the indebtedness. On June 1, A, the creditor-obligee may demand performance
from Cindy if and only if Becky is placed in default.
W..
Guarantor of Collectability-Creditor Must Exhaust All Remedies against Debtor Rvst
I-I
3.
A guarantor of collectability is liable only if the creditor is unable to collect
from the debtor after exhausting all legal remedies, including demand,
MY\.. EGsuit, judgment, and exhaustion of all supplementary proceedings.
B. Statute of Frauds-Surety's Promise Must be Evidenced by a Writing 1'"0 be
The Statute of Frauds requires written evidence of the promise to answer for the debt of
another. A suretyship undertaking not evidenced by a written memorandum is by Sl.wety
unenforceable.
C. Gratuitous and Compensated Sureties
1. Gratuitous Surety-Not Compensated
A gratuitous surety is one who is not compensated for his promise to the creditor. A
parent signing as a surety for a child's loan is a typical example of a gratuitous surety.
a. Treatment-Any Variation of Surety's Risk Releases Surety
A gratuitous surety is treated more favorably than a compensated surety. If the
creditor does anything that varies the gratuitous surety's risk, then the surety's
obligation is discharged.
b. Consideration
The only consideration a gratuitous surety receives is the creditor's performance
(or promise to perform) to the principal. As such, to be binding, the surety's
promise must be a condition (usually precedent) of the creditor's making the loan.
Generally, a suretyship promise made after the loan contract has been made will
not bind the gratuitous surety due to lack of consideration.
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2. Compensated Surety-Paid Surety
A compensated or commercial surety is paid for his promise to the creditor. A bonding
company is a typical example of a compensated surety.
a. Treatment-Material Change Increasing Risk Releases Surety
A compensated surety is treated less favorably than a gratuitous surety. In order
to discharge a compensated surety, the creditor must make a material change in
the contract that increases the surety's risk of loss.
b. Consideration is Compensation
A compensated surety's consideration is his or her compensation. Thus, a
compensated surety is bound to perform regardless of the timing of the promise.
II. THE SURETY'S RIGHTS
A. Against Creditor
1. There is No Right of Notice
Where the principal has missed payments or defaulted on the obligation, the creditor
need not immediately notify the surety.
2. Generally No Right to Compel Collection
Generally, the surety does not have a right to compel the creditor to collect from the
principal debtor.
3. Generally No Right to Compel Creditor to Apply Security Held
Generally, the surety also does not have the right to compel the creditor to apply
security held to reduce the debt before proceeding against the surety.
PASS KEY
When a debtor defaults in a suretyship situation, the creditor may do any of the following in any order:
Immediately demand payment from the surety
Immediately demand payment form the debtor 11'SI.We+y'1 - llc:l\ble
Immediately go after collateral if there is any
The surety does not have the right to require the creditor to take any of the above mentioned action. A
cguarantoj)of collectability would have the right to require a creditor to first proceed against the debtor or
against available collateral.
EXAMPLE
Principal is in bankruptcy. Creditor holds a mortgage on Principal's factory as security on the obligation.
There will be considerable delay before Creditor can realize on the security due to the bankruptcy. Surety has
no right to force Creditor to go against the collateral. Surety must pay in full. Surety is then subrogated to
Creditor's rights against Principal on the mortgage (see below).
B. Against Principal Debtor
1. Exoneration (suit to compel payment) "Be-Pove
"
SI.We+y fc:l\YS
a. The principal owes his surety a duty to perform. If the principal fails to pay the
creditor, the surety may bring a suit for exoneration in equity to compel the
principal to pay.
R6-48
b. Exoneration will not impair a creditor's right to proceed against a surety.
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A-Ptev 3.
2.
<Step sl-\oes o-P
2. Subrogation (enforcement of creditor's right against principal) 1'1!Hi.lflMI
a. paid the principal's obligation, the surety may enforce (i.e., is
subrogated to) any rights that the creditor had against the principal.
b. This includes the right to enforcement of any security interest and any priority in
bankruptcy that the creditor had.
Reimbursement (suit against principa/(aftet}payment)
a. The surety is entitled to reimbursement from his principal for any amount the
surety paid on behalf of the debtor. This is also called a right to
"indemnification."
b. Reimbursement should be distinguished from exoneration. In the latter, the
surety compels the principal to pay the creditor and the surety himself does not
pay.
C. AgainstlCo-Suretiesl
1. Defined-Two or More Sureties of the Same Obligation
Co-sureties are two or more sureties of the same obligation. Co-sureties are jointly and
severally liable (i.e., anyone or more may be liable for the entire obligation).
Exoneration (suit to compel payment) "Be-Pove
"
to
If it becomes necessary for the sureties to pay the creditor, one surety may compel his
co-sureties, by a suit in equity for exoneration, to pay their pro rata shares of the debt.
.(a 3. Contribution "A#ev
"
- pvO Vc:l\tc:l\ llc:l\bmty
On payment, a surety is entitled to contribution from his co-sureties on their share of
the payment. Contribution should be distinguished from exoneration in that the right of
contribution arises only after the one surety has already paid more than his share.
a. If the contract does not specify the liability of each surety, each surety is liable for
a pro rata share determined by the number of solvent sureties.
.(a EXAMPLE
There are three solvent and two insolvent sureties. Each solvent surety is liable for one-third
of the debt.
b. Where co-sureties are obligated for varying amounts by their agreements and
the debt is reduced by part payment by the principal, each co-surety remains
liable for the original amount stated in his agreement. But payment of more than
his pro rata share of the reduced debt entitles a co-surety to contribution from his
co-sureties for the excess in the proportion of the amounts of their original
liability.
EXAMPLE
Cloans D $9,000 and X, Yand Z agree to be co-sureties. The maximum liability of each is: X
$6,000, Y$3,000 and Z $9,000. After making payments, D defaults and Z pays the entire
balance ofG6,000) Z can collect a pro rata share from X and Y. X would have to contribute
6,000/18,000 of $6,000 or $2,000. Y would have to contribute 3,000/18,000 or $1,000.
'/ )C , ==-)c 2,000
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c.
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If a co-surety's obligation is discharged in bankruptcy, her agreed share should
not be considered in determining the pro rata share of the remaining co-sureties.
The co-surety is eliminated from the calculation because nothing can be
collected from the co-surety.
EXAMPLE
Cloans D $9,000 and X, Yand Z agree to be co-sureties. The maximum liability for each is: X
$6,000, Y$3,000 and Z $9,000. After making payments, D defaults and Z pays the entire
balance of $6,000. X's debts, including his surety obligation were previously discharged in
bankruptcy. Z cannot collect anything from X. Z can collect 3,000/12,000 of $6,000 from Yor
$1,500. Xwas eliminated from the calculation because Xwas discharged in bankruptcy.
III. DEFENSES OF SURETY CveAttov t$ c:l\ bc:l\A 8l.\Y CPR'-S
A. Defrauded Principal
The surety may use as a defense that the principal was induced to enter into his contract by
the creditor's fraud. Fraud by the principal debtor is not a good defense for the surety against
the creditor unless the creditor was aware of the fraud.
B. Duress upon Principal
The surety is not liable if the principal's promise was obtained by duress and the surety did
not know of the duress.
C. Illegality of the Principal's Obligation
A party to an illegal bargain is not entitled to the assistance of the courts in enforcing it, either
against the principal or against his surety.
D. Discharge of Principal's Obligation
1. Payment and Tender of Payment
a. If the debtor or a third party pays the obligation, the surety is discharged.
b. If the principal tenders payment, the surety is discharged (i.e., the creditor cannot
refuse payment from the debtor and demand that the surety pay).
2. Release of Principal Debtor
If the creditor releases the principal, the surety is discharged unless the creditor
reserved her rights against the surety.
3. Covenant Not to Sue
A covenant not to sue, given to the principal by the creditor, does not release the
surety. However, the covenant does not affect the surety's right of subrogation against
the principal. A release of the principal with a reservation of rights against the surety is
construed as a covenant not to sue.
R6-S0
E. Surety's Incapacity or Bankruptcy
The surety's own contractual incapacity (e.g., minority, adjudicated insanity, etc.) or
bankruptcy is a defense for the surety.
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F. Variations of the Surety's Risk
1. Alteration of Principal's Contract
a. Gratuitous Surety-Any Change Releases Surety
If the principal and the creditor agree to modify the terms of their contract in any
manner, the gratuitous surety is discharged. Discharge will result even if the
variation decreases the surety's risk.
EXAMPLE
The principal is originally obligated to build a parking lot 148 feet by 90 feet. If the principal
and creditor agree to change the contract to a lot 138 feet by 90 feet, the gratuitous surety is
discharged. The risk has been varied.
b.
P4l'\ytl4l'\l
yele4l'\se
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b. Compensated Surety-Material Increase in Risk Releases Surety
A compensated surety is discharged only if he can show a material change in the
contract that increased the surety's risk of loss.
2. Extension of Time
If a debtor and creditor agree to extend the time for the debtor's performance:
a. A gratuitous surety is discharged because the agreement was changed;
b. A compensated surety may be discharged if the extension materially increased
the compensated surety's risk;
c. But if the creditor does not agree to extend time, but rather merely delays in
collection, the surety is not released.
3. Loss of Security
a. Release
The release of security held by the creditor discharges the surety in the amount
of the value of the security released.
Inaction
If the security is lost due to the creditor's inaction (e.g., due to his failure to take
the steps necessary to perfect it), the surety is discharged in the amount of the
value of the security unless substantial and burdensome acts were required for
protection of the security.
4. Release of Co-surety
A release of a co-surety without the other co-surety's consent results in the remaining
co-surety losing the right of contribution against the released co-surety. Thus, the
remaining surety is discharged to the extent that the surety could have recovered from
the released surety.
EXAMPLE
Ingot loans Flange $50,000. Quill and West agree to act as compensated co-sureties in the amount of
$50,000 each. Ingot releases West without Quill's consent and Flange defaults on the entire
obligation. Ingot demands payment from Quill. Quill is discharge for 50% of the loan or $25,000,
because this is the amount Quill could have collected from West by reason of the right of contribution.
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G. No Defense Situations IIPVl1l\clfc:l\llS c:l\ 8l.\Y" - wl-\y
The following are not available to a surety as defenses. Sl.\very
1. Principal's Fraud or Duress upon Surety
a. If the surety has been induced to enter into the suretyship through the fraud or
duress of the principal, the surety does not have a defense against an innocent
creditor unless the effect of the fraud was such as to make the surety's
undertaking absolutely void.
b. Fraud by the principal debtor is a valid defense for the surety if the creditor was
aware of the fraud.
2. Incapacity of Principal
While the surety's contractual incapacity is a defense for the surety, the principal's
incapacity is not a defense to the surety (e.g., the fact that the principal is a minor is not
a defense for the surety).
3. Bankruptcy of Principal
While the surety's bankruptcy is a defense for the surety, the principal's bankruptcy is
not a defense of the surety even though it discharges the rights of both the creditor and
the surety against the principal.
ANCILLARY MATERIAL (for Independent Review)
IV. CREDITOR'S RIGHTS OUTSIDE OF SURETYSHIP
2.
A. Debtor Remedies
1. In General
When a debtor owes a creditor money and does not have sufficient funds to pay, the
debtor has a few options to alleviate the debt. Besides filing a petition in bankruptcy
(discussed in the Bankruptcy section), the debtor can enter into a creditors'
composition or make an assignment for the benefit of creditors.
Creditors' Composition
When a debtor has insufficient funds to pay all of his creditors, the debtor and two or
more creditors can enter into a creditors' composition.
111II"',1
1
a. A composition is an agreement between the debtor and at least two creditors that
the debtor pays the creditors less than their full claims in full satisfaction of their
claims.
b. Contract consideration arises from the agreement by each creditor with each
other to take less than his or her full claim.
c. This procedure results in the debtor being discharged in full for the debts of the
participating creditors after the debtor has paid the agreed amount.
R6-52
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I-I
-
3. Assignment for the Benefit of Creditors
a. In an assignment for the benefit of creditors, the debtor transfers
some or all of his or her property to a trustee, who disposes of
the property and uses the proceeds to satisfy the debtor's debts.
b. The debtor is not discharged from unpaid debts by this procedure since creditors
do not agree to any discharge.
END OF ANCILLARY MATERIAL
v. JUDICIAL LIENS AND GARNISHMENT
A. In General
Creditors without a security interest or mortgage in the debtor's property can gain rights in the
debtor's property through imposition of a judicial lien on property in the debtor's hands@
garnishment of property in the hands of a third party.
B. (Judicial Lien)
1. If a debtor is adjudged to owe a creditor money and the judgment has gone unsatisfied,
the creditor can request the court to impose a lien on specific property owned and
possessed by the debtor.
2. After the court imposes the lien, it will issue a writ (e.g., a writ of attachment), usually to
the local sheriff, to seize property belonging to the debtor, sell it, and turn over the
proceeds to the creditor.
3. With personal property liens, the lien usually attaches upon seizure of the property by
the sheriff. Where the property is real property, the lien usually attaches on the date
the judgment is docketed by the court.
4. Before final judgment in a suit on a debt is rendered, where the creditor has reason to
believe that the debtor will not pay, the creditor can ask the court to provisionally attach
a piece of the debtor's property.
a. The property is then seized so that if the creditor prevails, she will be assured of
recovering on the judgment through sale of the property.
b. Generally, a hearing must be held before property can be attached by the court,
and most courts require the creditor to post a bond for any damages that result if
the creditor does not ultimately prevail in the suit.
C. Garnishment
Where the debtor is adjudged to owe the creditor money and the debtor has property in the
hands of a third party (e.g., money the debtor is owed by his employer, money in a bank
account, debts owed to the debtor), a writ of garnishment may be sought.
1. The writ orders the person holding the property to turn it over to the creditor or be held
personally liable for the value of the property not turned over.
2. Federal law provides that social security payments are not subject to garnishment,
execution, levy, or attachment.
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D. Exemptions
Most states protect certain property of the debtor to ensure that the debtor does not become
destitute.
1. Many states provide a('homestead)exemption that excludes items of a person's
household, up to a certain amount, from the liens of most creditors (the exclusion does
not apply to persons with PMSls in personal property or purchase money mortgages
against real property).
2. Many states also protect personal injury awards from liens, except liens of creditors
who rendered medical assistance.
3. Similarly, states often limit the amount of an employee's wages that may be garnished
(e.g., no more than one-fourth of an employee's weekly salary) to prevent the debtor
from becoming destitute.
4. When a taxpayer fails to pay federal taxes, the IRS can file a lien on all of the
taxpayer's property, including property exempt from levy under state law.
ANCILLARY MATERIAL (for Independent Review)
VI. MECHANIC'S AND MATERIALMAN'S LIENS
A. Mechanic's Liens and Artisan's Liens
1. Under common law, a mechanic or artisan who works on property and either improves
it or repairs it automatically has a lien on the property-for the price of the repairs-for
as long as the property is in the lienor's possession.
2. These liens are possessory-they dissolve as soon as the lienor lets the owner have
the property back.
3. If a mechanic, artisan, innkeeper, etc., goes unpaid, he or she may give the owner
notice of the intention to sell the retained property to pay the owner's bill. Alternatively,
the lienor may foreclose on the property by filing suit.
B. Materialman's Lien
Materialman's liens often are imposed in favor of contractors who perform work on, or provide
supplies for, real property improvements. The unpaid materialman must file a notice with the
local recorder of deeds in order to preserve his or her lien.
VII. FRAUDULENT CONVEYANCES
A. In General
A fraudulent conveyance occurs when a debtor transfers property with the intent to hinder,
delay, or defraud any of her creditors.
B. Indications of Fraudulent Conveyances
In determining if a fraudulent conveyance occurred, a court will consider whether:
R6-54
1.
2.
3.
The transfer was to an insider (e.g., relative, partner, and co-employee);
The debtor retained possession or control of the property transferred;
The transfer was not disclosed or was concealed (i.e., done secretly);
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...
4. The transfer was of substantially all the debtor's assets;
5. The value received by the debtor for the asset was not reasonable; and
6. The debtor was insolvent or became insolvent shortly after the transfer.
C. Remedies
1. A fraudulent conveyance is void or voidable and will be set aside in a proper
proceeding. However, a creditor cannot, without legal process, repossess fraudulently
transferred property (i.e., there is no self-help here).
2. In an action for relief against a fraudulent transfer, a creditor may:
a. Avoid the transfer to the extent necessary to satisfy the creditor's claim;
b. Obtain an attachment against the asset transferred or other property; or
c. Obtain an injunction against further transfers by the debtor or a transferee, of the
asset transferred.
END OF ANCILLARY MATERIAL
VIII. FAIR DEBT COLLECTION PRACTICES ACT (FDCPA)
The Federal Fair Debt Collection Practices Act (FDCPA) curbs abuses agencies11in
collecting consumer debts. The Act does not apply to a creditor attempting to collect its own debts;
just to services that collect consumer debts for others.
A. Prohibited Acts
The Act severely restricts collection agencies' ability to call third parties, such as
relatives of the debtor, to indirectly pressure the debtor. A collection agency can
contact third persons to discover a debtor's whereabouts, but may not disclose
that it is a collection agency or that the debtor owes a debt. The FDCPA also prohibits:
1. Contacting the debtor at inconvenient or unusual times; in most cases "convenient"
times are between 8:00 am and 9:00 pm;
2. Contacting the debtor directly if the debtor is represented by an attorney;
3. Using harassing or abusive language in talking to the debtor (e.g., "payor we'll break
your knee caps"); E-P-PecHve b",,+-
4. Making false or misleading claims (e.g., "we can have you thrown in jail for not
paying");
5. Contacting the debtor at her place of employment if the employer objects.
B. Remedies under the Act
1. Debtor's Power to Terminate Contacts
a. A debtor has the power to terminate the collection agency's contacts by notifying
the agency in writing that the debtor will not pay the debt and to stop further
communication.
b. The agency must stop communications except to inform the debtor that it is
bringing a lawsuit or seeking other remedies.
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Damages
a. The FDCPA gives debtors the right to sue for actual damages caused by the
collection agency's misconduct.
b. The FDCPA also provides a statutory $1,000 damage award.
3. Federal Trade Commission
The Federal Trade Commission can bring administrative enforcement actions under the
Act to force a collection agency to comply with the Act's provisions.
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MONEY LAUNDERING
ANCILLARY MATERIAL (for Independent Review)
I. INTRODUCTION
A. Defined
Money laundering is the criminal practice of processing ill-gotten gains, or "dirty" money,
through a series of transactions so that the gains appear to be proceeds from legal activities.
Money laundering schemes are used to facilitate crimes such as drug trafficking and
terrorism, and can adversely impact the global economy. The schemes can be quite
complex, but basically they involve three independent steps that can occur simultaneously:
1. Placement-Putting Proceeds of Illegal Activities into Financial System
The first stage of laundering money is placement. Criminals attempt to put proceeds
from unlawful activities into the financial system without attracting the attention of
financial institutions or law enforcement. Placement techniques include:
a. Structuring currency deposits in amounts to evade reporting requirements (e.g.,
dividing large amounts of currency into less-conspicuous smaller sums that are
deposited directly into a bank account); and
b. Commingling currency deposits of legal and illegal enterprises.
2. Layering-Move Funds Around to Make it Difficult to Follow
Layering involves moving funds around the financial system, often in a complex series
of transactions to create confusion and complicate the paper trail (e.g., purchasing a
series of monetary instruments such as cashier's checks or money orders that are then
collected and deposited into accounts at other financial institutions, or wiring or
transferring funds to and through numerous accounts in one or more financial
institutions).
3. Integration-Movement of Money into Legitimate-Looking Transactions
Integration is the final goal of the money laundering. The layered money is moved
through additional legitimate transactions in order to provide a plausible explanation for
the source of the funds. Examples include the purchase and resale of real estate,
investment securities, foreign trusts, or other assets.
B. Bank Secrecy Act (BSA)
The Bank Secrecy Act (BSA) was enacted in 1970 and is one of the primary tools used to
fight money laundering. The Bank Secrecy Act is sometimes known as an anti-money
laundering law (AML); sometimes the terms are combined (BSA/AML).
1. Amendments
The BSA has been amended by a number of other laws since its adoption, including
the Anti-Drug Abuse Act of 1988, the Uniting and Strengthening America by Providing
Appropriate Tools to Restrict, Intercept and Obstruct Terrorism Act of 2001 (better
known as the U.S.A. Patriot Act), and the Intelligence Reform & Terrorism Prevention
Act of 2004.
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C. Government Agencies Involved
1. Financial Crimes Enforcement Network (FinCEN)
FinCEN is a bureau of the U.S. Treasury. It administers the BSA by issuing regulations
and interpretive guidance, providing outreach to regulated industries, supporting the
examination functions performed by federal banking agencies (discussed below), and
pursuing civil enforcement actions when warranted.
PASS KEY
When testing on similar federal statutes, the examiners have asked tricky questions concerning who
may enforce. Note well that the FinCEN may pursue civil enforcement actions. It may not pursue
criminal enforcement actions. Criminal enforcement actions are brought by the Department of
Justice. The Department of Justice may bring criminal actions for money laundering that may include
criminal fines, imprisonment, and forfeiture actions.
2. Federal Banking Agencies
The federal banking agencies are responsible for the oversight of the various banking
entities operating in the United States, such as the National Credit Union
Administration, Office of the Comptroller of the Currency, Federal Deposit Insurance
Corporation and National Credit Union Administration.
a. Each of these banking agencies requires banks under their supervision to
establish and maintain a BSA compliance program.
b. They also must include a review of the BSA compliance program at each
examination of an insured depository institution.
II. REQUIRED REPORTS AND RECORDS
The BSA regulations require all financial institutions (and in some cases, ordinary people) to submit
five types of reports to the government.
A. Required Reports
There are five main reports that must be filed under the BSA, as amended: (i) Currency
Transaction Reports; (ii) Suspicious Activity Reports; (iii) Reports of International
Transportation of Currency or Monetary Instruments; (iv) Reports of Foreign Bank and
Financial Accounts; and (v) Designation of Exempt Person Forms. Each of these
reports/forms will be discussed below.
1. Currency Transaction Report (CTR) - Transactions of More than $10,000
Financial institutions must file a CTR (IRS Form 4789) for each deposit, withdrawal,
exchange of currency, or other payment or transfer, by, through or to a financial
institution, which involves a transaction in currency of more than $10,000.
a. Multiple Transactions May be Combined
Multiple currency transactions must be treated as a single transaction if the
financial institution has knowledge that: (a) they are conducted by or on behalf of
the same person; and, (b) they result in cash received or disbursed by the
financial institution of more than $10,000.
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b. Timing
A completed CTR must be filed with FinCEN within 15 days after the date of the
transaction (25 days if filed magnetically or electronically).
c. Financial Institution Defined
The term financial institution includes not only banks, credit unions, and savings
and loans, but also businesses such as: pawn brokers; casinos; automobile,
plane, and boat sales businesses; travel agencies; stock and commodities
brokerages; issuers and redeemers of travel checks; credit card companies;
insurance companies; and dealers in precious metals, stones, or jewels.
2. Suspicious Activity Report (SAR)
Banks must file a SAR (Treasury Department Form 90-22.47 and acc Form 8010-9,
8010-1) for any suspicious transaction relevant to a possible violation of law or
regulation. Suspicious activity reporting forms the cornerstone of the BSA reporting
system. It is critical to the United States' ability to utilize financial information to combat
terrorism, terrorist financing, money laundering, and other financial crimes.
a. Know Thy Customer Requirements
In order to have an opinion on whether a particular customer's deposit is
suspicious, banks are required to adopt policies to learn about their customers
businesses and normal deposit and withdrawal practices. Computer software is
available to help with this task.
b. Required Filings
Along with developing their own policies to learn about their customers' banking
habits, banks must develop their own SAR reporting policies. They are required
to file SARs with respect to:
(1) Criminal violations involving insider abuse in any amount;
(2) Criminal violations aggregating $5,000 or more when a suspect can be
identified;
(3) Criminal violations aggregating $25,000 or more regardless of a potential
suspect;
(4) Transactions conducted or attempted by, at, or through the bank and
aggregating $5,000 or more, if the bank knows or suspects that the
transaction may involve money laundering, is designed to evade BSA
regulations, has no apparent lawful or business purpose, or is not the type
that the customer normally would be expected to engage in.
c. Timing of a SAR Filing
A SAR must be filed no later than 30 calendar days from the date of the initial
detection of facts that may constitute a basis for filing a SAR. If no suspect can
be identified, the time period for filing a SAR is extended to 60 days.
d. Must Notify Board of Directors of SAR Filings
Banks are required to notify the board of directors or an appropriate board
committee that SARs have been filed.
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e.
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Must Not Notify Suspect
A bank or director, officer, employee, or agent of a bank, that reports a
suspicious transaction may not notify any person involved in the transaction that
the transaction has been reported.
3. Report of International Transportation of Currency or Monetary Instruments
(CMIR) Exceeding $10,000
Each person (including a bank) who physically transports, mails or ships, or causes to
be physically transported, mailed, shipped or received, currency, traveler's checks, and
certain other monetary instruments in an aggregate amount exceeding $10,000 into or
out of the United States must file a CMIR (U.S. Customs Form 4790).
4. Report of Foreign Bank and Financial Accounts (FBAR) Exceeding $10,000
Each person (including a bank) subject to the jurisdiction of the United States having an
interest in, signature or other authority over, one or more bank, securities, or other
financial accounts in a foreign country must file an FBAR (Department of the Treasury
Form 90-22.1) if the aggregate value of such accounts at any point in a calendar year
exceeds $10,000.
5. "Designation of Exempt Person" Form
Banks must file a designation of exempt person form (TDF 90-22.53) to designate a
customer who is exempt for the purpose of CTR reporting. The exemptions are
discussed in detail below.
R6-60
B. Recordkeeping Requirements
The BSA regulations require banks to maintain a variety of records for five years to ensure,
among other things, that transactions can be reconstructed, including the following:
1. Customer Identification Program ("CIP") Information
Banks and credit card issuers must establish a customer identification program ("CIP").
At a minimum, the program must provide for retention of the identifying information
(name, address, date of birth for an individual, tax identification number (TIN)), along
with any document that was relied on to verify identity, noting the type of document
(e.g., driver's license), the identification number, the date and place of issuance, and, if
any, the expiration date.
2. Monetary Instrument Sales Records
Banks sell a variety of monetary instruments (e.g., bank checks or drafts, including
foreign drafts, money orders, cashier's checks, and traveler's checks) in exchange for
currency. Purchasing these instruments in amounts of less than $10,000 is a common
method used by money launderers to evade large currency transaction reporting
requirements. Once converted from currency, criminals typically deposit these
instruments in accounts with other banks to facilitate the movement of funds through
the payment system. In many cases, the persons involved do not have an account with
the bank from which the instruments are purchased.
a. Purchaser Verification
Banks are required to verify the identity of persons purchasing monetary
instruments for currency in amounts between $3,000 and $10,000, inclusive, and
to maintain records of all such sales.
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3. Funds Transfer Record Keeping and Travel Rule Requirements
A financial institution (including car dealers, pawn brokers, etc.) must maintain a record
of each funds transfer of $3,000 or more which it originates, acts as an intermediary for,
or receives.
4. Phase I Exemptions from the CTR Filing Requirements
Banks are not required to file CTRs on large currency transactions conducted by
certain "exempt persons," including:
(i) Domestic depository institutions, such as banks;
(ii) A federal, state, or local government agency or department;
(iii) Any entity exercising governmental authority within the United States; and
(iv) Any entity (and its subsidiaries if majority is owned by entity), other than a bank,
whose common stock or analogous equity interests are listed on a national stock
exchange or on NASDAQ (except stock or interests listed under the separate
"NASDAQ Small-Cap Issues" heading);
a. Timing
Banks must file a one-time Designation of Exempt Person form to exempt a
Phase I entity from currency transaction reporting. The exemption of a Phase I
entity covers all transactions in currency with the exempted entity, not only
transactions in currency conducted through a particular account.
(1) The form must be filed with the Internal Revenue Service (IRS) within 30
days after the first transaction in currency that the bank wishes to exempt.
5. Phase II Exemptions from the CTR Filing Requirements
A business that does not fall into any of the Phase I categories may still be exempted
under the Phase II exemptions if it qualifies as either a "non-listed business" or as a
"payroll customer."
a. Non-listed Businesses
A "non-listed business" is a commercial enterprise that (i) has maintained a
transaction account at the exempting bank for at least 12 months, (ii) frequently
(e.g., more than eight times a year) engages in transactions in currency with the
bank in excess of $10,000, and (iii) is incorporated or organized under the laws
of the United States or a state, or is registered as and eligible to do business
within the United States or a state.
(1) Ineligible Businesses
If a business' majority revenue stream is derived from one of the following,
it is not eligible to be treated as an exempt non-listed business:
(a) Serving as a financial institution or as agent for a financial institution
of any type;
(b) Purchasing or selling motor vehicles of any kind, vessels, aircraft,
farm equipment, or mobile homes;
(c) Practicing law, accounting, or medicine;
(d) Auctioning of goods;
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(e) Chartering or operation of ships, buses, or aircraft;
(f) Operating a pawn brokerage;
(g) Engaging in gaming of any kind (other than licensed pari-mutuel
betting at race tracks);
(h) Engaging in investment advisory services or investment banking
services;
(i) Operating a real estate brokerage;
0) Operating in title insurance activities and real estate closings; or
(k) Engaging in trade union activities.
b. Payroll Customers
A "payroll customer" is a person who: (i) has maintained a transaction account at
the bank for at least 12 months; (ii) operates a firm that regularly withdraws more
than $10,000 in order to pay its U.S. employees in currency; and (iii) is
incorporated or organized under the laws of the United States or a state, or is
registered as and is eligible to do business within the United States or a state.
c. Filing Time Frames
After a bank has decided to exempt a Phase II customer, the bank must file an
initial Designation of Exempt Person form (FinCEN Form 110) within 30 days
after the first customer transaction the bank wishes to exempt.
III. INTERNAL BSA COMPLIANCE PROGRAMS
All national banks must develop, administer, and maintain a program that ensures and monitors
compliance with the BSA and its implementing regulations, including record keeping and reporting
requirements. At a minimum, a bank's internal compliance program must be written, approved by
the board of directors, and noted as such in the board meeting minutes.
A. Overview of Program Requirements
The program must include:
1. A system of internal controls to ensure ongoing compliance;
2. Independent testing of compliance;
3. Daily coordination and monitoring of compliance by a designated person; and
4. Training for appropriate personnel.
B. Independent Testing of Compliance
Internal review or audit findings should be incorporated into a board and senior management
report and reviewed promptly. A bank's internal or external auditors should be able to:
R6-62
1.
2.
3.
Attest to the overall integrity and effectiveness of management systems and controls,
and BSA technical compliance;
Test transactions in all areas of the bank with emphasis on high-risk areas, products,
and services to ensure the bank is following prescribed regulations;
Assess employees' knowledge of regulations and procedures;
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Becker Professional Education I CPA Exam Review Regulation 6
4. Assess adequacy, accuracy, and completeness of training programs; and
5. Assess adequacy of the bank's process for identifying suspicious activity.
C. Compliance Officer
A national bank must designate a qualified bank employee as its BSA compliance officer,
who has day-to-day responsibility for managing all aspects of the BSA compliance program
and compliance with all BSA regulations.
D. Training
Banks must ensure that appropriate bank personnel are trained in all aspects of the
regulatory requirements of the BSA and the bank's internal BSA compliance and anti-money
laundering policies and procedures.
IV. MONEY LAUNDERING PENALTIES
A. Criminal Sanctions
Persons convicted of money laundering can receive up to 20 years imprisonment and/or a
fine of up to $500,000 or twice the value of the money laundered, whichever is greater.
B. Civil Forfeitures
In addition to the criminal penalties, the anti-money laundering statutes provide for forfeiture
of any property involved in a money laundering transaction or traceable to the proceeds of
the criminal activity, including property such as loan collateral, personal property, and, under
certain conditions, entire bank accounts.
C. Other Penalties
In addition, banks risk losing their charters, and bank employees risk being removed and
barred from banking.
END OF ANCILLARY MATERIAL
2010 DeVry/Becker Educational Development Corp. All rights reserved. R6-63
2011 CPA review and final review are available at www.CPAsimulations.com WWW.BECKERCPA.COM
Regulation 6
R6-64
NOTES
Becker Professional Education I CPA Exam Review
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Becker Professional Education I CPA Exam Review
TASK-BASED SIMULATION SAMPLE 1 -Negotiability
Regulation 6
TASK-BASED SIMULATIONS
'i' Negotiability IAuthoritative Literature I Help I
Jane wishes to obtain a loan of $90,000 from Silver. At the request of Silver, Jane has entered into an agreement
with Bing, Piper and Long to act as co-sureties on the loan. The agreement between Jane and the co-sureties
stated that the maximum liability of each co-surety is as follows: B '0
P '30
Bing $60,000; Piper $30,000; Long $90,000 t. "0
\gO
Based upon the surety relationship, Silver agreed to make the loan. After paying three installments totaling
$30,000, Jane defaulted.
For items 1 and 2, double click on the shaded cells in Column A and select the correct answer from the option
choices provided. An answer may be selected once, more than once or not at all.
Item Column A
1. Prior to making payment, the co-sureties may seek the remedy of:
E"""ev(:I\H""
2. A distinction between a surety and a co-surety is that only a co-surety is
C""+vib'"H"" entitled to:
For items 3,4, and 5, assume that Long properly paid the entire debt outstanding of $60,000. Record the dollar
value in Column A that Long could recover from the other co-sureties.
Item Column A
3. What is the amount Long may collect from Bing?
'0/18'0" '0 $20,000
4. What is the amount Long may collect from Piper?
;0/18'0 " '0
$10,000
5. For this item only, if Piper's debts, including his surety obligation to Silver,
$24,000
were discharged in bankruptcy, what is the amount Long may collect from
Bing?
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1 ~ == 40% " '0
~ , , + - 18'0
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Regulation 6 Becker Professional Education I CPA Exam Review
TASK-BASED SIMULATION SAMPLE 2 - Priorities to Collateral
r Priorities to Collateral IAuthoritative Literature I Help I
During an audit of Trent Realty Corp.'s financial statements, Clark, CPA, reviewed the following instrument:
$300,000
Belle, MD
September 15, Year 1
For value received, ten years after date, I promise to pay to the order of Dart Finance CO.
T!tI'U, IIturdnd T!tOMaJrd aJrd oq/100 do/iaN with interest at 9% per annum
compounded annually until fully paid
This instrument arises out of the sale of land located in MD.
It is further agreed that:
1. I will pay all costs of collection including reasonable attorney fees.
2. I may prepay the amount outstanding on any anniversary date of this instrument.
tZ &aM
G. Evans
The following transactions relate to the instrument.
On March 15, Year 1, Dart endorsed the instrument in blank and sold it to Morton for $275,000.
fvo\\t O\\ly
Wviti
J.
V\\CO

On July 10, Year 1, Evans informed Morton that Dart had fraudulently induced Evans into signing the tv\o\\e" o\\ly
instrument.
0\\ J.
On August 15, Year 1, Trent, which knew of Evan's claim against Dart purchased the instrument from "" "t
o 0 OV d e
Morton for $50,000. Morton endorsed the note before delivering It to Trent.
OvJ.e ov
For each item, double click on the shaded cells in Column A and select the correct answer. An answer may be
selected once, more than once or not at all.
2. The instrument is:
3. On July 10, Year 1, Morton would have been considered a:
4. Trent is considered a: HolAev HOC
5. Trent could recover on the instrument from:
R6-66
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Becker Professional Education I CPA Exam Review
TASK-BASED SIMULATION SAMPLE 3 - Property Terminology
'( Property Tenninology IAuthoritatil,le Literature I Help I
Regulation 6
Several parties have an interest in the same property. For each interest listed below, indicate the order of priority
by assigning the numbers 1 through 6, where 1 represents the highest order of priority and 6 represents the lowest.
7/1
5'"/1
1. Creditor who attaches April 2 and perfects his or her security interest in
S"
inventory goods by filing July 1.
2. Debtor.

,
3. Buyer in the ordinary course of business.
rlvst
1
4. Purchase Money Security Interest in inventory goods filed May 13 with
4-
debtor taking delivery of the goods May 14 without giving notice to prior
creditors.
I.GlJ\\ove
5. Creditor who files May 1 and attaches a security interest in debtor's
,
inventory on May 2.
6. Purchase Money Security Interest in inventory goods filed April 26 with
2
debtor taking delivery of the goods May 8, and with notice to prior secured
creditors.
\) Boe . .
20 revlotA - eqL\lr.
2) Pev-l'ect-eA PI'ISI "'o!-ice -Pov ,\\ve\\t-ory
- CO\\SL\"",ev
'3) Pev-PectetA (-PlvSt to -Pile OV rev-Pect)
4)
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