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STUDY UNIT SEVEN


NEGOTIABLE INSTRUMENTS AND RELATED TOPICS

7.1 Types of Negotiable Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1


7.2 Elements of Negotiability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
7.3 Transfer and Negotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
7.4 Holders in Due Course . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
7.5 Liabilities, Defenses, and Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
7.6 Discharge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
7.7 Documents of Title . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
7.8 Letters of Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

Negotiable instruments are contracts used extensively in business transactions as a substitute for
money and to extend credit. Such instruments may be repeatedly negotiated. They include notes,
certificates of deposit, drafts, and checks. Important issues include (1) the distinction between the
transfer of an instrument by assignment and by negotiation, (2) the requirements of negotiability,
(3) identifying the parties to an instrument, (4) effects of the types of endorsement, and (5) the contract
or warranty liability of primary and secondary parties. Central to the law of negotiable instruments is
the holder in due course (HDC) concept. Questions frequently test the ability to identify an HDC and
the distinction between real and personal defenses. Real defenses generally result from nonexistence
of the initial obligation. Personal defenses generally are contractual and arise out of a valid obligation.
This study unit also discusses documents of title and letters of credit.

7.1 TYPES OF NEGOTIABLE INSTRUMENTS


1. Negotiable instruments are formal written contracts and a form of property. Thus,
negotiable instruments require mutual assent, consideration, capacity, and legality.
2. Negotiable instruments law is codified primarily in Article 3 of the Uniform Commercial
Code (UCC). Article 3 does not apply to (a) money; (b) payment orders governed by
Article 4A, Funds Transfers; or (c) investment securities governed by Article 8.
3. A promissory note is a negotiable instrument containing a promise. The maker
(a) promises unconditionally (b) to pay a fixed amount of money (c) to the order of the
payee or to bearer (d) on demand or at some defined future date.

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2 SU 7: Negotiable Instruments and Related Topics

a. The maker is a person who signs or is identified in a note as a person undertaking to


pay.
b. A note that qualifies as an order instrument may be negotiated by endorsement and
transfer of possession.
c. A note that qualifies as a bearer instrument may be negotiated without endorsement.
Thus, any person may negotiate it by transfer of possession alone.
4. A certificate of deposit (CD) is an instrument containing an acknowledgment by a bank of
receipt of money with a promise by the bank to repay it. It typically bears interest.
a. A CD is a form of promissory note. It evidences deposit of funds, but it contains an
unconditional promise to repay the amount.
b. The bank is the maker, and the payee is generally an individual or a business.
c. The classes of CDs are
1) Demand certificates (payable on demand)
2) Time certificates (payable at a definite time after issue)
5. A draft is a negotiable instrument that contains an order. Thus, a draft is (a) an
unconditional written order (b) by one person, the drawer, (c) to another person, the
drawee, (d) to pay a fixed amount of money (e) to a third person, either to an identified
person (the payee) or to bearer.

a. The drawer is a person who signs or is identified in a draft as a person ordering


payment.
b. The drawee is the person ordered to make payment. The drawee must be obligated
to the drawer either by agreement or through a debtor-creditor relationship before
becoming obligated to honor the order.
c. Drafts are usually classified as one of the following:
1) A time draft is payable at a definite time in the future.
2) A sight draft (demand draft) is payable on demand (upon presentation to the
drawee).
d. Time draft. The payee usually presents the draft to the drawee for acceptance
(agreement to pay) before the instrument’s due date.
1) The drawee accepts the draft by writing the acceptance on the instrument.
2) The acceptance may consist of the acceptor’s signature alone.
3) It is usually written vertically across the face of the instrument.
4) Once accepted, the time draft is returned by the drawee-acceptor to the payee
who holds it until its due date (at which time the payee presents it again for
payment).

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SU 7: Negotiable Instruments and Related Topics 3

5) A trade acceptance is a special form of time draft. It is used by sellers as a


means to extend credit to buyers of their goods.
a) The seller draws a draft ordering the buyer to pay money to the seller (or a
third party) at some time in the future.
b) The seller presents the draft to the buyer, and the buyer accepts it,
becoming liable on the instrument.
c) The seller may be both drawer and payee of the draft.
6. A check is a form of draft. It is always drawn on a bank, and it is always a sight draft that
is payable on demand on or after its date.
a. The drawer is a customer who has an account at a drawee bank.
b. The payee may be an individual, firm, or organization designated on the face of the
check to receive payment.
c. Checks usually enable the drawer to make distributions from a single fund (the
drawer’s bank account).
d. The drawer obtains a record of expenditures. Checks issued by the drawer eventually
clear the bank collection process and are returned to the drawer, or the drawer
receives a periodic bank statement.
e. Checks are generally issued as payment for goods or services as part of an underlying
contract.
f. A postdated check is a time draft. It bears a date later than the date on which the
check is drawn.
1) A postdated check is valid and is payable on or after the indicated date.
2) Postdating a check is not illegal (unless to defraud a party to the check).
3) To facilitate the automated check collection system, a bank may pay a postdated
check when presented and before the stated date unless the drawer gives
notice to the bank.
g. A certified check is one that the drawee bank has accepted, even if the funds in the
drawer’s account are insufficient.
1) The check is presented to the payor bank by either the drawer or the payee.
2) Certification makes the check more equivalent to money.
h. A cashier’s check is drawn by a bank on itself. The bank is obligated to itself. A
cashier’s check is often obtained by a remitter, a person not a party to the instrument
who purchases it from the issuer, usually to pay a debt to the identified payee.
i. A teller’s check is a draft drawn by one bank (1) on another bank or (2) that is
payable at or through a bank.
j. A traveler’s check is a three-party instrument. The traveler is the drawer, and the
bank or issuing firm is the drawee.
1) For purposes of identification, the traveler must sign the traveler’s check twice,
once when the seller issues it and a second time when the traveler cashes it.
2) When the drawee is a nonbanking organization, such as American Express, the
so-called traveler’s check is not technically a check but a draft.

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4 SU 7: Negotiable Instruments and Related Topics

7.2 ELEMENTS OF NEGOTIABILITY


1. Negotiability is strictly a matter of form. A negotiable instrument is presumed to have been
issued for consideration. Thus, consideration need not be proven or stated for an
instrument to be negotiable. If an instrument is drafted and issued in a specified manner, it
is negotiable, even if it contains additional language or uses wording different from that in
the UCC. Otherwise, it is nonnegotiable and is not subject to UCC Article 3. However, it
may be enforceable as an ordinary contract.
2. A negotiable instrument must be in writing and signed by the maker (a note or CD) or the
drawer (a draft or a check) or by an authorized representative. It need not be signed by the
payee. It also must
a. Contain an unconditional promise or order to pay a fixed amount of money, with or
without interest or other charges described in the promise or order.
b. Be payable on demand or at a definite time.
c. Be payable to order or bearer when it is issued or first comes into possession of a
holder. (But a check meeting the other requirements need not be payable to order or
to bearer to be negotiable.)
d. Not state any undertaking or instruction in addition to payment of money.
3. A negotiable instrument must contain an unconditional promise or order to pay.
However, it need not contain the word promise.
a. The instrument must not state an express condition to payment. The promise or order
may not be subject to or governed by another writing. For example, a note subject to
a mortgage is not negotiable. However, a note may be secured by a mortgage.
b. Mere reference to another writing does not create a condition.
c. Payment may be limited to a particular fund or source.
d. A promise is “a written undertaking signed by the person undertaking to pay”
(UCC 3-103). It is not simply an acknowledgment of an obligation.
e. An order is “a written instruction to pay signed by the person giving the instruction”
(UCC 3-103). It is not a mere request.
4. A negotiable instrument must state a promise or order to pay a fixed amount of money,
with or without interest or other charges described in the promise or order.
a. Money is an authorized medium of exchange of a domestic or foreign government.
Thus, it may be domestic or foreign currency.
b. Interest is not payable on a negotiable instrument unless it is provided for in the
instrument.
c. Prepayment provisions and default penalties are allowed.
5. A negotiable instrument must be payable on demand or at a definite time.
a. A promise or an order that does not state any time of payment is payable on demand.
b. Instruments payable on demand include those payable at the will of the holder.
Examples are instruments containing the words “payable on demand,” “payable at
sight,” or “payable at presentation.”
c. By definition, a check is payable on demand.

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SU 7: Negotiable Instruments and Related Topics 5

d. If an instrument is not payable on demand, it must be payable at a definite time


specified on the face of the instrument. A promise or an order is payable at a definite
time if it is payable
1) On elapse of a definite period of time after sight or acceptance, or
2) At a fixed date or dates (or at a time or times) readily determinable at the time
the promise or order is issued. This date or time may be subject to rights of
a)Prepayment
b)Acceleration
c)Extension at the option of the holder
d)Extension to a further definite time at the option of the maker or acceptor or
automatically after a specified act or event
e. An instrument may be antedated, postdated, or undated. The stated date
determines the time of payment if it is payable at a fixed period after the date. The
date of an undated instrument is the date of issue or when it first comes into the
possession of a holder.
f. An acceleration clause may appear on the face of the instrument. It allows a payee
or other holder of a time instrument to demand payment of the entire amount, with
interest, before the stated due date if a triggering event occurs.
g. An extension clause permits the date of maturity to be extended beyond the time
specified in the instrument.
1) To maintain the negotiability of the instrument, the period of extension must be
specified if the right to extend is given to the maker or acceptor.
2) If the holder of the instrument can extend the time for payment, the maturity does
not have to be specified.
6. The instrument must not state any other undertaking or instruction by the person
promising or ordering the payment of money. The following are the sole exceptions:
a. An undertaking or power to give, maintain, or protect collateral.
b. An authorization or power to the holder to (1) confess judgment or (2) convert the
collateral to money or otherwise dispose of it.
1) A confession of judgment is a debtor’s agreement not to contest the entry of
judgment against him/her for nonpayment. States regulate or prohibit such
agreements because they are inconsistent with due process.
c. A waiver of any law enacted for the benefit of anyone obligated under the instrument,
e.g., waiver of trial by jury.
7. The instrument must be payable to order or bearer.
a. These words clearly indicate that the parties intend that the instrument be capable of
circulating in commerce as a money substitute.
b. Order paper enables a person identified on the instrument to designate the payee.
The intended payee should be designated with reasonable certainty.
1) An order instrument is a promise or an order not payable to bearer if it is
payable to
a) The order of an identified person or
b) An identified person or order.
2) The initial payee is determined by the intent of the person signing as or for the
issuer. If the signature is automated, the payee is determined by the intent of
the person who supplied the name or identification of the payee. Identification
may be by any means, such as by name, office, or account number.

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6 SU 7: Negotiable Instruments and Related Topics

3) A promise or an order that is payable to order is payable to the identified


person.
4) Order paper allows the maker or drawer to transfer it to a specific person. That
person can transfer the instrument to whomever (s)he wishes.
5) Examples of acceptable language for an order instrument are
a) “Payable to the order of P. Cruz.”
b) “Pay to P. Cruz or order.”
6) The following language renders the instrument nonnegotiable:
a) “Payable to P. Cruz.”
b) “Pay to P. Cruz only.”
c. Bearer paper is an instrument that does not designate a specific payee. The maker
or drawer agrees to pay anyone who presents the instrument for payment.
1) A promise or an order is payable to bearer if it
a) Does not state a payee
b) Indicates that it is not payable to an identified person
c) Is payable to cash or to the order of cash
d) States that it is payable to bearer or to the order of bearer
e) Indicates that the person in possession is entitled to payment
2) For example, an instrument made payable as follows is bearer paper:
a) Pay bearer
b) Pay to the order of bearer
c) Pay to the order of P. Cruz or bearer
d) Pay any person presenting
e) Pay $500
f) Pay cash
g) Pay to the order of cash
8. The place of payment is that stated in the instrument. If none is stated, it is payable at the
stated address of the drawee or maker.
9. Contradictory terms. (a) Handwritten terms prevail over typewritten and printed terms,
(b) typewritten terms prevail over printed terms, and (c) words prevail over numbers.
10. An incomplete instrument is a signed writing intended to be completed. If it is negotiable,
it may be enforced as is or as augmented by completion. If it is negotiable only after
completion, it may be enforced as augmented by completion. An unauthorized completion
is an alteration (a real defense).
a. However, the statement of a maker or drawer that the instrument is intended to be
negotiable does not make it so.
11. An instrument may be within the definition of a note and a draft. This ambiguity does not
defeat negotiability. The person entitled to enforce the instrument may treat it as either.
12. A signature may be any symbol executed or adopted with intent to authenticate the writing.
Thus, use of a rubber stamp or a machine will suffice.

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SU 7: Negotiable Instruments and Related Topics 7

7.3 TRANSFER AND NEGOTIATION


1. Transfer of an instrument is a delivery (a voluntary transfer of possession) by a nonissuer
for the purpose of giving the recipient the right to enforce the instrument (UCC 3-203).
2. Negotiation is a special transfer that may allow the transferee to take free of personal
defenses. It is “a transfer of possession, whether voluntary or involuntary, of an instrument
by a person other than the issuer to a person who thereby becomes its holder”
(UCC 3-201). Negotiation cannot occur unless the document is in negotiable form.
Moreover, negotiation requires transfer of the entire instrument. If the transfer is of less,
the transferee has only the rights of a partial assignee.
a. Consideration is not needed.
3. A holder is a person in possession of a bearer instrument. If the instrument is payable to an
identified person, a holder is the person in possession if the identified person is in
possession. A holder need not have given value, taken in good faith, or been unaware of
defects in the instrument or of claims to it.
a. If an instrument is payable to bearer, negotiation is by transfer of possession. If it is
payable to an identified person, negotiation is by transfer of possession and
endorsement by the holder.
b. If a holder does not endorse an order instrument, a mere transfer occurs. The transfer
constitutes an assignment of the transferor’s rights. The transferee is merely an
assignee and is subject to both real and personal defenses.
1) However, a transfer of an order instrument for value gives the transferee the
specifically enforceable right to the unqualified endorsement of the
transferor unless it is specifically agreed that the transaction is an assignment.
Proper negotiation by transfer and endorsement may confer the favored status
of HDC but only at the time the conditions are satisfied.
c. Rescission of negotiation or other remedies may be available under other law.
However, they may not be asserted against an HDC or a person who paid in good
faith and without knowledge of facts that are the basis for such a remedy.
1) Thus, negotiation is effective (but may be subject to rescission or other
remedies) even if it was obtained (a) from a person lacking capacity (including a
minor or a corporation acting ultra vires); (b) by means of fraud, duress, or
mistake; (c) in an illegal transaction; or (d) as a result of a breach of duty.
2) For example, assume X issues an instrument payable to the order of A. A has
been adjudicated as an incompetent, but A nevertheless negotiates the
instrument to B. A’s lack of capacity is a basis for rescission. But, if B further
negotiates the instrument to C, an HDC, before rescission of the original
transaction, the instrument cannot be recovered by A from C.
4. Endorsement is a signature that negotiates the instrument, restricts payment, or incurs
endorser’s liability.
a. Endorsement is required to negotiate an order instrument.
b. Endorsements are usually written on the back of the instrument itself.
c. The placement of any endorsement and the relative liability of endorsers are
presumed to be according to the order in which their signatures appear.
d. If an instrument is payable to a holder under a name that is not that of the holder, for
example, a misspelled name, it is payable in either name.
e. A forged endorsement ordinarily is ineffective to negotiate an instrument payable to
an identified person. Hence, no transferee can be a holder.
f. The signature of a person as maker, drawer, or acceptor is not an endorsement.

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8 SU 7: Negotiable Instruments and Related Topics

5. A blank endorsement is an endorsement by the holder that is not a special endorsement.


Thus, it identifies no particular payee. It may consist of merely the signature of the
endorser or his/her authorized agent.
a. A check payable to the order of Paula Payee can be endorsed in blank by her signing
the back of the check.
b. An instrument payable to order and endorsed in blank becomes payable to bearer
and is negotiable by transfer of possession alone.
6. A special endorsement is an endorsement by a holder that identifies the person to whom
the instrument, whether payable to an identified person or to order, is payable.
a. Thus, an endorsement “Pay to Grace Smith” or “Pay to the order of Grace Smith” is a
special endorsement.

b. A specially endorsed instrument becomes payable to the order of the special


endorsee and requires his/her endorsement for further negotiation.
c. Words of negotiability are not required in an endorsement.
d. A holder may convert a blank endorsement consisting only of a signature into a special
endorsement by writing above the signature of the endorser words identifying the
payee.
e. The last endorsement determines whether the instrument is order paper or bearer
paper.
7. A restrictive endorsement may restrict or further limit the negotiation of the instrument.
However, it cannot prevent further transfer or negotiation.
a. A party who takes the instrument may become an HDC if (s)he complies with the
endorsement or is certain of compliance.
b. Warranty liability is unaffected.
c. The UCC identifies the following four types of restrictive endorsements:
1) Conditional endorsements
2) Endorsements prohibiting further transfer or negotiation
3) Endorsements for deposit or collection
4) Endorsements to a fiduciary
8. A conditional endorsement is one by which the endorser purports to make the rights of the
endorsee subject to the happening or nonhappening of a specified event.

a. A conditional endorsement is ineffective to condition payment (UCC 3-206).


b. The maker, drawee, or subsequent endorser is obligated to pay the instrument when
due without regard to whether the condition has been satisfied.
c. Nevertheless, the conditional endorsee may be liable in damages to the endorser on
the underlying contract for obtaining payment without performance. This liability
exists irrespective of the conditional endorsement.

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SU 7: Negotiable Instruments and Related Topics 9

9. An endorsement prohibiting further transfer or negotiation does not prevent further


transfer or negotiation.

10. An endorsement for deposit or collection forces the instrument into the banking system
for deposit or collection.

a. This endorsement limits negotiation consistent with the endorsement. It gives notice
to (1) all nonbanking persons, (2) the depositary bank (the first bank to receive an
item for payment unless it is presented for immediate payment over the counter), and
(3) a bank that makes immediate payment over the counter that they must comply
with the endorsement. However, other banks (the payor bank and intermediary
banks) may disregard the endorsement.
11. A qualified endorsement disclaims or limits contractual liability on the instrument.
a. The notation “without recourse” is commonly used.

b. A person who endorses the instrument “without recourse” does not undertake to pay
the instrument if not paid by the primary party.
1) The qualified endorser does not undertake secondary payment liability.
2) A qualified endorser may incur warranty liability.
c. Qualified endorsement does not destroy negotiability or prevent further negotiation of
the instrument. It may lessen marketability of the instrument.
d. A qualified endorsement is often used by persons acting in a representative capacity.
The representative is merely endorsing payment through to the principal and should
not be required to pay the instrument if it is later dishonored.
e. An unqualified endorsement usually guarantees payment of the instrument if the
primarily liable party does not pay.
12. An anomalous endorsement is made by a person who is not the holder. It has no effect on
negotiability. Moreover, a signature is an endorsement unless the circumstances
unambiguously indicate otherwise.
13. Sometimes an endorser signs to incur liability so as to assist another party who might
otherwise be unable to obtain funds. Such party is a surety known as an accommodation
endorser. An anomalous endorsement or a signature with words indicating suretyship or
guaranty provide notice that the instrument has been signed for accommodation
(UCC 3-419).

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10 SU 7: Negotiable Instruments and Related Topics

7.4 HOLDERS IN DUE COURSE


1. Under UCC 3-301, the person entitled to enforce an instrument may be
a. The holder
b. A nonholder in possession who has the rights of a holder
c. A person not in possession who was entitled to enforce it when (1) loss of possession
occurred without a transfer or a lawful seizure, and (2) possession cannot be
reasonably obtained because of loss, destruction, or theft (UCC 3-309)
d. A person not in possession from whom payment has been recovered by a payor
following payment by mistake (UCC 3-418)
2. The person legally entitled to enforce an instrument
a. May transfer, negotiate, discharge, or enforce payment in his/her own name.
b. Enjoys the same status as an assignee of a contractual right. The assignee
generally steps into the shoes of the assignor(s). (S)he obtains only those rights that
the predecessor-transferor had in the instrument. Generally, (s)he acquires a
negotiable instrument subject to all claims and defenses to it.
3. A holder is subject to personal and real defenses. A holder in due course (HDC) takes a
negotiable instrument free of all personal defenses even if his/her transferor was not an
HDC. However, an HDC is subject to real defenses. A holder becomes an HDC if “the
instrument when issued or negotiated to the holder does not bear such apparent evidence
of forgery or alteration or is not otherwise so irregular or incomplete as to call into question
its authenticity.” The holder also must take the instrument
a. In good faith
b. For value
c. Without notice
1) That (a) the instrument is overdue, (b) has been dishonored, or (c) an uncured
default has occurred with respect to another instrument in the same series
2) Of an alteration or an unauthorized signature
3) Of a claim to the instrument, e.g., that it was collateral for a loan
4) Of a defense or claim in recoupment
4. An HDC must have given value for the instrument.
a. A person who receives an instrument as a gift or an inheritance is not an HDC.
b. Value does not have the same meaning as consideration in the law of contracts. For
example, future consideration, such as a contractual promise, is not value.
UCC 3-303 provides that a holder gives value
1) To the extent that (a) a promise has been performed or (b) a security interest or
lien in the instrument (other than one obtained judicially) is acquired
a) Under UCC 3-302, if the promise of performance that is consideration for
the instrument is partially performed, the holder may assert rights as an
HDC “only to the fraction of the amount payable under the instrument
equal to the value of the partial performance divided by the value of the
promised performance.” For example, a party qualifying as an HDC may
have only partially performed before receiving notice of a circumstance
that disqualifies him/her as an HDC.
b) A collecting bank is considered to give value on a customer’s account for
purposes of determining HDC status only to the extent that it has a
security interest in an item (UCC 4-211). It has a security interest to the
extent to which credit given for an item deposited in a customer’s account
has been withdrawn or applied. Moreover, a FIFO rule applies: Credits
first given are deemed to be first withdrawn or applied (UCC 4-210).

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SU 7: Negotiable Instruments and Related Topics 11

2) By taking an instrument in payment of, or as security for, an antecedent claim


against any person
3) By issuing or transferring a negotiable instrument
4) By incurring an irrevocable obligation to a third party
5. A holder must take the instrument in good faith to qualify as an HDC.
a. Good faith means “honesty in fact and the observance of reasonable commercial
standards of fair dealing.”
b. The good-faith requirement applies only to the holder.
c. Good faith is a subjective (honesty in fact) and an objective (reasonable commercial
standards) determination.
d. But if a person takes an instrument under circumstances that clearly establish
existence of a defense to the instrument, for example, purchase at a very deep
discount, (s)he does not take it in good faith.
1) Purchase at a reasonable discount is normal and is not indicative of bad faith.
6. Whether an instrument is overdue depends on whether it is a time or demand instrument.
a. A demand instrument is overdue at the earliest of
1) The day after demand for payment
2) In the case of a check, 90 days after its date
3) In the case of a noncheck, when it has been outstanding for a period after its
date that is unreasonable in the circumstances
b. An instrument payable at a definite time is overdue
1) Upon default on an installment payment of principal
2) The day after the due date if the instrument is not payable in installments
3) The day after an accelerated due date for principal
c. An instrument is not overdue because of a default on payment of interest unless the
due date for principal has been accelerated.
7. The shelter principle. A person who does not qualify as an HDC but who derives his/her
title through an HDC can acquire the rights and privileges of an HDC.
a. Transfer of an instrument vests in a transferee who is not an HDC any right of the
transferor to enforce the instrument, including any right as an HDC [UCC 3-203(b)].
Thus, the transferee is an assignee of the HDC-transferor and therefore not subject
to personal defenses.
b. A transferee who was a party to fraud or illegality affecting the instrument cannot
acquire the rights of an HDC (that is, launder his/her status) by later acquiring the
instrument from an HDC (UCC 3-203).
8. The FTC rule. Consumer groups objected to the shelter principle. It does not permit a
maker or a drawer of an instrument to assert a legitimate defense after the payee transfers
a negotiable instrument for value to a third person.
a. Thus, the FTC requires a seller or a lessor of consumer goods or services to include in
a consumer credit contract the following prominently printed notice:
NOTICE
ANY HOLDER OF THIS CONSUMER CREDIT CONTRACT
IS SUBJECT TO ALL CLAIMS AND DEFENSES
WHICH THE DEBTOR COULD ASSERT AGAINST
THE SELLER OF GOODS OR SERVICES OBTAINED
PURSUANT HERETO
OR WITH THE PROCEEDS HEREOF

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12 SU 7: Negotiable Instruments and Related Topics

b. The notice requirement applies to all consumer credit contracts affecting interstate
commerce.
c. The presence of this notice preserves all claims and defenses that a consumer may
have, even against a good-faith purchaser for value without notice of any defenses,
and effectively cancels HDC status.
d. Failure of the seller to provide the required notice constitutes an unfair and deceptive
practice under the Federal Trade Commission Act of 1914.

7.5 LIABILITIES, DEFENSES, AND RIGHTS


1. If an instrument is negotiable, the person(s) entitled to enforce it, the person(s) liable, and
the nature and amount of liability must be determined.
2. Nature of liability. Liability may arise both from the contractual promise made by a party
who signed the instrument and from that party’s transfer of the instrument as property.
This liability differs from that on any underlying contract for which the instrument constituted
consideration, e.g., one arising from a sale of goods.
3. Contractual liability. Signers of a negotiable instrument, except qualified endorsers, have
primary or secondary contractual liability for its face amount (including interest).
a. A person who (1) issues a check, (2) accepts a draft in which (s)he is named as
drawee, or (3) signs a promissory note is contractually liable for the face amount.
1) When a person endorses a check to cash it, the endorsement, if unqualified,
makes the endorser contractually liable. This liability extends to the endorsee
and any other transferee for the face amount if the drawee (usually the drawer’s
bank) does not pay.
b. Any person who signs a negotiable instrument is liable on it.
c. Agents. The authorized signature of an agent acts as the signature of the principal
and binds the principal on the instrument.
1) The agent’s authority and the principal’s liability are otherwise determined by
agency law. Thus, the principal is liable if the agent is authorized whether or
not the principal’s name is on the instrument.
2) A negotiable instrument may be signed in the name of an organization. If the
organization’s name is preceded or followed by the name and office of an
authorized individual, the organization is bound. The individual who signed the
instrument in the agent’s capacity is not bound.
a)
EXAMPLE: Pubco.
Angie, President.
d. A person is not liable on an instrument unless the person or his/her agent signed it.
However, an unauthorized signature
1) May be ratified by a principal.
2) Operates as the signature of the unauthorized signer in favor of a person who
pays the instrument in good faith or takes it for value (UCC 3-403). For
example, a person who forges a check can be held personally liable by a
drawee who pays it.

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SU 7: Negotiable Instruments and Related Topics 13

e. A party is primarily liable if (s)he is required to pay by the terms of the instrument
itself. Primary liability is unconditional. The primary party is liable for the face
amount and can be sued for it when the instrument comes due.
1) The maker of a note (including the issuer of a cashier’s check or certificate of
deposit) and the acceptor of a draft (including a bank that has certified a
check) are primary parties.
a) Acceptance is the drawee’s signed agreement to pay a draft as presented
(UCC 3-409).
2) The maker of a note promises to pay the note. The words “I promise to pay”
state the maker’s obligation to pay the instrument according to the terms as
written at the time of the signing.
3) The acceptor of a draft (the drawee) is in virtually the same position as the
maker of a note.
a)A drawee who does not accept has breached a contractual duty to the
drawer to pay in accordance with the drawer’s orders. However, the
drawee owes no duty to either the payee or any holder.
b) A draft has no primarily liable party until acceptance by the drawee.
f. A party is secondarily liable when an obligation to pay arises only if the party with
primary liability fails to pay. Accordingly, drawers and endorsers have secondary
liability.
1) A drawer is not liable unless the drawee refuses to pay. If the drawee
dishonors an unaccepted draft, the drawer must pay according to its terms
when it was issued. If it was not issued, payment is according to its terms when
it first came into possession of a holder.
a) After acceptance by a bank (certification), the drawer is discharged
regardless of when or by whom acceptance is obtained. If acceptance is
by a party other than a bank, the drawer’s liability after acceptance is that
of an endorser (UCC 3-414).
b) Acceptance of a draft by a bank after endorsement discharges the
endorser (UCC 3-415).
c) If the acceptance varies the terms of the draft, the holder may refuse and
treat the instrument as dishonored. If the holder agrees, the obligation of
any drawer or endorser who does not expressly agree is discharged
(UCC 3-410).
d) A drawer may disclaim liability by drawing without recourse unless the
draft is a check (UCC 3-414).
2) An endorser is not liable unless the drawee, maker, or, possibly, other endorsers
do not pay.
a)
An unqualified endorser is liable to a subsequent endorser or a party
entitled to enforce the instrument even if the endorsement was not
necessary.
b) Endorsers are usually liable in the order in which they endorse.
c) An endorser may avoid liability by a qualified endorsement.
g. An accommodation party signs as maker, drawer, acceptor, or endorser to lend
his/her name (credit) to another party to the instrument. The accommodation party
must pay in the capacity in which (s)he signs (UCC 3-419).
1) An accommodation maker or acceptor is primarily liable.
2) An accommodation drawer or endorser is secondarily liable.
3) An accommodation party who pays has recourse against the accommodated
party but is not liable to that party.

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14 SU 7: Negotiable Instruments and Related Topics

h. A guarantor is a signer of a negotiable instrument who adds “payment guaranteed” or


equivalent words to the signature. A guarantor promises that if the instrument is not
paid when due, (s)he will pay it without the holder being required to resort to (make
demand on) any other party.
4. Warranty liability. Because a negotiable instrument is property, sellers and other
transferors have warranty liability. This liability is in addition to the contract liability based
on a party’s signature. It applies to endorsers and nonendorsers. Breach of warranty
may occur whenever a person transfers or presents for payment an instrument (the
property) that is defective in some respect, e.g., as a result of a forged signature.
a. Sellers of a negotiable instrument make transfer warranties. Transfer warranties
arise whenever an instrument is transferred for consideration or acceptance. A seller
is a person who transfers a negotiable instrument for consideration.
b. Persons who present a negotiable instrument for payment or acceptance make
presentment warranties.
c. Some parties have warranty liability without contractual liability: (1) A qualified
endorser (“without recourse”), (2) a person who negotiates an instrument without
endorsing it, and (3) an endorser who has been discharged because of the holder’s
unexcused delay in making presentment. Warranty liability may be the only avenue
of relief for a wronged party.
d. Claims of breach of warranty usually arise in cases involving forged, altered, or stolen
instruments.
e. Warranty rules allocate loss to the person in the best position to avoid the loss. They
generally place the loss on the person (or bank) who dealt with the wrongdoer.
5. Transfer warranties. Any person who transfers an instrument and receives consideration
makes certain warranties to the immediate transferee. If the transfer is by endorsement,
the same warranties also are made to any subsequent transferee who takes in good
faith.
a. The following are the transfer warranties:
1) The warrantor is entitled to enforce the instrument.
2) All signatures are authentic and authorized.
3) The instrument has not been altered.
4) No defense or claim in recoupment of any party is good against the warrantor.
5) The warrantor has no knowledge of insolvency proceedings against the maker,
drawer of an unaccepted draft, or acceptor.
b. For breach of warranty, a good-faith transferee may recover the loss suffered (but
not more than the amount of the instrument plus expenses and loss of interest).
c. Notice of a claim for breach of warranty should be given to the warrantor within
30 days after the claimant has reason to know of the breach and the identity of the
warrantor. The liability is discharged to the extent of any loss caused by any further
delay in giving notice.
d. Transfer warranties cannot be disclaimed with respect to checks.
6. Presentment warranties are made by persons obtaining payment or acceptance of an
unaccepted draft. They also are made by previous transferors of the draft to drawees who
in good faith pay on or accept the draft.
a. The following are the presentment warranties:
1) The warrantor is (or was at the time of transfer) entitled to enforce the draft.
Alternatively, the warrantor is (or was) authorized to obtain payment or
acceptance on behalf of a person who was entitled to enforce the draft. For
example, such a warranty provides protection against missing or unauthorized
endorsements.

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SU 7: Negotiable Instruments and Related Topics 15

a)This warranty also is given to a person who pays in good faith by


(1) a person obtaining payment and (2) a prior transferor when
i) A dishonored draft is presented for payment to the drawer or an
endorser.
ii) Any other instrument is presented for payment to a party who is
obligated to pay.
2) The draft has not been altered.
3) The warrantor has no knowledge that the signature of the drawer is
unauthorized.
b. The rules for transfer warranties stated on the previous page also apply to
presentment warranties.
7. Defenses to liability can bar collection from persons who would otherwise be primarily or
secondarily liable on the instrument. Real defenses can be asserted even against an
HDC. Personal defenses cannot.
a. An instrument may be void (not merely voidable) under state law because it has been
executed in connection with criminal or other illegal conduct. The defense of
illegality is absolute against both an ordinary holder and an HDC.
b. An instrument signed under extreme duress (rendering the instrument void under
state law) is unenforceable by any holder or an HDC. Ordinary duress making the
instrument merely voidable is a personal defense.
c. Fraud in the execution is committed against the signer when (s)he is induced to sign
without knowledge and a reasonable opportunity to learn of the true character and
essential terms of the instrument. Fraud in the execution (a real defense) differs from
fraud in the inducement (a personal defense).
d. If a party signs another’s name on an instrument without permission (an unauthorized
signature or forgery), the second party is not liable, even to an HDC. However, full
liability is imposed against the forger in favor of someone who in good faith pays the
instrument or takes it for value.
1) If the unauthorized signature is of an endorsement, negotiation ordinarily cannot
occur. No such transferee can be a holder or an HDC. However, if the forgery
is of a drawer’s or maker’s signature, the instrument is negotiable. A
transferee then may qualify as a holder or an HDC because the signature is
effective as that of the unauthorized signer.
a) Accordingly, an instrument may be paid or accepted in the mistaken belief
that the maker’s or drawer’s signature was authorized. In this case, a
person who (1) took in good faith and for value or (2) in good faith
changed position in reliance on the payment or acceptance need not
make restitution. For example, assume a bank (the drawee) pays on a
check to an HDC despite a forged drawer’s signature. The bank cannot
charge its customer’s account and cannot recover from the HDC. If it had
paid over a forged endorsement, however, it may be able to recover
from a prior transferor for breach of a warranty.
b) Exceptions to the forged endorsement rule apply in cases involving
impostors and fictitious payees. For example, when a person
impersonates a payee or the payee’s authorized agent, the named payee
is an impostor.
i) A fictitious payee results when (a) a person whose intent
determines to whom an instrument is payable (b) does not intend
the person identified as payee to have any interest in the
instrument. For example, a dishonest employee may (a) issue a
check to a nonexistent payee or (b) induce his/her employer to sign
the check payable to a payee who will not have rights in the
instrument.

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16 SU 7: Negotiable Instruments and Related Topics

ii)
In these situations, an endorsement by any person in the name of the
payee is effective in favor of a person who, in good faith, pays or
takes the instrument for value or collection. Treating these
endorsements as effective rather than as forgeries places the
losses on the drawer or maker. The rationale is that these parties
are in a better position than later holders to avoid the issuance of
instruments to fictitious payees or impostors.
e. Alteration is any unauthorized change in an instrument that modifies the obligation of
a party. It is also any unauthorized addition of words or numbers.
1) A fraudulent alteration discharges a party whose obligation is affected unless the
party assents or is precluded from asserting the alteration.
2) However, the instrument may be enforced according to its original terms by (a) a
drawee or payor bank paying the instrument or (b) a person taking for value, in
good faith, and without notice of the alteration. Moreover, such parties may
enforce the instrument as completed if it has been altered by an unauthorized
completion of an incomplete instrument.
f. Lack of legal capacity that renders an instrument void under state law is
unenforceable by any holder or HDC.
g. Minority or infancy is a real defense only to the extent that state law recognizes it as
a defense to a simple contract.
h. A discharge in bankruptcy is an absolute defense on any instrument regardless of
the status of the holder. The purpose of bankruptcy is to settle an insolvent party’s
debts.
i. A discharge of any party. The holder may have notice of the discharge of any prior
party, other than in an insolvency proceeding, when (s)he takes the instrument. In
this case, even an HDC is barred from collecting on the instrument from the
discharged party.
j. HDC status is precluded by notice of (1) alteration, (2) any claim or defense to the
instrument, or (3) that the instrument is overdue or dishonored.
k. Negligence may substantially contribute to a forged signature or an alteration. A
negligent person (e.g., a drawer or maker) is precluded from asserting such defenses
against a person who, in good faith, pays the instrument or takes it for value or
collection. Thus, these defenses are effectively changed from real to personal
defenses. However, if the person asserting the preclusion is also negligent, the loss
is allocated (UCC 3-406).
l. Personal defenses. Other traditional contract defenses are usually personal
defenses. They are effective against anyone not an HDC or a holder through an
HDC. They include the following:
1) Payment
2) Theft by the holder
3) Theft by a person through whom the holder holds
4) Fraud in the inducement
5) Unauthorized completion
6) Violation of a restrictive endorsement
7) No consideration
8) Failure of consideration
9) Condition precedent not performed
10) Delivery incomplete, conditional, or for a special purpose

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SU 7: Negotiable Instruments and Related Topics 17

8. Presentment. The holder of an instrument, including an HDC, must proceed through formal
steps to collect on a negotiable instrument: presentment, dishonor, and notice of dishonor
(unless waived or excused).
a. Presentment is a demand for payment or acceptance made by a person entitled to
enforce the instrument to a maker, drawee, or other party obliged to pay or to a bank.
b. Under UCC 3-501, presentment
1) May be made at the place of payment. It must be made at the place of payment
if the instrument is payable at a bank in the U.S.
2) Is usually effective when the demand for payment or acceptance is received.
3) Is effective when made to any one of two or more makers, acceptors, drawers,
or payors.
c. Upon demand, the person making presentment must meet the following
requirements:
1) The instrument must be exhibited.
2) The person presenting the instrument must have reasonable identification.
3) Agents who present the instrument must have evidence of their authority.
4) The person presenting the instrument must be willing to sign a receipt on the
instrument for partial payment or surrender the instrument for full payment.
d. Presentment may be by any commercially reasonable means, e.g., in person, by
mail, through a clearinghouse or a collecting bank, or electronically.
1) A clearinghouse is an association typically formed by banks to exchange
checks, drafts, or other forms of indebtedness held by one member and owed
to another.
e. An endorser’s liability (but not a guarantor’s) is discharged if a check is not
presented for payment (or given to a depositary bank for collection) within 30 days
after the day of the endorsement (UCC 3-415).
f. Lack of a necessary endorsement justifies return of the instrument without dishonor.
1) Similarly, payment or acceptance may be refused for failure to comply with the
terms of the instrument, the parties’ agreement, or an applicable law.
g. Presentment may be treated as occurring on the next business day if it is made after
an established cutoff not earlier than 2 p.m.
h. Assume that (1) a check is not presented or given for collection within 30 days after its
date, (2) the drawee suspends payments after the 30-day period, and (3) the drawer
is thereby deprived of the funds maintained with the drawee to cover the check. In
these circumstances, the drawer’s obligation on the check may be discharged by
assignment of its rights against the drawee to the person entitled to enforce the
check.
9. Dishonor
a. Dishonoring an instrument (refusal to pay) triggers secondary liability on the
instrument. Thus, a person entitled to enforce the instrument may proceed directly
against a secondary party. A secondary party promises to pay on the instrument only
if the conditions precedent are met:
1) The instrument is properly and timely presented (absent a waiver).
2) The instrument is dishonored.
3) Timely notice of dishonor is given to the secondarily liable party (absent a
waiver).

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18 SU 7: Negotiable Instruments and Related Topics

b. Dishonor of a demand note occurs if it is duly presented and is not paid on that day.
1) If the note is a time instrument payable at a bank or required to be presented,
dishonor occurs if it is not paid on the later of the due date or the date of
presentment. Other time instruments need not be presented. They are
dishonored if not paid on the due date.
2) However, most notes contain a waiver of compliance with the conditions
precedent. Thus, demand is irrelevant. A holder may proceed directly against
endorsers if payment is not made by the maker.
c. Unaccepted drafts that are ordinary checks are usually dishonored by being
returned or by notice of dishonor given by a bank’s midnight deadline (UCC 4-301).
1) For a check presented over the counter or a noncheck demand draft,
dishonor results from nonpayment on the day of a proper presentment.
2) A time draft payable on a given date is dishonored if it is presented on or after
the due date and the drawee refuses payment. Dishonor also occurs by a
refusal of acceptance before the due date. The latter method of dishonor also
applies when a draft is payable a stated period after sight or acceptance.
3) The principles pertaining to dishonor of unaccepted drafts apply to documentary
drafts. These are drafts to be presented for payment or acceptance if specified
documents, certificated securities, or other statements or certificates are to be
received before acceptance or payment. However, such acceptance or
payment may be delayed without dishonor until the end of the third business
day of the drawee after the day when acceptance or payment otherwise would
be required.
d. Accepted drafts must be properly presented and are dishonored if not paid at
presentment (demand drafts) or on the later of the due date or the date of
presentment (time drafts).
10. Notice of Dishonor
a. Adequate notice must be given to all prior endorsers (but not guarantors), or they are
discharged from liability for payment. However, the drawer of an unaccepted draft
need not be notified. A drawer must be given notice only if dishonor is by a nonbank
drawee-acceptor. A drawer of a certified check has no liability.
1) Most notes waive the notice requirement. Thus, an endorser of a note most
likely will not be entitled to notice of dishonor.
b. Notice of dishonor can be given in any commercially reasonable manner, including
by telephone, mail, electronic means, or in person.
1) The effective date of notice is the date of mailing.
c. Notice may be given by anyone. For example, a party who may be required to pay
may benefit from giving notice to other parties who also may be liable.
d. Timely notice of dishonor is required.
1) If an instrument is taken for collection by a bank, notice of dishonor must be
given by
a) The bank before midnight of the next banking day after the banking day the
bank received notice of dishonor (the midnight deadline). However,
Federal Reserve rules may require earlier notice.
b) All other parties within 30 days after notice of dishonor is received by such
a party.
2) For other instruments, notice must be given within 30 days after the day of
dishonor.

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SU 7: Negotiable Instruments and Related Topics 19

e. Presentment is excused if (1) a person, through exercise of reasonable diligence,


cannot make presentment; (2) the maker or acceptor has repudiated the obligation or
is dead or insolvent; (3) the drawer or endorser has waived presentment; (4) the
drawer instructed the drawee not to pay or accept; or (5) the drawee was not
obligated to the drawer.
1) The instrument itself also may render presentment or notice of dishonor
unnecessary.
2) Moreover, an obligor may waive presentment or notice, and a waiver of
presentment is also a waiver of notice.
3) Delay in giving notice is also excused if circumstances are beyond the control of
a person who exercises reasonable diligence after the cause of the delay no
longer operates.
4) If notice is excused or waived, a party will not be discharged from liability on the
instrument even if no notice is given.

7.6 DISCHARGE
1. The UCC provides many ways in which a party may be discharged from liability on an
instrument. However, a discharge is not effective against a person acquiring the rights of
an HDC without notice of the discharge.
2. A party may be discharged, in whole or in part, from liability by acts or agreements with other
parties that would discharge a simple contract for the payment of money.
3. The following are methods of discharging the liability:
a. Payment. A party who pays the amount of the instrument to a person entitled to
enforce the instrument is completely discharged.
1) If a secondary party makes payment, (s)he is likewise discharged. Other
parties who may be liable to the party making payment are not discharged.
2) Partial payment discharges only to the extent of the payment.
3) A party who pays an instrument in full may request return of the instrument.
a) A negotiable instrument remains negotiable even if all the parties have
been discharged.
b) To prevent fraudulent renegotiation, a person should take possession of
the instrument when making payment on it.
4) Payment ordinarily operates as a discharge of the obligor even if made with
knowledge of a claim to the instrument.
b. Tender. Assume a party tenders (offers) payment of an amount due to a person
entitled to enforce the instrument. The tendering party is discharged to the extent of
subsequent liability for interest on the amount tendered.
1) The tendering party is not discharged as to the principal or interest accrued to
the date of tender.
2) An endorser or accommodation party may have a right of recourse with respect
to the obligation to which a refused tender relates. Such a party is discharged
to the extent of the amount tendered.

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20 SU 7: Negotiable Instruments and Related Topics

c. Cancelation. A person entitled to enforce the instrument may discharge a party by an


intentional voluntary act. Consideration is not required. The act may include
(1) surrender of the instrument to the party; (2) destruction, mutilation, or cancelation
of the instrument; (3) canceling or striking out the party’s signature; or (4) adding
words to the instrument.
1) However, canceling or striking out an endorsement has no effect on the rights of
a party derived from the endorsement.
d. Renunciation. A person entitled to enforce the instrument may agree not to sue or
otherwise renounce rights against a party by a signed writing.
1) A cancelation appears on the instrument itself. A renunciation often appears in a
separate document or letter.
e. Reacquisition is the transfer to a former holder by any means. The former holder
may then cancel any intervening endorsements. If the instrument is thereby made
payable to the reacquirer or to bearer, the reacquirer may negotiate it. A canceled
endorsement discharges that endorser, and the discharge is effective against any
subsequent holder.
f. Impairment of right of recourse or collateral. Discharge by cancelation or
renunciation does not discharge the obligation of an endorser (including a drawer of
a draft accepted by a nonbank entity) or accommodation party with a right of
recourse against the discharged party. However, an agreement by a person entitled
to enforce the instrument to (1) extend the due date or (2) materially modify the
obligation of a party discharges such an endorser or accommodation party. The
discharge is to the extent the latter proves that the extension or modification caused
loss with respect to the right of recourse. An impairment of collateral by a person
entitled to enforce the instrument has a similar effect.
1) EXAMPLE: Able executed a promissory note to Baker and pledged a yacht as
collateral. Baker negotiated the note to Carr by an unqualified endorsement
and delivery. Carr allowed Able to sell the yacht. Carr has impaired the
security. Baker is discharged to the extent of the collateral.
g. Other methods of discharge are
1) Fraudulent alteration,
2) Certification of a check,
3) Acceptance of a draft after endorsement,
4) Acceptance varying a draft, and
5) Unexcused delay in presentment or notice of dishonor.

7.7 DOCUMENTS OF TITLE


1. Definition, functions, types. A document of title is a written instrument that permits
transfer of the ownership of goods that are in storage or transit. In the regular course of
business or financing, it is treated as adequate evidence that the person in possession is
entitled to certain rights. This person may receive, hold, and sell or otherwise dispose of
the document and the goods it covers [UCC 1-201(15)].
a. Documents of title are governed by Article 7 of the UCC. Article 3 of the UCC applies
only to negotiable instruments (UCC 3-102). Even if documents of title are
negotiable, Article 3 cannot apply to them because they cover goods. A negotiable
instrument must contain a promise or order to pay money (UCC 3-104). However,
negotiable instruments and documents of title share many similarities.

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SU 7: Negotiable Instruments and Related Topics 21

b. A document of title has three functions:


1) It is a written receipt for goods.
2) It is a contract between a bailor (one who entrusts personal property to another)
and a bailee (one who receives such property to hold in trust). This agreement
is for the storage or transport of goods. Thus, the arrangement is a bailment,
for example, the delivery of goods to a warehouser or carrier.
3) It is evidence of title to the goods.
c. The two fundamental types of documents of title are
1) Warehouse receipts
2) Bills of lading
d. These documents are generally issued by professional bailees. These parties are in
the business of either storing or delivering goods, i.e., warehousers and common
carriers, respectively.
e. Documents of title may be either negotiable or nonnegotiable.
1) Nonnegotiable documents of title are frequently referred to as “straight.”
2. Negotiable vs. nonnegotiable. A document of title is negotiable if it states that the goods
are to be delivered either to bearer (a person in possession of the document if it is payable
to bearer or endorsed in blank) or to the order of a named person. If bearer or order
language is not in the writing, the document is not negotiable.
a. Negotiable documents of title are negotiated in much the same manner as negotiable
notes, drafts, and checks.
1) Order documents of title are negotiated by endorsement and delivery.
2) Bearer documents are negotiated by delivery alone.
3) A blank endorsement (signature only) of an order document converts it to
bearer paper.
4) A special endorsement, e.g., endorsement to a specified person, of a bearer
document converts it to order paper.
a) Conditional or qualified endorsements do not apply to documents of title.
5) A forged endorsement does not result in negotiation because the transferee is
not a holder. It represents a real defense to enforcement.
b. If the document is negotiable, the goods must be delivered to the holder of the
document (or his/her agent or assignee). A holder is the person in possession if the
goods are deliverable to (1) bearer or (2) the order of the person in possession.
1) If the document is nonnegotiable, the goods usually must be delivered to the
person named in the document.
a) The person requesting the goods is not required to present the document
itself to obtain the goods if (s)he can prove that (s)he is (1) the bailor or
(2) an assignee of the rights of the bailor.
b) Carriers and warehousers have absolute liability for misdelivery.
3. A person who takes a negotiable document of title by due negotiation is in a position similar
to that of a holder in due course of a negotiable instrument.
a. Due negotiation means that a negotiable document of title is negotiated to a holder
who purchases it
1) In good faith
2) For value
3) Without notice of any defense against or claim to it
4) In the regular course of business or financing
5) Not in settlement or payment of a money obligation

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22 SU 7: Negotiable Instruments and Related Topics

b. A holder by due negotiation acquires title to the document and the goods.
c. Furthermore, a holder by due negotiation takes the document and the goods free of
claims and defenses raised by either the bailee or third parties. There are,
however, two exceptions:
1) The bailee is entitled to compensation for transportation or storage charges,
which are usually specified on the document.
2) The holder will not be entitled to the goods in cases in which the bailor had no
authority to deliver the goods to the bailee carrier or warehouser.
a)A document of title issued to a bailor who was a thief of the goods does
not represent title to the goods. However, a thief can negotiate a bearer
document or an order document that was endorsed in blank. A
subsequent holder who takes by due negotiation then acquires rights
superior to the original bailor’s.
d. A transferee of a document, whether negotiable or nonnegotiable, to whom the
document has been delivered but not duly negotiated, is an assignee. The
transferee acquires the title and rights that his/her transferor had or had actual
authority to convey (UCC 7-504).
4. Warehouse receipts. A warehouse receipt is a signed writing issued by a warehouser to
the firm or other person who deposits goods at the warehouse for storage. The depositor is
the bailor, and the warehouser is the bailee.
a. A warehouse receipt need not be in any special form as long as it contains the
following required information:
1) The location of the warehouse
2) The date of issue of the receipt
3) The person (bearer, a specified person, or a specified person or his/her order) to
whom the goods are to be delivered
4) The storage or handling charges
5) A description of the goods or their container
6) A statement of advances made or liabilities incurred for which the warehouser
claims a lien or security interest
7) The consecutive number of the receipt
8) Disclosure of the warehouser’s ownership interest in the goods, if any
b. With respect to the goods, a warehouser must exercise the same amount of care that
a reasonable person would under like circumstances.
1) The warehouser, like most other bailees, is liable only for those damages caused
by negligence or lack of due care.
c. A warehouser must keep goods covered by each receipt separate.
1) However, different lots of fungible goods may be commingled.
d. A warehouser has a lien on the goods enforceable by public or private sale.
5. Bills of lading. A carrier is the issuer of a written bill of lading evidencing the carrier’s
receipt of goods for shipment. The carrier is a bailee of the goods. The person delivering
the goods to the carrier for shipment is the shipper and also the bailor.
a. The shipper-bailor’s delivery of the goods to a carrier for transport is called a
consignment.
1) The shipper-bailor is the consignor.
2) The person to whom the carrier is to deliver the goods at their destination is the
consignee.

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SU 7: Negotiable Instruments and Related Topics 23

b. UCC Section 1-201(6) defines bill of lading as follows:


“Bill of lading” means a document evidencing the receipt of goods for shipment
issued by a person engaged in the business of transporting or forwarding goods,
and includes an airbill. Airbill (or air waybill) means a document serving for air
transportation as a bill of lading does for other transportation.
1) A destination bill is a bill of lading that is issued by a carrier at the place of
destination to the sender’s agent.
c. A carrier has a lien on the goods enforceable by public or private sale.
d. A bill of lading is both a contract and a receipt.
e. Common carriers are special bailees and are subject to strict liability for losses
occurring while goods are in transit. However, common carriers are not liable for
damage or losses caused by (1) an act of God, (2) the fault of the shipper, (3) an act
of a public enemy, (4) an act of public authority, or (5) the inherent nature of the
goods. A carrier may limit its liability by contract and notation on the bill of lading.
6. Warranties. An endorser or transferor of a document of title warrants to the transferee that
a. The document is genuine and not a forgery.
b. (S)he has no knowledge of any fact that impairs the document’s worth or validity.
c. His/her transfer or negotiation is rightful and fully effective with respect to the title to
the document and the goods it represents.

7.8 LETTERS OF CREDIT


1. UCC Article 5 governs letters of credit. Letters of credit are widely used in domestic and
international trade. They are intended primarily to facilitate the purchase and sale of
goods.
2. A letter of credit is (a) a definite undertaking by an issuer (such as a bank) (b) to a
beneficiary (such as a seller) (c) at the request or for the account of an applicant (such as
a buyer who is a customer of the bank) (d) to honor a documentary presentation by
payment or delivery of an item of value. A confirmer, such as a bank in the beneficiary’s
country, may serve as an intermediary between the seller and issuer.
a. No consideration is needed to establish a letter of credit.
3. A letter of credit may be issued in any form that is a record and is authenticated
a. By a signature or
b. In accordance with the parties’ agreement or the standard practice of financial
institutions that regularly issue letters of credit.
4. A letter of credit is revocable only if it so provides.
5. After its issuance, a letter of credit may be amended or canceled without consent of a
beneficiary, applicant, confirmer, or issuer. However, the letter must be expressly
revocable or state that the issuer may amend or cancel without consent.
6. The function of the traditional letter of credit is to finance the movement of goods in
commerce and to ensure that the seller will be paid.
a. A letter of credit is separate from the underlying contract between the applicant and
the beneficiary.
b. The issuer is required to look only to the terms of the letter of credit, not to the
contractual obligations between the parties.
c. The issuer of a letter of credit deals in documents, not contract performance.

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24 SU 7: Negotiable Instruments and Related Topics

7. The documents (a document of title, invoice, and insurance policy) should be duly
presented by the seller-beneficiary to the confirmer in compliance with the conditions
specified in the letter of credit. The confirmer confirms the letter of credit to the seller, who
then draws on the letter by writing drafts. The seller is paid when the documents are
presented to the confirmer. The issuer (the buyer’s bank) then is obligated to reimburse
the confirmer after inspection of the documents. The applicant-buyer then reimburses the
issuer.
a. The traditional letter of credit provides assurance to the seller of prompt payment upon
compliance with the conditions (typically, mere presentation of the documents). It
also assures the buyer that goods have been shipped.
b. A letter of credit simply involves the exchange of documents and money through
intermediaries.
8. A nontraditional use of a letter of credit obligates the issuer to pay only in the event of default
by the applicant. Under this standby or guaranteed letter of credit, the issuer receives
no documents of title. Thus, the issuer receives nothing of value other than the promise by
the applicant to reimburse the issuer for any expenditure made under the letter.

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