Payment Systems

Spring 2004 Professor W. David East; Rm. 760; Office 713-646-1879; Home 281-367-3356 EXAM: M/C (about 25 questions), Essay (one good essay question). Test questions do sometimes come from the comments. Totally open book and remember that East is only going to test us on a working knowledge of Payment Systems. Code Structure Definitions: the definitions in 1.102 apply to a transaction to the extent that it is governed by another chapter of the UCC, i.e., the definitions in 1.201 apply unless a particular chapter/article provides for a chapter-specific definition. Supplemented by CL, Equity, etc.: 1.103 provides that unless displaced by the particular provisions of the UCC, the principles of law and equity, including the law merchant and the law relative to capacity to contract, principal and agent, estoppel, fraud, misrepresentation, duress, coercion, mistake, bankruptcy, or other laws shall supplement the UCC. For example, federal or state laws on evidence will, but there are some overriding UCC presumptions. Notice: 1.202(a) provides that a person has notice of a fact if the person 1) Has actual knowledge of it; 2) Has received a notice or notification of it; or 3) From all the facts and circumstances known, has reason to know that it exists. Knowledge: 1.202(b) provides that knowledge means actual knowledge. Variation by Agreement for the UCC and Chapter 3 (but not Chapter 4) 1.302: In general, the effect of the provisions of the UCC may be varied by agreement. EXCEPTION: the obligations of good faith, diligence, reasonableness, and care prescribed by the UCC may not be disclaimed by agreement. But the parties, by agreement, may determine the standards by which the performance of those obligations is to be measured if those standards are not manifestly unreasonable (i.e., unreasonable on its face). REASONABLE TIME BY AGREEMENT: whenever the UCC requires an action to be taken within a reasonable time, a time that is not manifestly unreasonable may be fixed by agreement. Negotiable Instrument 3.104(a) 1) An unconditional promise or order to pay a fixed amount of money, 2) W/ or w/o interest or other charges described in the promise or order, if its a) Payable to bearer or to order at the time issued or first comes into possession of a holder; b) Is payable on demand or at a definite time; and c) Does not state any other undertaking or instruction by the person promising or ordering payment to do any act in addition to the payment of money, but the promise or order may contain: (1) An undertaking or power to give, maintain, or protect collateral to secure pmt;

(2) An authorization or power to the holder to confess judgment or realize on or dispose of collateral; or (3) A waiver of benefit of any law intended for advantage or protection of an obligor. INSTRUMENT: instrument means a negotiable instrument. CHECKS: a check is an instrument and is an order to the bank to pay a payee. To have a check or a draft, you must have an order. PROMISSORY NOTE: a promissory note is an instrument and a promise. Order: (1) A written instrument to pay money signed by the person giving the instruction; (2) The instruction may be addressed to any person, (3) including the person giving the instruction, or to (4) one or more persons jointly or in the alternative but not in succession, but an (5) authorization to pay is not an order (6) unless the person authorized to pay is also instructed to pay. Promise: (1) A written undertaking to pay money signed by the person undertaking to pay, but (2) An acknowledgement of an obligation by the obligor is not a promise (3) Unless the obligor also undertakes to pay the obligation. EAST SAYS FOUR CONCEPTS: 3.104(a) gives four concepts for negotiable instruments. Demand Draft 3.104(k) (Texas non-uniform) 1) A writing that is not signed by the customer 2) Created by a third party under the purported authority of the customer 3) For the purpose of charging the customers account with a bank, but a 4) Demand draft does not include a check drawn by a fiduciary; 5) A demand draft may contain any or all of the following: a) Customers printed or typewritten name or account number; b) A notation that the customer authorized the draft; and c) The statement no signature required, authorization on file, signature on file, or words to that effect. EFFECT: b/c the demand draft is created with the authority of the person identified as the drawer, that drawer will by the issuer. The draft will be issued to its creator; thus the deposit by the creator at a bank is a transfer. Further, to have a draft, there must be an order. EXAMPLE: an instrument created by a telemarketer to pay itself for goods or services delivered to the customer. It will be in the form of a draft and have the customers account number and other routing and processing information magnetically encoded so that it can be deposited at a bank and processed and collected through the banking system. Checking Accounts Definitions Bank: a person engaged in the business of banking and includes a savings bank, S&L association, credit union, and trust company. Check: means a (i) draft, other than a documentary draft, payable on demand and drawn on a bank or (ii) a cashiers check or tellers check. An instrument may be a check even though it is described on its face by another term, such as money order. Note vs. Draft: an instrument is a note if it is a promise, and is a draft if it is an order. If an

instrument falls within the definition of both note and draft, a person entitled to enforce the instrument may treat it as either. Drawer/Issuer: a person who signs or is identified in a draft as a person ordering payment. Drawee/Payor Bank: a person (bank) ordered in a draft to make payment. Payee: the person to whom the check is issued (usually the seller). Depository Bank: the first bank to take an item even if it is also the payor bank, unless the item is presented for immediate payment over the counter. Intermediary Bank: a bank to which an item is transferred in course of collection except the depository or payor bank (e.g., Fed Reserve Bank in Dallas). HYPO: If CJ writes a check to AM to buy a book, that check is drawn on CJs account at Rocky Mountain Bank. That makes Rocky Mountain the drawee or the payor bank. Cliff, the person that directs the payment by writing the check, is the drawer or issuer. AM, the person to whom the check is written, is the payee. Assuming that AM does not have an account at Rocky Mountain Bank, the process of collecting on the check will involve one or more intermediaries between the payee and the payor bank. For example, Archie is most likely to deposit the check in his account, at Colorado National Bank. That makes Colorado National the depository bank. Finally, if other banks (e.g., Federal Reserve Bank in Denver) handle the check before it gets from the depository bank to the payor bank, all of those banks intermediaries between the depository bank and the payor bankare intermediary banks. Regulation of the Checking Relationships: a checking account basically is a two-step arrangement between the bank and the customer, under which the customer deposits money with the bank and the bank then disposes of the money in accordance with the customers directions. 1) Agreement: many of the terms of that arrangement appear in the written K between the customer and the bank, which typically consists of a brief signature card that incorporates by reference a relatively length set of rules formulated by the bank that govern its accounts. 2) Federal and State Laws: in addition to that K, state and federal laws provide a variety of rules, many of which govern the rights of the parties even if they are contrary to the arrangements that the parties themselves select in their K. a) Federal: the federal-law rules are in the form of federal statutes (principally the Expedited Funds Availability Act) or rules promulgated by the Board of Governors of the Federal Reserve. 4.103(b) reflects the Codes recognition of federal preemption. b) State: the state-law rules generally appear in the UCC. Articles 3 and 4 provide a variety of rules that affect checking accounts and check transactions. Article 4A relates to wire transfers; article 5 relates to letters of credit; article 7 relates to documents of title; and article 8 relates to securities. (1) Article 3: governs negotiable instruments. (2) Article 4: governs the day-to-day functioning of the checking system (Bank Deposits and Collections). CHAPTER 4 TRUMPS: 3.102(b) provides that if there is a conflict between articles 3 and 4, article 4 governs (in fact, if article 3 and 9 (secured credit) conflict, 9 governs as well). Customer as creditor of the bankChecking Relationship: In the checking system, the transaction payor, or drawer/issuer (i.e., the person that writes the check) establishes that claim by opening a checking account. 1) For a checking account, the customer/depositor goes to the bank and

2) deposits money into a checking account, which creates a demand deposit account (DDA), 3) making the customer a creditor of the bank, and the bank becomes a debtor 4) b/c the bank is now indebted to customer to pay that money back the funds on deposit; 5) the account is a demand deposit b/c the customer is entitled to the money on demand 6) provided the timing for funds availability has been satisfied. EFFECT: when a customer issues a check, the order mandates the bank to discharge part of its debt to the customer by paying a third person. Effect of Issuing an Instrument on an underlying obligation 3.310 1) When an uncertified check or note is issued to satisfy an obligation, e.g., sale of goods, 2) 3.310(b) shows that two obligations emerge 3) the underlying obligation and the obligation that the check be honored, 4) And upon issuance of the check, the underlying obligation is suspended to the 5) Same extent the obligation would be discharged if an amount of money equal to the 6) Amount of the instrument were taken, and a) [SUSPENSION] The suspension continues until dishonor of the check or until it is paid or certified, and upon payment of the check or certification thereof, the underlying obligation is discharged to the extent of the amount of the check; and b) [DISHONORED AND OBLIGEE HAS POSSESSION AND ENFORCEMENT] If the check or note is dishonored then the payee of the check, provided he is entitled to enforcement of the instrument and has possession of the instrument, may enforce either the instrument or the underlying obligation (breach of K); c) [OBLIGEE NOT RIGHT TO ENFORCE INSTRUMENT] But if the right to enforce the instrument is held by somebody other than the seller (obligee), the seller cant enforce the right to payment of the price under the sales K b/c that right is represented by the instrument enforceable by somebody else. Thus, if the seller/obligee sold the note or the check to a holder and has not reacquired after it after dishonor, the only right that survives is the right to enforce the instrument. What that means is that even though the suspension of the underlying obligation may end upon dishonor, the obligation is not revived to sue for breach of K for example when the obligee does not have the right of enforcement of the instrument. (Come back and fill in the second part of 3.310(b)(4)!) TYPICAL: the typical case is that in which a buyer pays for goods or services by giving the seller the buyers personal check, or in which the buyer signs a note for the purchase price. The underlying obligation, which is suspended, to pay for the goods arises under 2.607(a) that if goods have been accepted, the buyer is obligated to pay for the goods. HYPO: BL issued a check payable to CL for 1500 for cooking equipment from First State Bank of Matacora. BL is saying discharge 1500 of your debt to me by paying CL. CL will ML take the check and deposit it in her own bank, i.e., the depository bank, which will send the check back to the payee bank, First State bank, for payment. When CL deposits the check, 3.310(b)(1) operates to suspend her right to sue for breach of K until the uncertified check is paid or certified. BL does not want the equipment anymore b/c it was slightly larger than he had understood. CL has refused to take back the equipment. This is a sale of goods. Remorse is not a defense for a K obligation; so, hes obligated whether happy or not, but what is a defense? If he had ordered it and never delivered, than that is failure of consideration, but what if delivered and its the wrong size? Is he obligated by 2.607? Sort out the article 2 and article 3 and 4 stuff.

Drawer Liability UCC 3.414(b) 1) If an item is dishonored, the drawer is obligated to pay the draft per its terms when issued to 2) a person entitled to enforce the draft, or an endorser held liable for endorser liability. EFFECT: this is the provision triggered under 3.310(b) that when a check issued for an obligation, the obligation suspended until check honored or dishonored, and if dishonored, the obligee can sue on either the check or the obligation. This section, 3.414(b) provides the basis for the obligee to recover on the terms of the dishonored check. ADVANTAGE TO SUING ON THE INSTRUMENT: sue on the instrument b/c under 3.308(b) if the validity of signatures is admitted or proved, a producing the instrument is entitled to payment if he is a person entitled to enforce (e.g., a holder), unless proves a defense or claim in recoupment. If a defense or claim in recoupment is proved, can still recover can prove he has rights of a holder in due course (subject of course to the then coming back w/ one of the 4 real defenses to a HDC). This puts the burden on the drawer to proffer a defense. On the other hand, if sue on the obligation, the burden is on the obligee to prove owed the money. EXCEPTIONACCEPTANCE: if a draft is accepted by a bank, the drawer is discharged, regardless of when or by whom acceptance was obtained. EXCEPTIONWITHOUT RECOURSE: if drawn without recourse or otherwise disclaims liability of the drawer to pay the draft, the drawer is not liable to pay the draft. EXCEPTION TO EXCEPTIONCHECK WITHOUT RECOURSE: a disclaimer of liability (without recourse) is not effective if the draft is a check. EXCEPTION30 DAY LIMIT: if the a) check not presented for payment or given to depositary bank for collection w/in 30 days, b) the drawee (payor bank) suspends payments after 30 days expire w/o paying check, and c) b/c of the suspension of payments, the drawer is deprived of funds maintained with the drawee to cover payment of the check, i) the drawer, to the extent deprived of funds may discharge its obligation to ii) pay the check by assigning to the person entitled to enforce the check iii) the rights of the drawer against the drawee. REMEMBER FORGERIES: a thief may be pinned with drawer liability b/c a forged signature is ineffective generally, but effective for purposes liability as if it was forgers real signature. ENDOSER HELD LIABLE FOR ENDORSER LIABILITY: this is an exception b/c the drawer is held liable to a person not technically entitled to enforce b/c not a holder usually but they took a check, e.g., forged endorsement, and deposited the check and had to pay out to a subsequent endorser for a dishonored check under 4.215 endorser liability. Now, the depositary bank merely charging back a provisional credit for a returned check is not endorser liability. Anatomy of a Check 1) In the upper left or right corner there is the check number; 2) The name, address, and other personal information of the customer/drawer; 3) The payee line, e.g., pay to the order of, ordering the bank to pay the amount; 4) The identification of the bank in the lower left corner, which is the drawee; 5) Under the drawee identification is a row of numbers and symbols written in magnetic ink with symbols that can be read by machines to process the transaction.

The Banks Right to Pay 4.401 When is it proper for the bank to pay? Generally 1) A bank may charge against the account of a customer1 an item that is properly payable 2) From the account even though the charge creates an overdraft, 3) But the bank may, on an overdraft, absent a specific agreement, not honor the check. Std for properly payable: an item is properly payable if (1) authorized by the customer, and is in (2) accordance with any agreement between the customer and the bank. STOLEN: If the check is stolen through no fault of the drawer/issuer and presented by a party that does not have any right to enforce the check, e.g., an item containing a forged drawers signature or forged instrument, the item is not properly payable b/c the customer issued the check to the order of the payee, or to whom the payee thereafter authorizes to receive payment. TYPICAL: in the checking context, the most common way for the customer to authorize payment (although not the only way) is by writing a check, which authorizes the bank to use funds in the customers account to pay the amount of the check to the payee. INTERMEDIARY BECOMES PERSON ENTITLED TO ENFORCE: usually, the payee does not take the check to the payor bank. Instead, the payee obtains payment from an intermediary such as the payees own bank or a check-cashing outlet. As long as the payee properly transfers the check to the intermediary the intermediary becomes, in terms of 3.301, a person entitled to enforce the check and this is just as entitled to payment of the check as the original payee. Liability for Overdraft 4.401(b) 1) A customer is not liable for the amount of an overdraft if the customer neither 2) Signed the item nor benefited from the proceeds of the item. Std: Neither the statutes or comments help you define benefited from the proceeds of the item, so have to use your common sense. POLICY: this rule was drafted for joint-account situations where one customer to the account may cause another joint-account holder to become liable for an overdraft. EFFECT OF OVERDRAFT: when a bank voluntarily pays a check as an overdraft, the bank has loaned the amount overdrawn to the customer creating a debt owed to the bank, and the bank may not seek restitution from the payee, b/c the payment was voluntary and not mistaken. DEPOSIT/ACCOUNT AGREEMENT: upon creating an account, a customer usually fills out a signature card that refers to and incorporates by reference a deposit/account agreement. Sometimes, these agreements include provisions for overdraft insurance. But keep in mind that a bank may pay an overdraft w/o overdraft insurance if properly payable if there is no specific provision within the agreement mandating or prohibiting overdrafts. Other times, the deposit agreement will require signatures of all account holders to authorize an overdraft. Or, the agreement may specifically delineate when an account holder is liable for an overdraft written by a joint-account holder; more beneficial would be a definition in the agreement as to what constitutes benefited from the proceeds of the item. Further, it may be the case that the parties have varied the effect of 4.401(b) by including a joint-liability clause binding one account holder to the others items regardless of whether the other signed or benefited [are such joint-liability clauses enforceable?]. .
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Customer means a person having an account with a bank or for whom a bank has agreed to collect items, including a bank that maintains an account at another bank.

HYPO--Problem 1.1: TL comes to you with a problem about a $1500 check that his wife R wrote recently on their joint bank account. The account contained only $50 at the time, and TL had declined to purchase overdraft protection from the bank, at which he maintained the account. Still, the bank honored the check and has now written TL a letter threatening serious consequences if it does not reimburse the bank for the amount of the check. Is TL liable for the check? - 4.401(a) provides that a bank can charge an item against an account if properly payable from that account even if causes an overdraft. To change the facts, if T paid the check, hes not in a position to complain if bank follows through with his authorization even it creates an overdraft. Here, his wife is no position either to complain. Here, the spouse drew the check, however, he is a customer on the account. The bank can recover from R, but can they recover from T? The rule is from 4401(b) that a customer is not liable from overdraft if he neither signed nor benefited from the proceeds of the item. This was authorized by a customer, and she is a customer on this account b/c says a joint account. There is no evidence of a deposit or account agreement regarding TLs liability for overdrafts specifically. Back to 4.401(b), there is a basic question of whether he signed the item or benefited from the proceeds of the item. ML, if not estranged from each other, TL and R benefited from the item as H&W, e.g., the item went to paying bills. Now, if R is estranged and bought a single ticket to London, and there is a possible situation where no benefit from that to make T liable. The Banks right to pay post-dated checks 4.401(c) 1) A bank may charge against the account of a customer a check that is 2) Otherwise properly payable from the account, even though payment was made 3) Before the date of the check, unless the customer has given notice to the bank of the 4) Postdating describing the check with reasonable certainty, and the notice is effective 5) For six months if written, and must be received at such time and in such manner 6) as to afford the bank a reasonable opportunity to act on it before the bank takes any action. Std: to ensure reasonably certain notice to the payor bank the customer should identify the three items read by automated check collection systems in the micro-line of magnetic ink: (1) the payor banks routing number, (2) the account number and the item number (i.e., check number), and (3) the amount of the check. EFFECT: if a bank charges against the account of a customer a check before the date stated in the notice of postdating, the bank is liable for damages for the loss resulting from its act. The loss may include damages for wrongful dishonor of subsequent items under 4.402. POLICY: this rule is necessary b/c the automated check collection system cannot accommodate postdated checks. A check is usually paid upon presentment w/o respect to the date of the check. HISTORY: under the former law, if a payor bank paid a postdated check before its stated date, it could not charge the customers account b/c the check was not properly payable. Hence, the bank might have been liable for wrongfully dishonoring subsequent checks of the drawer that would have been paid had the postdated check not been prematurely paid. HYPO Problem 1.2: BD is a senior VP at First State Bank of Matacora, which is owned by his father-in-law. He calls you one Monday afternoon to ask you about a problem. BD explains that this problem relates to a 900 dollar check drawn by his customer Jasmine Ball, which BDs bank received for payment on Monday, January 22. The check was payable to Matacora Realtors and

dated Feb 1 of the current year. B/c his banks new automated check-processing system does not examine dates and b/c Balls account at that time contained 1k, the system paid the check and deducted 900 form Balls account. Upon further examination, it appears that Ball sent the bank a letter in September of last year. The letter identified Balls account by number and explained that she would be paying her rent for the next year by postdated checks until the indicated dates. The bank never responded to the letter. Has BDs bank acted improperly? Under the former law, the bank acted improperly. But currently, the bank acted improperly only if Ball failed to comply with 4.401(c). Under 4.401(c), the customer must give notice of the postdating and describing the check with reasonable certaintyhere, in her letter, she gave her account number, but not a check number. What more could she have given the bank besides an account number for reasonably certain notice? The future dates, identify the payee, and most critically, the amount of the future check. Why? B/c the automated check collection system identifies three fields in the micro-line of magnetic ink: (1) the payor banks routing number, (2) the account number and the item number (i.e., check number), and (3) the amount of the check. She should have put one these indicators where the bank could set its system to pull the checks and not pay them until postdate. Without that, here its hard to conclude she complied with 4.401(c) reasonable certainty. Assuming she did comply, than as to time, this was a fourmonth old notice, but the notice is still effective b/c six months has not passed. And, further assuming she did comply, the bank should have pulled the check and it only has a narrow window of time to dishonor the check before the midnight deadline. If bank dishonored in time, than Matacora Realty could re-deposit the check on Feb 1, which is the post-date. Customers Right to Stop Payment; Burden of Proof of Loss 4.403 1) A customer (or any person authorized to draw on the account) may 2) stop payment (or close the account) by a written order to the bank, 3) dated, and signed, describing the item or account w/ reasonable certainty 4) received at a time and in a manner that affords the bank a reasonable opportunity 5) to act on it before any action by the bank with respect to the item, 6) and if the signature of more than one person is required to draw on an account, 7) Any of those persons may stop payment or close the account. EFFECT: A payment in violation of an effective direction to stop payment is an improper payment, even though it is made by mistake or inadvertence. This is termed a wrongful payment over a stop-payment order. EFFECTIVE PERIOD OF TIME: in Texas, a stop-payment order is effective for six months and is binding on the bank only if it is in writing,2 dates, and signed and describes the item with certainty (there is no Texas case on what constitutes certainty versus reasonable certainty, but ML need all three things, or two of three, recognized on the micro-line in the check collection system). A stop-payment order may be renewed for additional 6-month periods by a writing given to the bank within a period during which the stop-payment order is effective. BURDEN ON CUSTOMER TO PROVE LOSS: the burden of establishing the (1) fact and (2) amount of loss resulting from the payment of an item contrary to a stop payment order or order to close an account is on the customer. The loss from payment of an item contrary to a stop
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The official UCC 4.403(b) provides that oral stop-payment orders are binding, but only for 14 days, unless the customer provides a written order within the first 14 days, whereupon the six-month term is triggered. Texas, however, does not recognize oral stop-payment orders as binding. But a bank may take the risk as a business judgment to voluntarily abide by an oral stop-payment order from a good customer.

payment order may include damages for dishonor of subsequent items under 4.402. EXCEPTION: a payee or indorsee has no right to stop payment. The sole exception to this rule is 4.405 on payment after notice of death, by which any person claiming an interest in the account can stop payment. EXCEPTION: the customer has no obligation to explain why he or she is issuing a stop-order b/c its a right of the customer, period. HYPO Problem 1.3: Check drawn by BL payable to CL and decided not want it, b/c too big of an item for him, and CL not take it back so BL filled out a stop-payment form, identified the account number, as well as the number, amount, and date of the check. Unfortunately, a clerk incorrectly entered the information supplied by BL. As a result, the system did not recognize the check to CL when she came in and cashed it the next day. Bud is furious and insists that the bank re-credit his account. The VP of the bank wants to know if he must re-credit BLs account. -Upon the successful issuance of the stop payment order, the check no longer was properly payable. So, by the clerk making the mistake, BL, as the customer has the burden of proving the fact and amount of any loss from the banks error in effectuating the stop payment order. As comment 7 to 4.403(c) provides, improper payment of a stop order can be by mistake or inadvertence. And, BL may recover those damages available for subsequent items wrongfully dishonored on account of not complying with the order. But can BL prove, even assuming there was an improper payment in violation of the stop order, that he has suffered a loss to entitle him to a re-credit by the bank? Even if there was not an overdraft, the money is no longer there. Under 3.310(b), the banks payment suspended the underlying K obligation to pay CL for the goods. Under 2.607(a) he accepted the goods and is obliged to pay the purchase price. Now, under 2.601(4) he does have the opportunity for a reasonable inspection, and if he found a defect he had the right to return or reject the goods; but here the goods are not defective, but the wrong size for his cabinets, which is not the same as defective unless he had them custom made. Thus, he has ML not suffered any loss; in fact, he has ML benefited from the banks omission to notice the stop-order payment b/c he was obliged to pay for the goods and that has been discharged. Further, under 3.310(b)(3), if the bank had instead enforced the stop order, he would be subject to liability under both his check that he issued to CL being dishonored, and the underlying obligation for suit in K under 2.607. When Items Subject to Notice, Stop-Payment Order, Legal Process or SetoffBank must have a reasonable time to act 4.303(a) 1) Any legal process, setoff, or stop-payment order directed to a payor bank must come within 2) A reasonable time for the bank to act, and a reasonable time has passed after a) The bank accepts or certifies the item; b) The bank pays the item in cash; c) The bank settles for the item; d) The bank becomes accountable b/c missed midnight deadline for payor bank to dishonor; BANK CAN PROCESS IN ANY ORDER: 4.303(b) allows a bank to address items in any order; a bank is not required to process items on a first-come, first-serve basis. Payor Banks Right to Subrogation on Improper Payment 4.407 (defense to stop-order) 1) If a payor bank has paid an item over the order of the drawer to stop payment, or

2) After an account has been closed, or otherwise for a basis for objection by the drawer, 3) To prevent unjust enrichment and only to the extent necessary to prevent loss to the bank 4) By reason of its payment of the item, the payor bank is subrogated to the rights of the a) Holder in due course on the item against the drawer; b) Payee against the drawer either on the item or the underlying obligation; c) Drawer against the payee with respect to the transaction out of which the item arose. HOLDER IN DUE COURSE: A defense frequently interposed by a bank in an action for wrongful payment over a stop-payment order is that the drawer suffered no loss b/c it would have been liable to a holder in due course to any event. Payment can be stopped, but if it is, the drawer is liable and the sound rule is the bank is subrogated to the rights of holder in due course. PAYEE: it may well be that the payee is not a holder in due course but still has good rights against the drawer. These may be on the check but also may not be as, for example, where the drawer buys goods from the payee. If the drawer retains the goods it is obligated to pay for the goods. If the bank has paid the check it should be subrogated to this claim of the payee against the drawer and note the bank, like the payee under 3.310(b), can go after the drawer for either the check, or the underlying obligation. DRAWER: if, for example, the payee was a fraudulent salesman inducing the drawer to issue a check for defective securities, and the bank pays the check over a stop-payment order but reimburses the drawer for such payment, the bank should have a basis for getting the money back from the fraudulent salesman. HYPO 1.4?: in the previous hypothetical with BL and CL, if the bank reimburses BLs account, the bank is subrogated to the rights of the payee, CL, to prevent BLs unjust enrichment and avoid loss to the bank for the amount of the item it paid to CL; so the bank steps into CLs shoes now and can sue on the item (check) or 2.607. What the bank will practically do with its subrogation right, after it has paid CL over the stop-payment order out of BLs account, is just tell BL thats it, you get nothing, b/c it would be illogical and risky (in the sense BL may immediately spend the mo ney) for the bank to re-credit his account the amount of the check and demand it back. Now, if the goods were never delivered, or there was fraud in the transaction on CLs part, than the bank would be subrogated to the rights of BL and go after CL for the amount of the item. In other words, if BL had a good faith defense to paying for the goods, than BL could show the fact and the amount of a loss resulting from the bank disobeying the stoppayment order; the bank would reimburse BLs account and go after CL in subrogation for that reimbursement. Variation by Agreement for Chapter 4 4.103 (two parts) 1) The effect of the provisions of ch 4 may be varied by agreement, but the parties cannot disclaim a banks responsibility for its a) Lack of good faith, or b) Failure to exercise ordinary care, or c) Limit the measure of damages for the lack or failure; 2) However, the parties may determine by agreement the a) standards by which the banks responsibility is to be measured b) if those standards are not manifestly unreasonable. Good Faith: 1.201(20) defines good faith to mean (1) honesty in fact and the (2) observance of reasonable commercial standards of fair dealing. Fair dealing goes to the

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fairness of conduct rather than the care with which an act is performed. Std for second part: for the second part, to undo an agreement, the party must show both (1) that the agreement is in fact an attempt by the parties to set the standards to measure whether the bank has acted in good faith and exercised ordinary care, and (2) the standards are manifestly unreasonable. The difference between unreasonable and manifestly unreasonable is that manifestly unreasonable means unreasonable on its face, or patently unreasonable. TYPICAL: these agreements typically vary the banks obligation to pay items that are otherwise properly payable (unless creates an overdraft w/ no overdraft agreement in force) under 4.402. LIMITED: 4.103(a) is a limited tool to undo an agreement b/c 4.103 is liberal in its application of allowing parties to vary the effects of article 4. The best tactic is to remind the bank of its strict liability for wrongful dishonor if the predicates triggering the agreement are not truly met. HYPO Problem 1.5: CG is the president and sole SH of GMI, Inc. GMI has had its only bank account at Bulstrode Bank for the last three years. The signature card for GMI (executed at the time the account was opened) listed as authorized signatories on the account CGs daughter, MG, and his son-in-law, FV, who took over operational control of GMI from CG about five years ago. Because GMI has been losing money, CG lost his patience and decided to regain control of GMI. He convened a SHs meeting at which he voted his shares to elect himself the sole director of the corporation. He then removed MG and FV as officers and named himself president. When he went to remove MG and FV from the signature card, the account officer, NB told CG that the bank would freeze all funds in the account until CG presented the bank with a letter from MG and FV consenting to their removal from the account. NB relied on the following provision in the account agreement: If another person or entity makes a claim against funds in your account, or if we have reason to believe there is or may be a dispute over matters such as the ownership of the account or the authority to withdraw funds, we may, in our sole discretion, (1) continue to rely on current signature cards, resolutions or other account documents, (2) freeze all or part of the funds until the dispute is resolved to our satisfaction, or (3) pay the funds into an appropriate court of law for resolution. You are satisfied that CG has complied with all of the appropriate corporate formalities. MG and FV are out of town. Can CG force the bank to release the funds w/o providing the letter from MG and FV? The UCC does not help us much here b/c 4.103 allows the effect of article 4 to be varied by agreement, which is entered into between the bank and customer delineating rights and remedies. The agreement here gives authority to the bank to freeze the account for the above three options. But the predicate is that the bank must reasonably believe, inter alia, authority to funds, and here bank ML has such a reasonable belief to freeze the account. Now, the bank must pay checks that are outstanding as properly payable signed by MG and FV. In advising CG, must do so legally, and practically. Legally, the bank is within its rights ML, but it would be worth contacting the bank and trying to persuade them they dont have reason to believe their rights to freeze the account have been tripped. Also, try to contact the banks counsel that if we win, if there are checks written by CG that are wrongfully dishonored, the damages can be extreme. Can the agreement be attacked as unenforceable under 4.103(a)? This K is varying the banks right to pay items properly payable under 4.401, and the banks obligation to pay properly payable checks under 4.402 (unless paying the item would create an overdraft and there is no overdraft agreement in force). Does this agreement attempt to disclaim the banks responsibility for lack of good faith or

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responsibility to exercise ordinary care? ML not. But you want to make these arguments as counsel for CG. As to good faith under 1.201(20), has the bank been honest in fact? ML. Has the bank observed reasonable commercial standards of fair dealing, which comment 4 to 3.103 states that this is a concern of fairness of conduct rather than the care with which an act is performed? ML. This is a hard argument. The next issue is whether the agreement at issue sets manifestly unreasonable standards by which to determine the banks responsibility. This too is a stretch b/c the agreement is facially reasonable. So, left with arguing that if want to keep CG as a customer, than dont enforce the agreement, or at least look at the corporate documents evidencing that the proper procedures were taken putting CG in power. Bank discretion in charging fees for stop-payment orders and dishonored checks 1) Courts have uniformly held that a bank can individually charge fees to customers for 2) Dishonored checks and stop-payment orders b/c of administrative time. POLICY: these expenses should be borne by the customer who caused the expense and not the entire customer-base or the SHs of the bank. The banks obligation to pay checks Generally 1) A bank has the option to pay any item that is properly payable from the customers account, 2) But when the account has funds available to cover the item, however, the bank has an 3) Affirmative obligation to pay the item, but that obligation runs only to the 4) Banks customer (the drawer), not to the payee or any subsequent holder of the check; thus, 5) even if funds are available to pay the item at the time the item comes to the bank, the 6) payee has no claim against the bank if the customer prevents the bank from paying the check 7) by withdrawing those funds or issuing a stop-payment order. EFFECT: We were looking at the banks right to pay checks that are properly payable even if an overdraft. Here, we are looking at the banks obligation of paying checks and the obligation of the depositary bank to make funds available. The effect of a bank not fulfilling its obligation is the sanction of wrongful dishonor under 4.402. Bank Not Obligated to Pay Checks More than Six Months OldStale Checks 4.404 1) A bank is under no obligation to a customer having a checking account to pay a check, 2) Other than a certified3 check, that is presented more than 6 months after its date, but it may 3) Charge its customers account for a payment made thereafter in good faith. CONSULTING: this rule does not mandate the bank consult with its customer before charging a customers account for a check more than 6 months old, but its normal for it to do so. Thus, argue the second aspect of good faith was not followed because not consulting the customer was not an observance of reasonable commercial standards of fair dealing. EFFECT: The bank is given discretion to pay a check more than 6 months old if pays in good faith; but banks are still obligated to pay on certified checks regardless of how stale. TYPICAL: a lot of times, its dividend checks that are deposited after 6 months, but the corporation will always want those to be paid against their account. ARTICLE 3: defines stale check as more than 90 days old. HYPO problem 2.1: CG calls you and tells you about a check that the payor bank recently
3

A certified check must be paid b/c they are the primary obligation of the certifying bank. The obligation runs directly to the holder of the check. The customers account was presumably charged when the check was certified.

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honored dated seven months ago. CG thinks it ridiculous that the bank honored a check so stale. Was the bank within its power to pay the 7-month old check? It depends on whether the bank acted in good faith. An argument the bank did not act in good faith is that it did not consult CG before charging his account as a customer. Availability of Funds History: for many years, the only legal rule governing the banks evaluation of funds availability was 4.215(e). That statute grants the depositary bank unfettered discretion to protect itself by permitting the bank to limit the customers access to funds deposited by check until the depositary bank can determine whether the check will be honored. In 1987, Congress responded by passing the Expedited Funds Availability Act (EFAA). The Federal Reserve has implemented the EFAA by issuing Part 229 of Title 12 of the CFR. Part 229 is referred to as Reg CC. For Reg CC, the framework generally depends on (1) whether the customer deposited the funds in the form of a local check or a non-local check, and (2) whether the customer wishes to use those funds indirectly (by writing checks against them) or directly (by withdrawing cash). Funds Availability UCC 4.215(e) Subject to (i) applicable law stating a time for availability of funds (e.g., Reg CC or other state laws), and (ii) any right of the bank to offset an obligation owed to it from the customer, credit given by a bank for an item in a customers account becomes available for withdrawal as of right if 1) The bank has received a provisional settlement for the item: when the settlement becomes final and the bank has had a reasonable time to receive return of the item and the item has not been received within that time; or 2) The bank is both the depository bank and the payor bank, and the item is finally paid: at the opening of the banks second banking day following receipt of the item. APPLIES: the first situation applies to the situation in which a bank has given a credit (usually provisional) for an item to its customer and in turn has received a provisional settlement for the item from an intermediary or payor bank to which it has forwarded the item. In this situation before the provisional credit entered by the collecting bank in the account of its customer becomes available for withdrawal as of right, it is not only necessary that the provisional settlement received by the bank for the item becomes final but also that the collecting bank has a reasonable time to receive return of the item and the item has not been received within that time. Std for reasonable time: depends on the distance the item has to travel and the number of banks through which it must pass (having in mind not only the travel time by regular lines of transmission but also the successive midnight deadlines of the several banks). PREEMPTED BY REG CC: CC usually controls b/c its schedules are shorter for availability. SUPERCEDED: state law supercedes Reg CC if the state law was enacted and in force on or before Sept. 1, 1989 and provides for a shorter availability schedule. BIG EXCEPTION: if a bank learns of final settlement of an item the bank must make the funds available for withdrawal regardless of the availability schedule in Reg CC. The purpose of these restrictions are to make them available to customer as soon as reasonably practicable not that bank can use it during holding time. How would a bank ever know the check has actually been paid? As a matter of practice, notice in the banking system goes to dishonor,4 not honored items.
4

For example, 229.33 provides that if a paying bank determines not to pay a check in the amount of $2500.00 or more, it shall provide notice of nonpayment such that the notice is received by the depositary bank by 4 pm on the

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So, in fact it is not normal at all for bank to learn that the item has been finally paid, instead, banks wait a reasonable time, and if not heard it is not coming back, and thus reasonably assumes it has been paid. But the customer will often pester the depositary bank enough that the bank calls the payor bank and inquires as to final settlement. Reg CC Definitions Business day: a calendar day other than a Saturday or a Sunday, January 1, the third Monday in January, the third Monday in February, the last Monday in September m the second Monday in October, November 11, the fourth Tuesday in November, or December 25. Banking day: that part of any business day on which an office of a bank is open to the public for carrying on substantially all of its banking functions. Thus, it cant be a banking day unless its also a business day. UCC Banking Day: the definition of banking day in Reg CC is different from banking day in 4.104(a)(3) in that it need not be a business day to be a banking day as long as the bank is open to the public and substantially performing banking functions. Under article 4 a Saturday can be a banking day, but not under Reg CC. But even its a banking day on Saturday for art 4, the availability deadlines do not attach from Reg CC b/c not a Reg CC banking day. Depositary bank: the first bank to which a check is transferred even though it is also the paying bank or the payee. Local paying bank: a paying bank located in the same check-processing region as the physical location of the branch, contractual branch, or proprietary ATM of the depositary bank. The check-processing region is the geographical area serving an office of a fed reserve bank for its check processing. We are in the gulf-coast region, and the federal reserve bank down the street on San Jac is an office of the Dallas 11th bank. Local check: a check (i) payable by or at a local paying bank, or (ii) a check payable by a nonbank payor and payable through a local paying bank. Nonlocal check: a check payable by, through, or at a nonlocal paying bank. 229.10 Next-day availability Certain check deposits 229.10(c)(1)(i)-(vi) A depository bank shall make funds deposited by check available for withdrawal not later than the business day after the banking day on which the funds are deposited, in the case of 1) A U.S. Treasury check deposited in an account held by a payee of the check; 2) A U.S. Postal Service money order deposited a) In an account held by a payee of the money order; and b) In person to an employee of the depository bank. 3) A check drawn on the Federal Reserve Bank or Federal Home Loan Bank and deposited a) In an account held by a payee of the check; and b) In person to an employee of the depository bank. 4) A check drawn by a state or local government and deposited a) In a depository bank located in the state that issued the check, or the same state as the local government that issued the check; and
second business day following the banking day on which the check was presented to the paying bank. Notice may be provided by any reasonable means, including the returned check, a writing (including a copy of the check), telephone, Fedwire, telex, or other form of telegraph.

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b) In person to an employee of the depository bank; and c) With a special deposit slip or deposit envelope, if such slip or envelope is required by the depository bank. 5) A cashiers, certified, or tellers check deposited a) In an account held by a payee of the check (i.e., customer must be payee); b) In person to an employee of the depositary bank; and c) With a special deposit slip or deposit envelope if required by the depositary bank; 6) A check deposited in a branch of the depository bank and drawn on the same or another branch of the same bank if both branches are a) located in the same state or the b) same check-processing region. 7) And, in the case of an ordinary check deposited, the lesser of a) $100 of the check (even if check is for 1k), or b) the aggregate amount deposited in one banking day to the accounts of the same customer. PAST $100: for the availability of funds in a check above $100, go to 229.12. ALSO NEXT DAY: in addition to the above (1) certain check deposits, a depositary banks must also make funds available the business day after the banking day of a (2) cash deposit and (3) electronic payments actually paid in full. Check DepositChecks not deposited in person 229.10(c)(2) 1) For checks not deposited in person, a depository bank shall make funds deposited by 2) check available for withdrawal not later than the second business day 3) after the banking day on which funds are deposited, if the check is a) A US Postal Service Money Order deposited in an account held by payee; or b) A check drawn on a Fed Reserve Bank or Federal Home Loan Bank and deposited in an account held by a payee of the check; or c) A check drawn by a state or a local government and deposited in an account held by a payee of the check, and the depositary bank is located in the state that issued the check, or in the same state that the local government is located within; or d) A cashiers, certified, or tellers check deposited in an account held by a payee of the check; 4) But a a) U.S. Treasury check; or b) Check deposited in a branch of the depositary band and drawn on the same or another branch of the same bank if both branches are located in the same state or the same check processing region; (also look to see later if 229.10(c)(1)(vii) applies here). 5) Are still subject to next-day availability. 229.12 Availability Schedule (availability past $100 on ordinary checks up to $5000) Local checks 229.12(b)(1) 1) A depository bank shall make funds deposited by a customer available for withdrawal 2) not later than the second business day following the 3) banking day on which funds are deposited for local a) ordinary checks; b) U.S. Treasury checks where the customer is not the payee; c) U.S. Postal Service money order where the customer is not the payee, and not to teller;

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d) Federal Reserve Bank or Federal Hole Loan Bank where customer not payee, and not in person to a teller; e) State or local government check where customer is not the payee, not in a depositary bank located in the state that issued the check, or the same state as the unit of general local government that issued the check, and not in person to a teller; f) Cashiers, certified, or tellers check where customer is not the payee, and not to teller Nonlocal checks 229.12(c) The Five Day Rule 1) In the case of a nonlocal check, a depositary bank shall make funds available 2) Not later than the fifth business day following the banking day of deposit. Time period adjustment for withdrawal by cash or similar means 229.12(d) 1) A depositary bank may extend by one business day the time that funds deposited 2) By local (two days) or non-local check (five day rule) for cash withdrawal or similar means, 3) Which include a) electronic payment, b) issuance of a cashiers or tellers check, or c) certification of a check, or d) other irrevocable commitment to pay, but 4) the five day rule applies as usual for the granting of credit to a a) bank, a b) federal reserve bank, or a c) federal home loan bank 5) that presents a check to the depositary bank for payment. $ 400 EXCEPTION: a depositary bank shall, however, make $400 of these funds available for withdrawal by cash or similar means not later than 5 pm on the business day on which the funds are available under the five-day rule. This $400 is in addition to the $100 available under 229.10(c)(1)(vii) (the $100 dollar rule). Commentary Prohibition of K Variation of Reg CC Availability Rules in Sub-part B 1) In the staff commentary to the federal rules, there is a parenthetical statement that 2) The funds availability requirements in sub-part B may not be varied by agreement. EXCEPTIONS: (1) this prohibition is merely in the commentary, and (2) Reg CC 229.37 provides that the effect of the provisions of Subpart C may be varied by agreement, except that no agreement can disclaim the responsibility of a bank for its own lack of good faith or failure to exercise ordinary care, or can limit the measure of damages for such lack or failure; but the parties may determine by agreement the standards by which such responsibility is to be measured if such standards are not manifestly unreasonable. Six Exceptions to Availability under Reg CC229.13(a)-(f) Under these exceptions, the bank may extend the time for availability, subject to the time limitation in 229.13(h) below. These exceptions are written so that a depositary bank must proceed account-by-account, or item-by-item, versus extending the deadlines by blanket application. The depositary bank must find a particular exception that applies. But usually the facts of a problem will not fit neatly into a single exception. Instead, more than one exception

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may apply, and the establishment of one exception may justify another, e.g., a re-deposited check might provide reasonable cause to doubt collectibility. EXCEPTIONNew Accounts229.13(a) A deposit in a new account 1) Is subject to the next-day availability rules in 229.1(a) and (b) for deposits by cash or electronic payments regardless of the amount; 2) Is subject to the ordinary next-day availability for deposits by check, up to $5000.00 in the case of a a) US Treasury check deposited in payees account (no need to be in person with US Treas); b) US Postal Service money order deposited in payees account and in person; c) Fed Res Bank or Federal Home Loan Bank check deposited in payees account and in person. d) State or local government check in payees account in state of government, in person; e) A cashiers, certified, or tellers check in payees account, in person; 3) Is subject to the second-day availability rule, up to $5000.00, of 229.10(c)(2) when a check is not presented in person (but remember that still next day if its a US Treasury Check); 4) But the amount of deposit in excess of 5k shall be available for withdrawal not later than the ninth business day following the banking day of deposit; 5) And for all new accounts, a) the next-day availability rule in 229.10(c)(1)(vi) for a check deposited in a branch of the depositary bank and drawn on the same or another branch of the same bank if both branches located in same state or check processing region; b) nor does the $100 dollar rule of 229.10(c)(1)(vii) apply; c) and none of the availability rules of 229.12 apply (e.g., five-day rule). NEW ACCOUNT: an account is a new account during the first 30 calendar days after the account is established. An account is not considered a new account if each customer on the account has had, within 30 calendar days before the account is established, another account at the depositary bank for at least 30 calendar days. EXCEPTIONLarge Deposits229.13(b) 1) Sections 229.10(c) and 229.12 do not apply to the aggregate amount of deposits by 2) One or more checks to the extent that the aggregate amount is in excess of $5000 on 3) Any one banking day. EFFECT: if a check, or more than one check, is deposited that in the aggregate is more than $5k, than the bank may invoke this exception, and, for the amount over $5000, extend the time for availability under 229.13(h). EXCEPTIONRedeposited Checks229.13(c) 1) None of the ordinary availability rules for checks (229.10(c) and 229.12) apply to a 2) Check that has been returned unpaid and re-deposited by the 3) customer or the depositary bank. EXCEPTIONS TO EXCEPTION: this exception does not apply to eviscerate the availability rules with respect to (1) a check returned for a missing indorsement and re-deposited after the missing indorsement has been obtained, if the reason for return indication on the check states that it was returned due to a missing indorsement; or (2) a check that has been returned b/c it was

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post-dated, if the reason for return indicated on the check states that it was returned b/c it was post dated, and if the check is no longer postdated when redeposited. EXCEPTIONRepeated Overdrafts229.13(d) 1) If any account or combination of accounts of a depositary banks customer has been 2) repeatedly overdrawn, then for a period of six months after the last such overdraft, 3) none of the availability rules for checks (229.10(c) and 229.12) apply. REPEATEDLY OVERDRAWN: a depositary bank may consider a customers account to be repeatedly overdrawn if a) On six or more banking days within the preceding six months, the account balance is negative, or the account balance would have become negative (at all) if checks or other charges to the account had been paid; or b) On two or more banking days with in the preceding six months, the account balance is negative, or the account balance would have become negative, in the amount of $5000.00 or more, if checks or other charges to the account had been paid. EXCEPTIONReasonable Cause to Doubt Collectibility229.13(e) The General Rule 1) None of the availability rules for checks (229.10(c) and 229.12) apply to a check deposited 2) In an account at a depositary bank if the depositary bank has reasonable cause to believe that 3) The check is uncollectible from the paying bank. Std: a) reasonable cause to believe a check is uncollectible requires the existence of facts that would cause a well-grounded belief in the mind of a reasonable person, b) but such belief shall not be based on the fact that the check is of a particular class or c) is deposited by a particular class of persons. Overdraft and returned check fees 1) A depositary bank that extends the time when funds will be available for withdrawal 2) Under the general rule, and does not furnish the depositor with written notice 3) At the time of deposit shall not assess any fees for any subsequent overdrafts, 4) Including use of a line of credit, or return of checks or other debts to the account 5) If a) The overdraft or return of the check would have occurred except for the fact that the deposited funds were delayed under the general rule; and b) The deposited check was paid by the paying bank. EXCEPTIONEmergency Conditions229.13(f) 1) None of the ordinary availability rules for checks apply (229.10(c) and 229.12) to funds 2) Deposited by check in a depositary bank in the case of a) An interruption of communications or computer or other equipment facilities; b) A suspension of payments by another bank; c) A war; or d) An emergency condition beyond the control of the depositary bank, if the depositary bank exercises such diligence, as the circumstances require.

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Availability (temporally) of deposits subject to exceptions229.13(h) 1) If a bank chooses to invoke one of the six exceptions, e.g., large deposits, the depositary bank 2) May extend the time periods for availability by a reasonable period of time. Std for reasonable period of time: a reasonable period is an extension of up to a) One business day for checks under the next day availability rule (229.10(c)(1)(vi)) that are deposited in a branch of the depositary bank and drawn on the same or another branch of the same bank if both branches are located in the same state or the same check processing region; b) Five business days for local checks (229.12(b)(1)) normally available for withdrawal not later than the second business day following the banking day of deposit; c) Six business days for non-local checks (229.12(c)(1)) normally available for withdrawal not later than the fifth business day following the banking day of deposit; d) A longer extension may be reasonable, but the bank has the burden of so establishing. EFFECT: these times are in addition to the ordinary availability rules and are per se reasonable periods of time; if the bank wishes to go beyond these times, it has burden to show reasonable. EXCEPTION: 229.12(d) is not mentioned in 229.13(h); thus, the additional times available under 229.13(h) are not to begin on the extra day following the two days for a local check under 229.12(b), nor the extra day following the two days for non-local checks under 229.12(c). HYPO: non-local check deposited for $10,000, and cash is wanted, than $100 the following business day, $400 by 5 pm on the fifth following business day, $4500 on the sixth following business day, but as to the remaining $5000, that is a large deposit, and the bank may tack on an additional six days to the fifth business day following the banking day of deposit (not the sixth business day following the banking day of deposit added b/c of cash desired under 229.12(d)). Thus, the remaining $5000 will be available for withdrawal on the 11th business day following the banking day of deposit. And, if the bank wishes to extend the period beyond that, it has the burden of showing reasonableness, which the bank would ML extend beyond six days, for example, if a check was for $700k and wait for final settlement. HYPO Problem 2.5: Jodi Kay called again, asking advice about her recent job assignment. Several of the branches discussed in problem 1.6 have received checks (often quite large) drawn on nonlocal banks that the payor banks eventually have refused to honor. Those branches have lost a substantial sum of money on those checks in cases in which the customers withdrew the funds and closed their accounts before CountryBank learned that the checks would not be dishonored. Jodi mentions that a large share of the problems occurred in cases that involved recently opened accounts or accounts on which overdrafts had been frequent past occurrences. Jodi wants to know if there is anything she can do about that problem. She wants to extend to six business days the hold that the bank puts on all nonlocal checks deposited at the problem banks. Her problem is she cannot blanket put a holder on all non-local checks b/c ML not reasonably doubt the collectable nature of all non-local checks and further 229.13(e)(1) does not apply to checks from a particular class, which this may be. As to these non-local checks, whether these are deposited in new accounts, or they may be large deposits, or repeated overdrafts, i.e., nothing in problem distills this into one of the specified exceptions, but you must have one of these exceptions apply to extend the deadline and it must be for a specific account or item(s). HYPO problem 2.2: JK must audit the banks funds availability policies to ensure compliance with Reg CC. She wants to know when CC requires the bank to release the funds from the following deposits made into accounts at a Houston branch of CountryBank. Each deposit was

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made on Monday March 1 and CountryBank is open for substantially all of its operations six days a week. a. CE wishes to withdraw cash against funds deposited w/ one of the banks tellers in the form of a 7k check written by AM on AMs Seattle bank account. How soon can Carl get the cash from this 7k check? The first 5k of the check will fall under 229.10 and 229.12. Under 229.10(c)(1)(vii), the general rule is on all deposits by check you must make 100 available not later than the business day after the banking day after the funds are deposited. The check for 7k was deposited on Monday, March 1, which is a banking day b/c its a business day. Thus, 100 dollars must be made available by the next business day, which is March 2. What if CE had deposited the check by an overnight drop, instead of with a teller? CE would then have to wait one extra day, Wednesday, to be able to get the one hundred dollars. As to the rest of the funds up to 5k, 229.12 must be consulted for the general availability schedule. The check CE deposited from AM was written on AMs Seattle bank account. This is a non-local check b/c Seattle is in a different check-processing region than Houston, which is where the depository bank is located. Thus, CountryBank must make 4900 of the 7k check available not later than the 5th business day following the banking day of deposit. Here, the 5th business day following Monday, March 1, is the next Monday, March 8 (note that a business day under CC does not include Saturdays or Sundays, thus, even if Saturday CountryBank substantially provides all of its services, its not a banking day b/c its not a business day; thus, five days following Monday is the next Monday). But b/c CE wants cash, than 229.12(d) applies, which means that CountryBank, at its discretion, can extend the five day rule one extra day, except that CE can get $400 of the deposit on the ordinary deadline for the 5 day rule if CountryBank does trigger 229.12(d). Thus, CE will be able to get $100 cash on Tuesday, March 2 (the business day following the banking day of deposit), $400 in cash on Monday March 8 b/c deposited in person to a teller (the fifth business day following the banking day of deposit), and $4,500 in cash on Tuesday, March 9. There is 2k left over from the 7k check; thus, large deposits under 229.13(b) applies meaning that the normal availability rules do not apply. Under 229.13(h) the bank may extend the availability times to a reasonable period of time for the 2k left over. Under 229.13(h)(4), an additional six business days is prescribed as reasonable to tack on to the fifth business day following the banking day of deposit. Thus, CE must wait until the 11th business day following the banking day of deposit, which is Tuesday, March 16. What if CE deposited 7k on March 1, and on March 3, Wednesday, CountryBank learns the item has been finally settled? CountryBank must make all funds available for withdrawal regardless. b. CE deposits a 1k cashiers check w/ one of the banks tellers. The check was drawn on Rocky Mountain Bank in Seattle. The check originally was payable to Riverfront Tools, Inc. (to purchase some machines tools for Archie Moons print shop), but was properly indorsed from that corporation to Carl. Reg CC 229.10(c)(1)(v) would seem to apply for next day availability b/c this is a cashiers check and was deposited in person to a teller of the depositary bank, but it doesnt b/c CE is not the payee of the check. The cashiers check was originally payable to River Front Tools. Carl is an endorsee of the check and may enforce it as a holder. Also, 229.12(b)(4) does not apply for second day availability for a cashiers check where customer is not payee and not to a teller b/c here this is not a local check. So, we are again under non-local check rules, which means the 100 dollar rule applies under 229.10(c)(1)(vii) to mean that 100 dollars is available the following business day after the banking day of deposit, here Tuesday, March 2. The remaining 900 dollars falls under the 5-day rule for non-local checks under 229.12(c)(1)(i). Thus, the remaining 900 dollars will be available five days following the banking day of deposit,

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which is Monday, March 8. He is not requesting cash, therefore the money is available on that day, whereas if he wanted cash, he could get 400 dollars on Monday by 5 pm (should the bank choose to make that election) and the rest Tuesday, March 9. c. CE deposits a $1000 check, payable to himself from the U.S Treasury, at one of CountryBanks ATMs in Houston. US Treasury checks are subject to next-day availability if deposited in an account held by a payee of the check. Here, that is the case. But 229.10(c)(2) might apply, which converts next-day, into second-day availability for most checks that would qualify under 229.10(c)(1) if the check is not deposited in person; however, second-day availability does not apply in this case b/c 229.10(c)(2) only applies to 229.10(c)(1)(ii)-(v), and US Treasury checks fall under 229.10(c)(1)(i). So, CEs check must be available next day, Tuesday, March 2. Banks Liability to Customer for Wrongful Dishonor 4.402 1) Under 4.402(a), a payor bank wrongfully dishonors an item if it dishonors an item that is 2) properly payable, but a bank may dishonor an item that would create an overdraft 3) unless it has agreed to pay the overdraft; the effect is strict liability for damages 4) proximately caused by the wrongful dishonor of an item, but liability is limited to 5) actual damages proved and may include damages for an arrest or prosecution of the 6) customer (atty fees) or other consequential damages; but whether any consequential damages 7) are proximately caused by the wrongful dishonor is a question of fact case-by-case. Std for proximate cause: whether the damages were reasonably foreseeable in the zone of injury under the circumstances. (This is a tort law concept for 4.402(b), not K law, for consequential damages where the nature and type of damages caused must be foreseeable.) EFFECT: wrongful dishonor arises if a bank fails its obligation to pay checks; therefore, the situation of wrongful dishonor usually arises b/c of the banks payment of an item that was not properly payable that caused a subsequent check to be dishonored that would have been properly payable but for the banks prior payment of an item not yet properly payable. CUSTOMERS COA: section 4.402 has been construed to preclude an action for wrongful dishonor by a other than the banks customer. But some courts have allowed a other than the customer to sue when the customer is a business entity that is one and the same w/ the individual or individuals operating the entity, e.g., president of corporation signs a check and is picked up for a hot check. STRICT LIABILITY: it doesnt matter whether the bank was reasonable or acted in good faith. MENTAL ANGUISH: Texas Supreme Court has held that damages for mental anguish under 4.402 cannot be recovered absent a showing of an (1) intentional tort, (2) gross negligence, (3) willful and wanton disregard, or (4) accompanying physical injury (e.g., aggravated ulcer). (Thus, to recover mental anguish (emotional distress) damages for wrongful dishonor, the level of proof is higher for proximate cause in Texas, and other states.) ARRESTED: if arrested for hot check writing, consequential damages are almost inferred from the wrongful dishonor. SIGNIFICANT: in Maryott, the proved 250k for lost income, 200k for lost business, and 150k for emotional distress were proximately caused by a wrongful dishonor of a 68k check. Banks Determination of Account Balance for Decision to Honor or Dishonor 4.402(c) 1) A payor banks determination of the customers account balance on which a decision to 2) Dishonor for insufficient funds is based may be made at any time between the

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3) Time the item is received by the payor bank and the time that the payor bank 4) Returns the item or gives notice in lieu of return (midnight deadline), and 5) No more than one determination need be made, however, if, at the election of the payor bank, 6) A subsequent balance determination is made for the purpose of reevaluating the banks 7) Decision to dishonor the item, the account balance at that time is determinative of 8) Whether a dishonor for insufficiency of available funds is wrongful. EFFECT: if a payor bank complies with this section and makes only one determination, and it ends up that after the decision to dishonor was made and before the midnight deadline there was sufficient funds available, the bank is in the clear for purposes of wrongful dishonor. But if the payor bank does take a second look, and there is sufficient funds available, must honor the item. TYPICAL: check presented against customers account and payor bank immediately gives a provisional settlement for the item from the presenting bank or clearing house; payor bank makes it determination within a few hours and finds NSF and sends notice of dishonor and a reversal of the provisional credit; if within minutes funds become available, the bank is in the clear provided it does not take a second look, even if before midnight deadline has passed. HYPO Problem 2.3: FSB, where Ben Darrow works, honored a rent check that Jasmine Ball had written for $900 even though Ball had provided the bank a valid postdating notice under 4.401(c). The day after those events (Tuesday, January 23), another check drawn on Balls account was presented, this one dated January 22, in the amount of $400, payable to GMAC. B/c the account at that time contained only $100 (as a result of the banks decision to cash the $900 rent check the day before), FSBs system auto-dishonored the check and charged Ball a $25 fee for issuing a check against insufficient funds. Darrow worried about bouncing Balls car payment when he read a notice in the paper this morning (January 29) that GMAC had repossessed Balls car and when he arrived there was a $2000 deposit in Balls account. The funds from that deposit would have been available in time to cover the postdated rent check. Does FSB have any significant liability? Yes, most likely, and the first question is whether there was a wrongful dishonor under 4.402(a) by wrongfully dishonoring an item that is properly payable. Here, the bank paid the rent check before it was properly payable b/c Ball had given reasonably certain notice of a post-dated check under 4.401, and that results in money out of Jasmines account. As a result of this, the car payment check was dishonored. That dishonor was wrongful under 4.402 because but for the banks mistake with the rent check, there would be enough money in the account making the car payment check properly payable. The next question is how significant FSBs damages will be and 4.402(b) provides that a payor bank is liable to its customer for damages proximately caused (reasonably foreseeable) by the wrongful dishonor of an item. FSB will be liable for more than the 400 dollars the check was written for. The $25 dollar NSF charge, and the cost of reacquiring the vehicle were both reasonably foreseeable. If Jasmine can show that the repossession of her car and the hassle of reacquiring her car caused her to lose her job, she can recover for lost income. Further, if Jasmine owned a business that lost value, she may get damages for lost business. And, Jasmine may recover mental anguish damages if she can show a sufficient physical impact from the stress of the ordeal, e.g., ulcer flare up. It is conceivable in second sentence in 4.402(b) will be arrested and prosecuted for hot check writing, and if so, the customer is entitled to recover damages for arrest and prosecution, e.g., attorneys fees. HYPO Problem 2.4: FSBs check-processing system is run by software designed to decide

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whether to honor a check by checking the balance in the account at the close of the banking day on the date that the check was presented. When BD saw a check written by Carol Long one morning including on a list of checks that were to be bounced for NSF in the account at the close of the previous banking day, he decided to recheck her account. Although he noticed a large cash deposit the previous day that had become available by the time he made the determination, he concluded that the software was working properly b/c the funds in the account at the close of the previous banking day were insufficient to cover the check. Discuss the legality of the banks practices. First, under 4.402(c), the payor bank need only make one determination of sufficient available funds to pay an item, between the time the bank is presented with the check and the time to dishonor. But here, b/c Darrow took a second look, FSB was required to make its decision at the time he looked again; therefore, the check should have been honored and FSB may be liable for wrongful dishonor under 4.402(a). Collection of Checks ISSUE: once payee has accepted a check from the drawer, the question is whether the payee has a legal right to force the payor bank to pay the check. Although the UCC characterizes the payee (or any bank that acquires the check from payee) as a person entitled to enforce an instrument under 3.301, that designation does not say anything about the payees rights to collection from the payor bank; on the contrary, an an ordinary check transaction, the payee has no rights whatsoever against the payor bank, even if the drawers account has sufficient funds. Payor Bank/Drawee Not Liable on Unaccepted Draft 3.408 1) A drawee/payor bank is not liable on an instrument to the payee or other holder 2) unless the drawee/payor bank accepts the draft, or 3) after the draft is presented, fails to dishonor the item by the midnight deadline under 4.302 (if a bank fails to dishonor an item, whether properly payable or not, by the midnight deadline after presentment, the bank has finally paid the item, and is liable for the payment). EFFECT: while the payor bank is obligated to the drawer to pay an item when there are sufficient available funds, the payor banks obligation, in general, does not run to the payee or holder of the instrument. A payee or holder of the instrument cannot force the payor bank to pay on an item unless accepts or fails to dishonor before the midnight deadline Std to accept UCC 3.409(a): acceptance means the payor bank, for a customer, has agreed to pay a draft as presented, but it must be in writing on the draft. A draft may be accepted although it has not been signed by the drawer, is otherwise incomplete, or has been dishonored. Note, a draft is presented for acceptance, and can later be presented for payment in collection. EFFECTCERTIFIED CHECK: once a check is accepted by the bank on which it was drawn under the check becomes a certified check b/c the drawee bank has promised to pay the check. The check is drawn on the customers account, but certified by the payor bank. SIGNATURE OF DRAWEE: the mere signature of the drawee on the instrument is a sufficient acceptance, and need not be accompanied by such words as accepted, certified, or good. It must not, however, bear any words indicating intent to refuse to honor the draft. EXCEPTION: acceptance is not the same as honoring a check. In the ordinary case of a check, not yet presented for acceptance, the bank is obligated to its customer to pay if its properly payable, but no obligation to the payee or other holder or what 3.301 calls one entitled to enforce, to pay the check, and can dishonor if it chooses even though may have hassle with its own customer, unless and until the bank has promised to pay the draft by acceptance.

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PAYMENT versus ACCEPTANCE: payment is the subject of 3.602 and occurs when a person entitled to enforce is actually paid by or on behalf of a person obligated to pay. Significantly, payment discharges the obligation on he instrument to the extent of the paymentif payment of the full amount of the instrument is made, the instrument is discharged and is no longer a live instrument [except in the hands of a holder in due course]. Acceptance consists of a promise by the drawee to pay, but is not the actual payment itself. An instrument that has been accepted is a live instrument; the acceptor is obligated to pay to a person entitled to enforce. The Midnight Deadline 4.104(a)(10) 1) With respect to a bank is midnight on its next banking day following the banking day 2) On which it receives the relevant item or notice or from which the time for 3) Taking action commences to run, whichever is later. Time of Receipt of Items 4.108 1) For the purpose of allowing time to process items, prove balances, and make the 2) Necessary entries on its books to determine its position for the day, 3) A bank may fix an afternoon hour of two p.m. or later as a cutoff hour for the 4) Handling of money and items and the making of entries on its books. EFFECT: an item or deposit of money received on any day after a cutoff hour so fixed or after the close of the banking day may be treated as received at the opening of the next banking day. EXCEPTIONseparate office of a bank 4.107: a branch or separate office of a bank is a separate bank for the purpose of computing the time within which and determining the place at or to which action may be taken or notices or orders must be given for articles 3 and 4. Thus, merely b/c an item is deposited in a different branch of the same bank does not mean that the depositary (or collecting) bank is also the payor bankeach branch is treated separately. REG CC: 229.19(a)(5) provides that funds may be considered deposited on the next banking day, in the case of funds that are deposited(1) on a day that it not a banking day for the depositary bank; or (2) after a cut-off hour set by the depositary bank for the receipt of deposits of 2 p.m. or later; or (3) for the receipt of deposits at ATMs, contractual branches, or off-premise facilities, of 12:00 noon or later. Responsibility of Collecting Bank after Deposit; When Action Timely 4.202 A collecting bank must exercise ordinary care in 1) Presenting an item or sending it for presentment; 2) Sending notice of dishonor or non-payment or returning an item other than a documentary draft to the banks transferor after learning that the item has not been paid or accepted, as the case may be; 3) Settling for an item when the bank receives final settlement; and 4) Notifying its transferor of any loss or delay in transit within a reasonable time after discovery thereof. Std for ordinary care: a collecting bank exercises ordinary care by (1) taking proper action (2) before its midnight deadline following receipt of an item, notice, or settlement, and (3) taking proper action within a reasonably longer time may constitute the exercise of ordinary care, but (4) the bank has the burden of establishing timeliness. Collecting bank: a bank handling an item for collection except the payor bank. Thus, the

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depositary bank (the first bank to take an item even though it is also the payor bank, unless the item is presented for immediate payment over the counter) can also be the collecting bank. Payor Banks Responsibility Upon Receipt of Item 4.302 WHEN PAYOR BANK IS NOT ALSO THE DEPOSITARY BANK: 1) After being presented with an item, a payor bank is accountable for the amount of 2) A demand item, other than a documentary draft, whether properly payable or not, 3) If the bank retains the item, or fails to return, or send notice of dishonor 4) beyond midnight of the banking day of receipt w/o providing a provisional settlement;5 5) if such a payor bank later decides to revoke a provisional settlement, it must 6) return the item or send notice of dishonor by midnight of the banking day 7) following the banking day of presentment (i.e., the midnight deadline in 4.104(a)(10)) . WHEN PAYOR BANK IS THE DEPOSITARY BANK (ON US ITEMS) 1) A payor bank that is also the depositary bank, after presented with an item, 2) Is accountable for the amount of a demand item, other than a documentary draft, 3) whether properly payable or not, if the bank does not return the item, or 4) send notice of dishonor by midnight of the banking day following receipt. EFFECT: if the deadlines are not followed, the accountability means final settlement. RETURN OR NOTICE OF DISHONOR: need not actually arrive at the collecting bank before the deadlines above. That the item is returned or notice is sent before the deadline is enough. ON US ITEMS: if its an on us item, the provisional credit by midnight on the day of receipt need not be given. Payor Banks Authority of Revocation & Recovery of Provisional Settlement 4.301 1) If a payor bank settles for a demand item before midnight of the banking day of receipt, 2) the payor bank may revoke and recover the settlement if, a) Before it has made final payment (before settlement becomes final), and b) before its midnight deadline, it 3) Returns the item, or sends written notice of dishonor or nonpayment. ON US ITEMS: where the payor bank is also the depositary bank, the requirement of a settlement on the day of receipt is omittedthat is, a payor bank, on an on us item, has until its midnight deadline to revoke and recover a provisional credit. Right of Collecting Bank to Charge-Back or Refund 4.214(a) 1) If a collecting bank has made a provisional settlement with its customer for an item that 2) Fails by reason of dishonor, suspension of payment by a bank, or otherwise 3) To receive settlement for the item that is or becomes final, the bank may 4) Revoke the settlement given by it, charge back the amount of any credit given, or 5) Obtain a refund from its customer, whether or not it is able to return the item, 6) If by its midnight deadline or within a longer reasonable time after it learns the facts 7) It returns the item or sends notification of the facts. LIABILITY FOR DELAY: if the return or notice is delayed beyond the banks midnight deadline or other longer reasonable period of time, the bank may still revoke the settlement,
5

This midnight is not the same as the midnight deadline. Practically, payor banks that are also not the depositary bank always give a provisional settlement, and usually the provisional credit is given to collecting/depositary bank that presented the item.

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charge back the credit, or obtain a refund from its customer, but it is liable for any loss resulting from the delay. EXCEPTIONFINAL SETTLEMENT: these rights to revoke, charge-back, or obtain refund terminate if and when a settlement for the item received by the bank is or becomes final. (The comments to 4.214 provide that if the bank fails to receive such a final settlement the right of charge-back or refund must be exercised promptly after the bank learns the facts.) Right of Payor Bank That is also the Depositary Bank to Charge-back or Refund 4.214(c) 1) A depositary bank that is also the payor may charge-back the amount of an item to its 2) Customers account or obtain refund in accordance with the section governing return of an 3) Item received by a payor bank for credit on its books (4.301). EFFECT: if a payor bank (thats also the depositary bank) acts per 4.301 to charge back the amount under 4.214(c), it may do so after the customer writes a check on the amount supposedly in his account, which will subtract prospectively funds from his account; or if the customers account does not have sufficient funds, it can obtain a refund from the customer. Final Payment (Settlement) by Payor Bank; Provisional Credits Become Final 4.215(a) An item is finally paid by a payor bank when the bank has first done any of the following 1) Paid the item in cash (e.g., cashed a check OTC); 2) Settled for the item w/o having a right to revoke the settlement under statute, clearing-house rule, or agreement; or 3) Make a provisional settlement for the item and failed to revoke the settlement in the time and manner permitted by statute, clearing-house rule, or agreement. EFFECT: if the depositary and collecting banks in the forward collection process gave provisional credits, and the payor bank fails or intends to not meet its deadlines for dishonor, than those provisional credits per se become final w/o more. DEFENSEPayment by Mistake 3.418(b)limited chance at restitution 1) If a bank has paid or accepted an instrument by mistake, the bank may a) Recover the payment from the person to whom payment was made; or b) In the case of acceptance, revoke the acceptance; 2) Unless the person to whom payment or acceptance was made a) Took the instrument in good faith and for value, or b) Who in good faith changed position in reliance on the payment or acceptance. APPLY: those cases of payment by the drawee (payor bank) bank of a check with respect to which the bank has no duty to the drawer to pay either b/c the drawer has no account with the bank or b/c available funds in the drawers account are not sufficient to cover the check. EXAMPLE (from the comments): F gives D a check for 10k as a birthday gift. The check is drawn on Bank in which both F and D have accounts. D deposits the check in her account at Bank. An employee of Bank, acting under the belief that Fs account had available funds, caused Ds account to be credited for 10k. In fact, Fs account was overdrawn and F did not have overdraft privileges. Since D received the check gratuitously three is clear unjust enrichment if she is allowed to keep the 10k and bank is unable to obtain reimbursement from F. Thus, Bank should be permitted to reverse the credit to Daughters account. But this case is not typical. In most cases, the remedy of restitution will not be available b/c the person receiving payment of the check will have given value for it in good faith.

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DEFENSEDelay (Force Majeur) 4.109(b) 1) Delay by a collecting bank or payor bank beyond time limits prescribed or permitted 2) By the UCC or by instructions (private agreement) is excused if the delay is caused by a) Interruption of communication or computer facilities, b) Suspension of payments by another bank, c) War, d) Emergency conditions, e) Failure of equipment, or f) Other circumstances beyond the control of the bank; and 3) The bank exercises such diligence, as the circumstances require. EXAMPLE: a payor bank that fails to make timely return of a dishonored item may be accountable for the amount of the item. 4.109(b) excuses a bank from this liability when its failure to meet its midnight deadline resulted from, e.g., a computer breakdown beyond the control of the bank if the bank exercised the degree of diligence called for by the circumstances. HYPO Problem 3.1: one Tuesday morning Tertius Lydgate calls w/ a complaint about Bulstrodes treatment of a $1000 check that Lydgate deposited into his bank account on the preceding Monday afternoon. The check was drawn on an account at a branch of Bulstrode located in New Haven, Connecticut. Lydgate deposited the check into a branch of Bulstrode in Boston, Massachusetts at about 3 p.m. Lydgate says that a sign on the counter indicated that items received after 2 p.m. would be treated as received the next day, but doesnt see why that matters. After all, either they got it Monday or they didnt, right? The Boston branch apparently gave Lydgate a provisional settlement for the check immediately and forwarded the check to the New Haven branch on Wednesday morning. The New Haven branch dishonored the check on Thursday afternoon, returning the check to the Boston branch by a courier that arrived back at the Boston branch before midnight on Thursday. On Friday, the bank called Lydgate to advise him that it was revoking the provisional settlement and removing the funds from his account. Muttering something about midnight deadlines, Lydgate wants to know if Bulstrode acted promptly enough for its dishonor to be effective. Under 4.108, Bulstrode bank in Boston is permitted to set a time after 2 pm for the processing of items regarding the time in which they are received. Therefore, the Boston branch of Bulstrode did not receive Lydgates check until Tuesday. Even if the New Haven branch of Bulstrode does not have the same 2 pm cutoff time, the check is still considered received on banking day Tuesday for the Boston branch of Bulstrode b/c under 4.107 they are considered separate banks. If the check is deposited on banking day Tuesday, what then is the obligation of the depositary bank, which is the Boston branch that is also the collecting bank? 4.202(a) tells us that a collecting bank must exercise ordinary care in sending an item for presentment, and (b) says a collecting bank does so if it takes proper action before the midnight deadline. Therefore, the Boston branch must use ordinary care in presenting Lydgates check for presentment to the New Haven branch, and it does so if it sends the check for presentment by its midnight deadline. Did the Boston branch meet its midnight deadline? Bostons midnight deadline was, under 4.104(a)(10), midnight Wednesday. The New Haven branch was presented with the check on Wednesday. Therefore, the Boston branch met its midnight deadline under 4.202; so, the Boston branch exercised ordinary care in presenting Lydgates check to New Haven. Under 4.302(a), as the payor bank that was not also the depositary bank, New Haven had until Midnight

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Wednesday, the banking day of receipt, to provide a provisional settlement to Boston branch for the item otherwise, it would be accountable for the item. New Haven then had until midnight Thursday to decide whether to revoke its provisional settlement and send notice of dishonor. Now, the facts show that on Tuesday, Boston gave an immediate provisional settlement and then sent the item to New Haven arriving on Wednesday. This is almost a red herring (but not entirely b/c of 4.214(a) below) in that this provisional settlement was from the depositary bank. Here, we are concerned with the payor banks actionsthat is, New Havens after it received the check on Wednesday, which it then had as the payor bank that was not the depositary bank until Wednesday midnight to return the item or send notice of dishonor, or make a provisional settlement. The facts do not show, but its a virtual certainty that New Haven automatically made a provisional settlement when it received Lydgates check. But the facts do show that New Haven did revoke its provisional settlement and send notice by the midnight deadline under 4.302(a) to the Boston branch: Thursday, midnight (the banking day following the day of receipt of the check). But its not relevant that the returned check actually arrived in Boston from New Haven by the midnight deadline b/c it was enough that it was sent before the midnight deadline, e.g., could have returned the item at 11:59 p.m. Under 4.214(a), once Boston receives the returned check from New Haven, it may revoke the provisional settlement given to Lydgate and charge back the amount of the credit given to Lydgates account but Boston must, by its midnight deadline (or from a longer reasonable period of time upon learning the facts) from receipt of the returned check, which here is midnight Friday, send notice or return the check to Lydgate. Here, Boston, the depositary bank, which is the collecting bank for 4.214(a) received the returned check on Thursday, but b/c it was after hours, it did not learn of the return until Friday, which is the same day it notified Lydgate. Therefore, Boston properly revoked its settlement under 4.214(a). HYPO Problem 3.2: Ben Darrow calls on Thursday afternoon and wants to know what he should do about a bad check his bank, FSB, received this morning. Bud Lassen came in first thing Thursday morning and deposited a 10k check written by Carol Long. When Bud deposited the check, Carols account contained only $100. Accordingly, the check was sent to Darrow for action. Darrow promptly placed a hold on the funds in Buds account and placed a call to Carol to see whether Col would deposit funds to cover the check. a. Later in the morning, Bud came back down to the bank and attempted to cash a check for the total balance in his account ($12000, including the funds from Carols check). B/c Darrow placed a hold on the fund, the teller refused to cash the check. Early in the afternoon, Darrow learned that Carol left town. Accordingly, Darrow doubts that he will be able to get funds from Carol to cover the check. What should Darrow do? (On the exam, would need to analyze, inter alia, availability requirement under Reg CC, but this problem principally goes to 4.301 and 4.302.) FSB is both the depositary and payor bank, i.e., the check from Carol to Bud is an on us item for purposes of 4.302(a) on the payor banks responsibility after receiving an item. FSB has until Midnight Friday to dishonor the check (midnight deadline), else FSB will be accountable for the 10k to Lassen. Under 4.301(b), a payor bank, on an on us item has until the midnight deadline to revoke and recover a provisional settlement. Here, that is also Friday midnight, and if it does so revoke and recover, the bank can recover a processing fee from Lassen, and charge Carol an NSF fee. b. Assume instead that the bank allowed Bud to cash Carols check when he first presented that check in the morning. Where would that leave the bank? Under 4.301(b), a payor

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bank for on us items, has until the midnight deadline to revoke and recover a provisional settlement, but only before a final settlement for the item. Under 4.215(a)(1), cashing a check is a final payment of an item. So, FSB has no right to revoke the final settlement given to Lassen. And, FSB is left with cashing a check for one of its customers for 10k when only 100 was in her account, leaving a 9900 difference. Now, FSB may be able to recover the payment to BL under 3.418(b) for payment by mistake, but FSB would be hard pressed to show that BL would not have changed its position in good faith by relying on the payment. c. Finally, assume that Darrow neglected to place a hold on BLs account, perhaps b/c he thought that the banks computerized check-processing system would do that automatically. As a result, the teller readily cashed Buds check when Bud returned later that morning (after depositing Carols check). Carols check has not been finally paid yet b/c it has not been cashed or otherwise finally settled. Therefore, FSB has time to revoke the provisional credit given to Lassens account under 4.301 provided FSB returns check or sends notice to Lassen before its midnight deadline under 4.302. Under 4.214(c), FSB may charge back Lassens account for the amount of Carols check after Lassen has already cashed one of his own checks against his account. Lassens check is now overdrawn in the amount of Carols check (if BL had 30k in his account, and with Carols check amounts to 40k, and if BL writes a check against his account for 10k, than nominally his account sits at 30k; however, if FSB charges back the amount under 4.214(c) on the authority of 4.301, his account sits at 20k). Reg CC & The Check Return Process OVERALL: Reg CC includes three significant provisions for the check-return process. First, it adds two new deadlines of its own, an accelerated return deadline and a notice-of-nonpayment deadline. Second, it significantly alters one of the UCCs rules, the standard 4.301(a) midnight deadline. PREEMPTION: 4.103(b) recognizes that in conflicts between the UCC deadlines and the Reg CC, Reg CC controls on federal preemption grounds. Reg CCs Accelerated Return Deadline(s) 229.30(a)(1), (2) If a payor bank determines not to pay a check, it shall return the check in an expeditious manner so as to satisfy one of two separate regulatory deadlines 1) Two-day/four-day test: (1) a payor bank must return the check in a manner such that the check would (2) normally be received by depositary bank not later than 4:00 p.m. (local time) (a) [local checks] the second business day following the banking day on which the check was presented to the payor bank (i.e., the day of actual receipt is day zero, from which you count two business days forward), if the bank is located in the same check processing region as the depositary bank; (b) [non-local checks] the fourth business day following the banking day on which the check was presented to the payor bank (i.e., the day of actual receipt is day zero, from which you count two business days forward), if the payor bank is not located in the same processing region as the depositary bank NUANCE: If the business day falls on a non-banking day for the depositary bank, the test is satisfied if the returned check is received by the depositary bank on or before the depositary banks next banking day. 2) Forward Collection Test:

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(1) Where the payor bank returns the check in a manner that a similarly situated bank (2) would normally send a check, of similar account, drawn on the depositary bank, (3) deposited for forward collection by noon on the banking day (4) following the banking day on which the check was presented to the payor bank. EFFECT: the payor bank satisfies this test if it returns the check to the depositary bank by the same procedures that a similarly situated bank would have used to send a deposited check to the depositary bank for collection (usually faster than the two-day/four-day test). EFFECT OF BREACH: a breach of the duty of expeditious return calls for damages, but the damages are limited by 229.34(d), which merely includes the face amount of the item, interest lost, and incidental expenses. POLICY: whereas the UCC return obligation (see 4.302) focuses only on the date that the payor bank puts the check in the mail, the Reg CC deadline is more functional: it focuses on the speed with which the depositary bank actually receives the dishonored check. Collecting banks can then use 4.214 to undo provisional settlements. Reg CC and the (extension of the) UCCs Midnight Deadline; 229.30(c) 1) UCC 4.302 requires the payor bank to return the check (that is, deposit it in the mail) by 2) midnight of the banking day after the banking day on which the payor bank receives the 3) check; in two circumstances, Reg CC alters (extends) that deadline and permits the payor 4) bank to defer return until the next day if the payor bank selects an appropriately 5) expeditious mode of return resulting in a faster delivery than the UCC deadline; a) The midnight deadline is extended to the time of dispatch (1) If payor bank delivers check by means ordinarily result in (2) transferor banks receipt by the first banking day after the midnight deadline. HYPO: even if the article four midnight deadline calls for action by the end of Wednesday, the payor bank acts properly if it returns the check to the transferor bank (e.g., federal reserve bank between depositary and payor bank) by messenger early Thursday morning (a process that would be much more expeditious than depositing the check in the mail on Wednesday evening). b) The midnight deadline is extended to the time of dispatch when the payor bank uses a (1) highly expeditious means of transportation, even if this means of transportation, (2) even if this means of transportation ordinarily would result in delivery (3) after the receiving banks next banking day. HYPO: because of the size of its operations in Southern California, a payor bank in NY deals directly with the Los Angeles Federal Reserve Bank and that the payor bank has decided to dishonor a check that it received directly from the Los Angeles Federal Reserve Bank. In that case (again assuming that the article four midnight deadline calls for action by the end of Wednesday), Reg CC permits the payor bank to forgo using the Wednesday night mail, wait until Thursday, and then send the check to the Los Angeles Federal Reserve Bank by an overnight delivery service for delivery Friday morning. Routing and Settlement Method for Returned Checks 229.31(c) 1) Collecting banks in the middle of the forward collection process upon receipt of a 2) Returned check shall settle with a bank sending a returned check to it for return by the 3) Same means that it settles or would settle with the sending bank for a check received

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4) For forward collection drawn on the depositary bank and this settlement is final when made. Reg CC Notice of Nonpayment of a Check of $2500.00 or more 229.33(a) 1) If a payor bank determines not to pay a check in the amount of $2500 or more, it 2) Shall provide notice of nonpayment such that the notice is received by the 3) Depositary bank by 4:00 p.m. on the second business day following the banking day 4) On which the check was presented to the payor bank; if the day the payor bank is required 5) To provide notice is not a banking day for the depositary bank, receipt of notice on the 6) Depositary banks next banking day constitutes timely notice. Std notice: notice may be provided by any reasonable means, including the returned check, a writing (including a copy of the check), telephone, Fedwire, telex, or other form of telegraph. EXCEPTION: satisfying this notice of nonpayment does not also mean the payor bank has met the midnight deadline for 4.302 (to not be accountable for an item) b/c the midnight deadline for 4.302 is shorter than the time prescribed for notice of non-payment per Reg CC 229.33(a). Payor banks warranties return of check/notice of nonpayment on Large Items 229.34(b) 1) Where a payor bank timely returns a check or gives notice of nonpayment, 2) it warrants to the transferee bank, to any subsequent transferee bank, 3) to the depositary bank, and to the owner of the check that the payor bank will 4) return the check within its midnight deadline under 4.302, or 5) extended midnight deadline under Reg CC 229.30(c), and that there will be an 6) an expeditious return for Reg CC 229.30(a), e.g., 2 day/4 day test or fwd collection test. EFFECT: Often a depositary bank will receive a timely notice of nonpayment after the midnight deadline has run for 4.302 (accountable), thus, the depositary bank has no right to charge revoke any provisional settlement and back a customers account; this warranty allows depositary banks to shift some of the loss to the payor bank in the case of a wrongful dishonor COA (4.402). This warranty also applies to Reg J to satisfy Fed Reserve bank deadlines so that a Fed bank is covered under the warranty as well. LIMITED DAMAGES: Reg CC 229.34(d) provides that damages for breach of this warranty only include the value of the item that was wrongfully dishonored by the depositary bank, plus interest compensation and expenses (NSF charges) related to the check or returned check, if any. This is a pittance b/c the damages for a wrongful dishonor include not only the face value of the item wrongfully dishonored, the NSF charge, and lost interest, but consequential (actual) damages proximately caused, loss of business, credit damage, and in Texas, mental anguish. THEORIES OF RECOVERY OUTSIDE REG CC & UCC: to compensate for the limited damages available under 229.34(d), the depositary bank and customer would be wise to assert a (1) plain negligence COA against a payor bank for failure to exercise reasonable care in meeting the midnight deadline (and objective unreasonableness may be shown by the fact they meet the notice of nonpayment deadline and disregarded the midnight deadline for 4.302); (2) a claim for lack of good faith in failure to subscribe to industry procedures (the problem is that the good faith provided for in the UCC is ML intended more as a defense than a sword to raise as an independent theory of liability); but (3) not K, b/c no K between depositary and payor bank. Effect of Breaching UCC Duties versus Reg CC Duties for Collection Process 1) Failure to meet the midnight deadline directly affects the settlement process a) The payor bank becomes accountable for the item under 4.302,

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b) Payment becomes final under 4.215, and the c) Depositary bank loses any right of charge-back under 4.214 (if not meet); 2) Failure to satisfy the Reg CC requirements has much less drastic consequences, 3) Generally limited to damages under Reg CC 229.38. EFFECT: a payor bank that meets the midnight deadline avoids responsibility for the item under the UCC even if it fails to satisfy its notice and return obligations under Reg CC. Three Requirements for a Successful Return (dishonor) of a Check by a Payor Bank 1) Midnight Deadline: send the item or notice of dishonor by midnight on the next banking day, however, Reg CC 229.30(c)(1) can, in some circumstances, extend the deadline. 2) Reg CC Expeditious Return: under 229.30(a), return the item to the depositary bank either by the two-day/four-day test, or by the forward collection test. 3) Reg CC Notice of Nonpayment $2500.00 or More: under 229.33(a), if the item is for $2500 or more, make sure the depositary bank is actually given notice by 4 p.m. on the second business day following the banking day of presentment to the payor bank. HYPO: Problem 3.3: recall the facts of First National Bank from assignment 2: Shelly is running a check-kiting scheme through FNB and Colonial Bank. On Tuesday February 11, FNB presents 1.5 million of checks to Colonial for payment. The checks had been deposited at FNB and drawn on one of the accounts of a Shelly entity at Colonial. Although Colonial is concerned about the possibility that something is amiss, Colonial does not dishonor the checks on Tuesday or Wednesday, largely b/c an officer at Shellys company assures the Colonial loan officer that everything is fine. Thursday morning, however, Colonial discovers the seriousness of Shellys misconduct and attempts to dishonor the checks at that time. Colonial lost the case b/c it had delayed its return of the checks past midnight Wednesday (see 4.302). If you had been by Colonial early Thursday morning, could you have suggested anything that might mitigate the situation? Maybe you could argue force majeur under 4.109(b), but no facts showing that. So, go to Reg CC 229.30(c), which extends the midnight deadline. Under 229.30(c)(1), Colonial should be advised to immediately send a notice of dishonor to FNB the same day (Thursday) by means that will ordinarily result in FNBs receipt of the notice the same day, e.g., courier. Or, if FNB is a state or two over, than use a highly expeditious means of transportation: to ensure receipt of the notice by FNB by Friday. If either of these two options are exercised, than 229.30(c)(1) extends the midnight deadline to the time of dispatch of the courier or other highly expeditious means of transportation. Note too that this check would have triggered the notice of nonpayment provision of Reg CC 229.33(a) to be given by the payor bank to the depositary bank: that is, Colonial must provide notice of dishonor that will actually be received by FNB by 4:00 p.m. on the second business day following the banking day on which the check was presented to Colonial. The second business day following presentment is Thursday. Therefore, such notice must be received by FNB by 4 pm on Thursday. Map of collection through the federal reserve system 1) The process of Federal Reserve clearing starts with the depositary banks decision to send a 2) Check to its local Federal Reserve bank; under Reg J (12 C.F.R. 210.6), the Fed Reserve 3) Undertakes to collect the check as an agent for the depositary bank and then to forward any 4) process back to that bank; operating on the assumption that the check will be honored, the

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5) 6) 7) 8)

local Federal Reserve bank gives the depositary banks account with it a credit for the check; the depositarys fed bank routes the check to the fed bank district in which the payor bank is located, and that fed bank charges the payor banks account and delivers it to the payor bank, who then has to decide whether to honor the check, and a) if the payor bank honors the check, it need not send notice of its decision b/c the system proceeds on the initial assumption that all checks will be honored; when the deadlines for dishonor pass the debit to the payor banks account at the Federal Reserve becomes final, the federal reserve banks credit to the depositary bank becomes final, and the provisional settlement that the depositary bank granted its customer, the payee, becomes final. USE: banks use the Federal Reserve System for checks that it cannot process through a clearinghouse or through direct-send and correspondent arrangements. The Fed system is usually the system of last resort b/c it is more expensive than other systems. REG J: incorporates the official text of the UCC to regulate Fed Reserve Banks and in Texas they adopt the business and commerce code. Settlements are final when made in the forward collection process Reg CC 229.36(d) 1) Settlements between banks (including Fed Reserve) for the forward collection of a 2) Check are final when made. BIG EXCEPTION: despite the finality of this rule, a collecting bank in the forward collection process may revoke a provisional credit if the payor bank timely dishonors an item and charge back under 4.214. Think of the final when made as an accounting function only so that a returned item does not have to be returned the way; this allows payor banks to return an item directly to the depositary bank. But this only applies when Reg CC applies. ZING RULE (4.215) & SETTLEMENTS FINAL WHEN MADE (Reg CC 229.36(d)): under 4.215, in the forward collection process, all provisional settlements given by collecting bankszingbecome final once a payor bank has failed to return or send notice of dishonor by their midnight deadline under 4.301. Reg CC 229.36(d) overrides this protracted process of revoking provisional settlements when an item is dishonored by making settlements between collecting banks final when made. But 229.36(d) applies only between banks, and not between the depositary bank and the depositing customer. Therefore, the credit given by a depositary bank to a customer is still provisional and not final when made so that if the item is returned, the depositary bank has the usual timelines for revoking and charging back a provisional settlement. Nor does 229.36(d) apply between a payor bank and a collecting bank (only between collecting banks are settlements final). Therefore, a payor banks provisional settlement upon presentment is not final when made but provisional in nature (unless payor bank makes it final when made). What Reg CC does is allow a payor bank return an item directly to the depositary bank (versus returning it back the way it came) and this is well laid out, e.g., under 229.30(a) returns must be expeditious through the 2-day/4-day test on return of checks directly to the depositary bank. HYPO: Problem 3.4: BD calls you back w/ another question, this one related to Carols account. Carol deposited a 2500 check from Jasmine Ball on Monday, September 9. The check was drawn on Balls account at TownBank in Los Angeles. FSB gave Carol a provisional credit for the Ball check on the date that Carol deposited the check and forwarded the check for collection through the Fed Reserve Bank in Dallas. Under ordinary conditions, that would get the check to TownBank late Tuesday night (and considered received at Townbank Wednesday banking day).

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At 3:00 p.m. on Friday afternoon, September 13, FSB received an electronic notice of nonpayment from TownBank, indicating that it was bouncing the check b/c Balls account had insufficient funds to cover it. FSB responded by immediately charging 2500 back to Carols account and mailing Carol a notice that it had removed the funds from Carols account b/c Balls check had bounced. On Monday morning (September 16), a check in the amount of 2000 was presented against Cs account. B/c of the charge-back on the Ball check Carol had deposited, FSB dishonored the 2k check. On Wednesday morning, September 18, FSB received the returned Ball check from TownBank by regular mail in an envelope bearing a Monday postmark. Reviewing Carols account in connection with the Lassen transaction, discussed in problem 3.2, Darrow became concerned that the bank might have acted improperly in dishonoring Carols 2k check. Did TownBank meet its midnight deadline to dishonor the Ball check given to Carol? FSB, as the depositary/collecting bank, has a right under 4.214 to charge back a provisional settlement if it has not received, inter alia, a final settlement. A final settlement under 4.215(a), occurs when a payor bank has, inter alia, made a provisional settlement for an item and failed to revoke the settlement on time per 4.302, clearing house rule, or by agreement. An issue is also present of whether FSB received any settlement from the Federal Reserve Bank, and if so, whether it was final. Yes, FSB received a provisional credit from the Fed, and under 229.36(d), that settlement is considered final when made. But it is understood that FSB still has the right to revoke the provisional credit given to Carol on the Ball check per 4.214. The Ball check was considered presented to TownBank on Wednesday. Therefore, TownBank, as the payor bank, had, under 4.302, until midnight Thursday to send notice of dishonor back to the Fed Reserve (now, TownBank might be able to argue that the midnight deadline was extended under 229.30(c)). ML, TownBank did not meet the midnight deadline per 4.302 b/c the returned check that arrived Wednesday was postmarked Monday, and there is no indication of another type of notice transmitted before midnight Thursday to FSB in lieu of placing the returned check in the mail before midnight Thursday. Also, under 229.33(a), b/c this is a check of 2500 (or more; i.e., large items), TownBank (as payor bank) must give (depositary bank) notice of nonpayment (by any reasonable means like here electronic message) that is received by FSB by 4 p.m. on the second business day following the banking day of actual receipt. Here, the second business day following TownBanks receipt was Friday. ML, TownBank from the facts met this notice of nonpayment requirement b/c electronic notice got there Friday at 3 p.m.). Also, Reg CC 229.30(a) requires a payor bank to return a check to depositary bank in an expeditious manner. This requirement is met under either the 2-day/4-day test, or the forward collection test. Balls check is a non-local check (b/c TownBank is located in Los Angeles and FSB is in Texasa different processing region); therefore, the four-day test is appropriate. The four-day test states that a payor bank returns a check in an expeditious manner if it returns the check in a manner that would ordinarily result in the depositary banks receipt of the returned check by 4 p.m. on the 4th business day following the banking day of receipt (presentment) by the payor bank. The 4th business day following presentment to TownBank is Tuesday b/c considered received by TownBank on Wednesday (that is, Wednesday is considered day zero for counting). Did Townbank meet this requirement? ML not b/c envelope containing returned check didnt arrive until Wednesday. We can surmise that return not mailed until Monday b/c thats the postmark. But thats not for sure, as it could have been deposited Saturday with postmark on Monday. Further, wed need the

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estimated time for delivery of a piece of mail from Los Angeles to Texas to determine whether the proper means to receipt by 4th business day by 4 pm was used by TownBank. Did TownBank meet the forward collection testdid TownBank return the check to FSB as if it were sending FSB the check for forward collection? ML not b/c if it wanted to get paid expeditiously TownBank would not have used ordinary mail postmarked Monday. So, it appears that TownBank has failed both tests under Reg CC 229.30(a) for expeditious return. So, b/c TownBank ML did not meet its midnight deadline per 4.302, it is accountable for the amount of the Ball check and therefore, FSBs provisional credit given to Carol on the check has now become final under 4.215(a)(3) (noting a settlement becomes final when a payor bank fails to timely return or send notice of dishonor). By extension, FSBs right, under 4.214(a), to charge back Carols account was not yet triggered. If that is true, Carol has a tenable claim against FSB for wrongful dishonor under 4.402 of the 2k check that was presented against her account on Monday. Now, FSB is in a tight situation b/c it received notice of nonpayment of a large item per Reg CC 229.33(a) on Friday, and naturally, it wants to charge back Carols account even though TownBank failed to meet its midnight deadline under 4.302; however, a timely notice of nonpayment for a large item under Reg CC 229.33(a) does not cure an untimely return of a check by a payor bank under 4.302s midnight deadline. So, is FSB protected in some way? Yes, the warranty of notice of nonpayment under Reg CC 229.34(b) may offset (against TownBank) some of the damages FSB may incur in a wrongful dishonor COA. The warranty also includes a promise that the expeditious return provisions will be met. But, this warranty will not cover the other actual damages available in a 4.402 COA, and serious mental anguish. This warranty also runs to Carol, and she too then is not adequately protected. Thus, Carol and FSB may try against TownBank lack of UCC good faith, or plain negligence in sending a notice of nonpayment w/o a timely return of the check by midnight deadline. Assuming, arguendo, that TownBank met its midnight deadline, than FSB, has until its midnight deadline (from the moment of learning of the payor banks return or notice of dishonor) to revoke its provisional settlement and charge back under 4.214(a). If FSB received the return check on Friday, than it has until Saturday midnight to revoke and charge back (assuming that on Saturday FSB is substantially open for business to be a banking day, which, under the UCC, unlike Reg CC, a banking day can fall on a Saturday). Encoding Warranties for Amount of Item (over-encoding/under-encoding) UCC 4.209 1) A depositary bank (or other person) who encodes information on or with respect to an item 2) After issue warrants to any subsequent collecting bank and to the payor bank that the 3) Information is correctly encoded; if the customer of a depositary bank encodes, that 4) Depositary bank also makes the warranty. EFFECT: a person to whom such warranties are made and who took the item in good faith may recover from the warrantor damages for breach of warranty actual damages suffered as a result of the breach, plus expenses and loss of interest incurred. EXCEPTION: a mis-encoding of the amount on the MICR line is not an alteration under 3.407(a), which defines alteration as changing the K of the parties. HYPO: if a drawer wrote a check for 2500 and the depositary bank encoded for 25000 on the MICR line, the payor bank could debut the drawers account for only 2500. The encoding warranty would allow the payor bank to hold the depositary bank liable for the amount paid out over 2500 w/o first pursuing the person who received payment. Now, if a drawer wrote a check

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for 25000, and the depositary bank encoded for 2500, the payor bank becomes liable for the full amount of the check. The payor banks rights against the depositary bank depend on whether the payor bank has suffered a loss. OVERENCODE: if a depositary bank over-encodes the amount on an item after issue, than the payor banks customer faces the risk of NSF for subsequent checks; therefore, the payor bank may face a wrongful dishonor suit from its customer who issued the check that was overencoded, whereupon, payor bank can sue depositary bank for breach of warranty under 4.209. UNDERENCODE: if a depositary bank under-encodes, than the depositary banks customer faces the risk of NSF for subsequent checks against their account b/c but for the under-encode it would have had more money in its account. In such a situation, the depositary bank is screwed. Reg CC 229.34(c)(3) 1) Each bank that presents or transfers a check warrants to any bank that subsequently handles it 2) That, as the time of presentment or transfer, the information encoded after issue in 3) Magnetic ink on the check is correct. LIMITED DAMAGES: 229.34(d) limits damages for breach of the encoding warranty to the face value of the check, interest lost, and incidental expenses. SET OFF: under Reg CC 229.34(c)(4), there is a setoff procedure for the bank doing significant mis-encoding to recover the amount of the check and fees, etc. HYPO Problem 3.5: Jodi Kay at CountryBank calls with a problem that Carl Eben wrote a check for $10.37 to purchase materials from Deuce Hardware. Deuces sales terminal mistakenly imprinted a MICR line indicating that the check was for $1,037,000.00. When Duece deposited the check in its account at Hunt Bank, Hund did not examine the check manually, but instead deposited the million dollars in Deuces account and forwarded the check to CountryBank for collection. B/c Jodi had authorized complete overdraft protection for Carls account, CountryBank paid the million dollars to Hunt Bank and charged Carls account; the computer generated and mailed an overdraft notice to Carl. When Jodi called Hunt Bank (depositary bank) to complain, Hunt Bank explained that it was Deuces mistake, not Hunt Bank. Jodi and CountryBank want advice. This is an encoding warranty problem. Under 4.209(a), Hunt Banks defense that it was Deuces (its customers) error is immaterial. A depositary bank still warrants the encoding even if done by one of its customers after issue of the item. B/c there is an overencoding, CountryBank could have faced a wrongful dishonor but for the overdraft protection. Thus, CountryBank should lift the overdraft and the fees for an NSF check, charge Carls account only for 10.37 and send a bill to Hunt Bank for any incidental expenses. Multi-lateral Arrangements (Clearinghouses) 1) Clearinghouses provide an efficient mechanism for clearing local checks; in most large 2) Metropolitan areas, banks clear checks drawn on other local banks through a multi-lateral 3) Clearinghouse system that nets out each banks checks on a daily basis; one of the more 4) Significant features of a clearinghouse is that the members among themselves 5) Can (and usually do) set a shorter deadline for member checks on return or notice of dishonor 6) Versus the ordinary midnight deadline under 4.302. HYPO Problem 3.6: Jodi from CountryBank mentioned that the local clearinghouse has a rule that checks presented to a clearinghouse member by the clearinghouse before 11 pm becomes final at 12 noon the next banking day. A problem occurred where b/c one of her bankers became stuck in traffic one morning. Unbeknownst to the banker, several notices were on his computer

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regarding checks written by his customers against insufficient funds. When he arrived at 12:30 in the afternoon, it was too late for him to act on the checks. The banks system proceeded to honor the checks. The bank was unable to collect the funds from the drawers of the checks and thus took a loss on the incident. Jodi wants to know what you think about the rule. She wants the clearinghouse rule pushed back later in the afternoon (maybe 6 pm). Jodi must remember that clearinghouse rules are terms of a multi-lateral contract between member banks regarding accountability for items and deadlines for dishonor, etc. Therefore, if Jodi is successful in pushing back the time to 6 p.m. the bank may have saved itself from the incident at hand, but it may be that next time its the depositary bank and a 12 noon deadline for dishonor would have been better for it b/c the payor bank would have been holding the bag this time. Risk of Loss in Checking Systemendorser liability; transfer and presentment warranties The Lifecycle of an instrument (e.g., checks and/or promissory notes) 1) Issue: first, a check is issued by the drawer to the payee (birth of the instrument); a) Under 3.105, issue means the first delivery of an instrument by the maker or drawer, b) whether to a holder or non-holder, for the purpose of giving rights on the c) instrument to any person. EFFECT: the order or promise may be drawn up and signed, but until it is issued by being delivered by the maker or drawer with the purpose of giving rights on the instrument it is only a writing. An instrument cannot be transferred until it has been issued b/c until it is issued there is no obligation to transfer. DELIVERY: an instrument must be delivered to be issued. NON-ISSUANCE NOT VIABLE DEFENSE AGAINST HOLDER DUE COURSE: in the unusual case where the instrument may not have been issued by intentional delivery, but it was prepared and signed and then found in the stream of commerce either by oversight of the maker or drawer or by improper conduct of someone else, the instrument will be enforceable by a holder in due course against the maker or drawer, but nonissuance is a good defense against holders not in due course and transferees not having the rights of a holder in due course. 2) Transfer: second, the payee transfers the check usually to the payees depositary bank (or maybe an intervening step of taking first to a check-cashing place); the depositary bank usually transfers the check to another bank in the forward collection process. Under 3.203, an instrument is transferred when it is i) delivered (by a person (i.e., a bank)) ii) other than its issuer, for the iii) purpose of giving to the person receiving delivery the right to enforce the instrument. ISSUE BEFORE TRANSFER: issuance of an instrument is not a transfer. Only after it is a live instrument, after issuance, can it be transferred. TRANSFER NOT PRESENTMENT: presentment to the payor bank is not a transfer, b/c the delivery to the person obligated to pay is made with the intent of collecting on the obligation rather than with the intent of transferring with the right to enforce. 3) Presentment: third, the depositary, or subsequent collecting bank, will present the instrument to the payor bank for payment. Under 3.501, presentment is defined i) As a demand made by or on behalf of a person (bank) entitled to enforce an ii) instrument to pay the instrument made to the drawee (payor bank) or to

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iii) accept a draft made to the drawee (payor bank). Under 3.602, an instrument is paid to the extent payment is made i) by or on behalf of a party (bank) obliged to pay the instrument, and ii) to a person entitled to enforce the instrument. EFFECT: once presented (surrendered) and paid, that is the death of the instrument. And, keep in mind that presentment is not the same as a transfer b/c the instrument is not delivered to payor bank for purpose of giving the right to enforce, but to pay or dishonor. EXCEPTIONHOLDER IN DUE COURSE: an instrument may be enforced a second time if someone comes into possession as a holder in due course. EXCEPTION: if the payor bank pays a person not entitled to enforce the instrument, as in the hypothetical case [a check stolen from the payee and on which a payment is made to the thief who forged the payees endorsement], the suspension of the underlying obligation continues b/c the check has not been paid. Therefore, even if a payor bank honors a forgery, that does not mean the item has been paid. Transfer and Presentment Warranties

Drawer Payee ~Check Casher Depositary Bank Payor Bank 1) Presentment Warranties (above parties in the diagram) can be enforced (a) against the presenter and all transferors (b) by the payor bank and only the payor bank. 2) Transfer Warranties (below parties in the diagram) can be enforced (a) against all transferors for consideration (b) by all transferees. The payor bank does not receive transfer warranties b/c the instrument is presented to the payor bank, not transferred to it. 3) Drawers make not warranties b/c they do not transfer instruments; they issue them. Person Entitled to Enforce Instrument 3.301 Person entitled to enforce an instrument means 1) the holder of the instrument; 2) a nonholder in possession of instrument who has the rights of a holder (under shelter rule); or (1) The shelter rule refers to a person in possession of the instrument (2) who received the instrument in a voluntary (e.g., stolen, shelter not apply) transfer (3) from a person entitled to enforce. 3) a person not in possession of the instrument who is entitled to enforce the instrument pursuant to 3.309 or 3.418(d) (so, non-holders can enforce). a) 3.309 Enforcement of Lost, Destroyed, or Stolen Instrumenta person not in possession of an instrument is entitled to enforce the instrument if (1) person was in possession and entitled to enforce when lost possession; (2) the loss of possession was not the result of a transfer or a lawful seizure; and (3) the person cannot reasonably obtain possession b/c the instrument was (a) destroyed, (b) its whereabouts cannot be determined, or (c) it is in the wrongful possession of an unknown person or a person that cannot

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be found or is not amenable to SOP. Holder 1.201(b)(21) 1) The person in possession of a negotiable instrument that is payable either to 2) bearer (e.g., payable to cash) or to the order of identified person that is in possession; 3) (or the person in possession of a document of title if the goods are deliverable 4) either to bearer or to the order of the person in possession.) POSSESSION: either way, to become a holder, or acquire the rights of a holder through the shelter doctrine, actual physical possession of the instrument is required. CONSTRUCTIVE POSSESSION: 4.201(a) provides when a check is deposited, the depositary bank is an agent for its customer, so the customer is in constructive possession of the check. OWNER OR WRONGFUL POSSESSION INCLUDED: a person may be entitled to enforce the instrument even though the person is not the owner of the instrument or is in wrongful possession of the instrument, e.g., a holder of bearer paper who is a thief. The right to enforce an instrument and ownership of the instrument are two different concepts. How to become a HolderPayee or Negotiation UCC 3.201 1) A person can become a holder of an instrument in one of two ways a) when the instrument is issued to that person, or b) when the instrument is negotiated to the person, and 2) Negotiation is a special type of transfer though which the transferee becomes the 3) holder of the instrument, and under 3.301 a holder is a person entitled to enforce; Std for negotiation: except for negotiation by remitter, if an instrument is a) Payable to an identified person, negotiation requires transfer of possession and its endorsement by the holder (thus, if a thief forges an endorsement and assigns to someone, that person assigned to is not a holder b/c no negotiation occurred); but SPECIAL INDORSEMNT: if an endorsement is made by the holder of an instrument, whether payable to an identified person or to bearer, and the indorsement identifies a person to whom it makes the instrument payable, its a special indorsement. When specially indorsed, an instrument becomes payable to the identified person and may be negotiated only by indorsement of that person. b) If an instrument is payable to bearer, it may be negotiated by transfer of possession alone. BLANK INDORSEMENT: if an indorsement is made by the holder of an instrument and it is not a special indorsement, it is a blank indorsement. When indorsed in blank, an instrument becomes payable to bearer and may be negotiated by transfer of possession alone until specially indorsed. This means you may have order paper that becomes bearer paper if endorsed in blank. EFFECTBREAK IN CHAIN OF TITLE: If a person takes an instrument payable to a specific person through a forged indorsement, than a negotiation has not taken place and the effect is similar to a break in the chain of title b/c all subsequent takers cannot be holders as the transferor was not a holder entitled to negotiate. VOLUNTARY--NORMALLY: negotiation occurs from a voluntary transfer of possession of an instrument by a holder to another person who becomes the holder as a result of the transfer. INVOLUNTARY: but in some cases the transfer of possession is involuntary and in some cases the person transferring possession is not a holder. Note that negotiation can occur by an involuntary transfer of possession. For example, if an instrument is payable to bearer and it is stolen by Thief or is found by Finder, Thief or Finder becomes the holder of the instrument when

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possession is obtained. In this case there is an involuntary transfer of possession that results in negotiation to Their or Finder. EXAMPLE OF BLANK INDORSEMENT: a blank endorsement is usually the signature of the indorser on the back of the instrument w/o other words. Another example is the holder of an instrument, intending to make a special indorsement, writes the words Pay to the order of w/o completing the indorsement by writing the name of the indorsee. The holders signature appears under the quoted words. The indorsment is not a special indorsement b/c it does not identify a person to whom it makes the instrument payable. Since it is not a special indorsement it is a blank indorsement and the instrument is payable to bearer. The result is analogous to that of a check in which the name of the payee is left blank by the drawerthe check is payable to bearer. Depositary Bank as Holder 4.205(a) (no endorsement needed) If a customer delivers an item to a depositary bank for collection, the depositary bank 1) Becomes a holder (entitled to enforce) if the customer at the time of delivery was a holder, 2) Whether or not the customer endorses the item, and 3) If the bank satisfies the other requirements of section 3.302, 4) The bank is a holder in due course. Presentment Warranties UCC 4.208 1) When a draft is presented to a drawee (payor bank) for payment or acceptance and 2) The drawee pays or accepts the draft, a) The person (bank) obtaining payment or acceptance, at the time of presentment, and b) All previous transferors of the draft, at the time of the transfer, c) warrant to the drawee that pays or accepts the draft in good faith that (1) the warrantor is entitled to enforce the draft (or authorized to obtain payment or acceptance of the draft on behalf of a person entitled to enforce the draft); (2) The draft has not been altered; (a) Alteration, under 3.407, means (i) unauthorized change purporting to modify the obligation of a party; or (ii) unauthorized addition of words or numbers or other change to an incomplete instrument relating to the obligation of a party. EFFECTCHECK OWNER: a fraudulent alteration discharges the obligation of the party affected by the alteration unless that party assents or is precluded from asserting that alteration, e.g., negligent safekeeping. (3) The warrantor has no knowledge that the drawers signature is unauthorized; (4) If the instrument is a demand draft, the creation of the draft according to the terms on its face was authorized by the person identified as drawer. UCC 3.417 PRESENTMENT WARRANTIES: article three has the exact same warranty as in 4.208; the reason is article four applies to banks in the forward collection process. PAYOR BANKS ONLY: the presentment warranties only apply to payor banks. EXCEPTIONFORGED DRAWERS SIGNATURE: when the situation is not a forged endorsement, but a forged drawers signature (making the check not properly payable under 4.401), the presentment warranty for the warrantor entitled to enforce is not breached. When a thief forges the drawers signature, that signature for purposes of liability, is enforceable against the thief. Therefore, the payee of such a check can enforce the check against the thief and an endorsement that is proper will qualify as a negotiation to make the transferee a holder who is

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then entitled to enforce the instrument against the thief. POLICY: under the rule of Price v. Neal payor banks face the risk of loss on forged drawers signatures. Transfer warranties, which do not apply to payor banks, provide ample protection to collecting banks from forged drawers signatures by the warranty that all signatures are authentic. There is limited protection for payor banks under the presentment warranty that the warrantor has no knowledge of forged drawer signature. DAMAGES (!!!): a payor bank may recover damages for breach of presentment warranties 1) equal to the amount paid by the payor bank 2) less the amount the payor received or is entitled to receive from drawer b/c of the payment (see 4.401(d) below that effects this part of the damage equation for presentment wtty). CHARGE BACK CUSTOMERS ACCOUNT FOR ALTRERATION 4.401(d): a bank that in good faith makes payment to a holder may charge the indicated account of its customer, even if an item is otherwise not properly payable, according to 1) The original terms of the altered item; or 2) The terms of the completed item, even though the bank knows the item has been completed (altered), unless the bank has notice that the completion was improper. HYPO: if a thief steals a check and forges the drawers signature and payable to Mr. X. Is Mr. X a holder? Yes, b/c the thiefs signature as drawer is effective for enforcement against the thief and treated as the thiefs actual signature. Thus when the payee of the check, Mr. X, endorses the check, that is an endorsement by the holder (a holder b/c issued to him) negotiated to the transferee making them now a holder entitled to enforce the instrument against the thief. Article 3 Transfer Warranties UCC 3.416 1) A person (banks included) who transfers an instrument 2) for consideration, warrants to the transferee, and 3) if transfer is by endorsement, to a subsequent transferee that a) warrantor is entitled to enforce the instrument; b) all signatures on the instrument are authentic and authorized; (1) This warranty reflects the ancient rule that payor banks take the risk of loss on forged drawers signatures in paying items that ultimately are not properly payable. That is, if this transfer warranty applied to payor banks, than it would not take such a loss b/c this warranty goes to all signatures being authentic. c) instrument has not been altered; d) the instrument is not subject to a defense (or claim in recoupment) of any party that can be asserted against the warrantor (e.g., maybe there is a fraud claim against the instrument being honored out there; or there was a break in the chain of holders); e) the warrantor has no knowledge of any insolvency proceedings commenced with respect to the maker or acceptor, or in the case of an unaccepted draft, the drawer; and f) if the instrument is a demand draft, the creation of the instrument according to the terms according to the terms on its face was authorized by the person identified as drawer. DAMAGES: a person to whom transfer warranties are made that took the instrument in good faith may recover from the warrantor an amount equal to the loss suffered as a result of the breach, but not more than the amount of the instrument plus expenses and loss of interest. DAMAGES LIMITED IF NOTICE OF BREACH BEYOND 30 DAYS: unless notice of a claim for breach of warranty is given to the warrantor (1) within 30 days (2) after the claimant has reason to know of the breach and the (3) identity of the warrantor, the liability of the warrantor is (4) discharged to the extent of any loss (suffered by warrantor) caused by the delay in giving

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notice of the claim. EXCEPTIONDISCLAIMER ON TRANSFERRED CHECKS: transfer warranties cannot be disclaimed with respect to checks. FORGED ENDORSEMENT: the transfer warranties apply against a forger of an endorsement (b/c if transfer by endorsement, the warranties of the endorser run to all subsequent transferees) b/c under 3.403, an unauthorized signature is ineffective except when forger signs a name w/o authorization to transfer to a person who, in good faith, pays the instrument or takes it for value. This means that a transferee may use the transfer warranties against a thief who forges an endorsement b/c the forged endorsement is treated as being signed by the forger. (But a forged endorsement will preclude negotiation making the transferee a holder and entitled to enforce.) FORGED DRAWERS SIGNATURE: when the situation is not a forged endorsement, but a forged drawers signature, the transfer warranty for the warrantor entitled to enforce is not necessarily breached. When a thief steals a check and forges the drawers signature, that signature is ineffective generally, but for purposes of liability, its enforceable against the thief. Therefore, the payee of such a check can enforce the check against the thief and an endorsement that is proper will qualify as a negotiation to make the transferee a holder who is then entitled to enforce the instrument against the thief. HYPO FOR CLAIM OF RECOUPMENT: for the warranty that the instrument is not subject to a claim in recoupment that can be asserted against the warrantor, this means there is no claim to recover the subject matter of the underlying transaction, e.g., breach of warranty regarding goods sold (dealt w/ in 3.305(a)(3) and (c) and look at comment 3 to 3.305 for the classical example). Article 4 Transfer Warranties 4.207 1) Article fours transfer warranties mirror article threes transfer warranties, but 2) 4.207 limits who can be a transferor to customers (of the bank) or collecting banks; 3) therefore, to pin a transfer warranty on a person other than a customer of a bank, 4) must look to 3.416 that applies to all persons. Demand Drafts (Telephone Checks) 1) A writing that is not signed by a customer, and that is created by a 2) Third party under the purported authority of the customer 3) For the purpose of charging the customers account with a bank, and a 4) Demand draft may contain any or all of the following a) The customers printed or typed name or account number; b) A notation that the customer authorized the draft; and c) The statement no signature required, authorization on file, signature on file, or words to that effect. EFFECT: Texas (and CA) adopted non-uniform warranty provisions under which each transferor (and all previous transferors) makes a transfer (3.416(a)(6)) and a presentment warranty (3.417(a)(4) that the purported drawer has authorized the item in the amount in which the item has been issued. EXCEPTIONCHOICE OF LAW RULES (3.416(e) & 3.417(g)): if the transfer or presentment warranty for demand drafts is not given by a transferor under applicable conflict of law rules, the warranty is not given to that transferor when that transferor is a transferee. In other words, if the non-Texas bank claiming breach of presentment or transfer warranties against a Texas bank would not extend to the Texas bank the demand draft warranty it is now asserting if the Texas

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bank was the transferee and the non-Texas bank was the transferor, than the demand draft warranty will not apply to the benefit of the non-Texas transferee bank. POLICY: prevent Texas transferor banks from being obligated to banks or other drawees in another state under this non-uniform warranty if Texas transferors would not be the beneficiaries of the same warranty if the situation of the parties were reversed. HYPO: Defrauder creates an unauthorized demand draft drawn against customers account in State X Bank, a bank outside of Texas. Defrauder deposits the unauthorized demand draft in its bank account in Texas Bank. The demand draft is sent by the depositary bank, Texas Bank, through the bank collection system to State X Bank, which pays the item. Customer in State X notifies State X Bank, which credits customers account for the amount of the item. State X Bank then wishes to know if it can recover against Texas Bank, the depositary bank, for breach of presentment warranty 3.417(a)(4). The answer, according to 3.417(g), depends on whether under the law of State X, including its conflict of law rules (or other applicable law if State X law did not apply), State X Bank would give the same presentment warranty to Texas Bank if their roles were reversed. If State X Bank were the depositary bank or collecting bank in which the unauthorized demand draft was deposited, or through which it was collected, and Texas Bank were the payor bank, would Texas Bank be the beneficiary of the same warranty that State X Bank seeks to assert against Texas Bank? If not, State X Bank cannot be the beneficiary of the warranty that would otherwise be given by Texas Bank. EXCEPTIONFIDUCIARIES: a demand draft does not include a check drawn by a fiduciary. TELEPHONE CHECKS: this is where the payee obtains consent for a transaction completed over the telephone; if the payee wants to use a telephone check (remotely-created consumer check) to obtain payment, it will induce the customer (the drawer of the check) to recite the routing and account number of the customer at his bank; the payee (usually a bill collection service or telemarketer) then will use that information to print a check drawn on the customers account; the check will not include a manual signature but will suggest in some way that a signature is not required, e.g., authorized by drawer. AUTHORITY: FTC regulations require the payee to retain a verifiable authorization of the transaction for 24 months (16 C.F.R. 310.5(a)(5)). That authorization could be in writing, or it could be a tape recording of an oral authorization (16 C.F.R. 310(a)(3)). PROBLEM: b/c fraud is easy for such transactions, payor banks are in a bad position b/c the item that is fraudulent is not properly payable and payor banks risk loss on forged drawers signatures. POLICY: depositary banks are in a better position to catch demand draft fraud. Endorser Liability UCC 3.415(a) 1) If an instrument is dishonored, an endorser is obliged to pay a person 2) entitled to enforce the instrument, or to a subsequent endorser who paid the endorsement, 3) the amount due on the instrument according to terms of the instrument at time endorsed, or if 4) the endorser endorsed an incomplete instrument, according to its terms when completed; a) WITHOUT RECOURSE: if an endorsement is made w/o recourse or otherwise disclaims liability of the endorser, the endorser is not liable to pay the instrument. b) ACCEPTANCE: if a draft is accepted by a bank after an endorsement is made, the liability of the endorser is discharged. c) 30 DAY LIMIT: if a check is not presented for payment, or given to a depositary bank for collection, w/in 30 days after the day the endorsement was made, the liability of the endorser is discharged.

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OWED TO WHOM: the obligation of the endorser is owed to a person entitled to enforce the instrument or to a subsequent endorser who paid the endorsement; triggered only if dishonored. STRICT: endorser liability is not based on breach of warranty or other wrong; if there is not enough money in the account or a drawer stops payment, the item is dishonored and the endorser, and previous endorsers can be held liable w/o fault. ENDORSER: an endorser can be a natural person, or a bank, or other person, b/c a negotiation cannot take place for order paper w/o an endorsement. ADVICE: as an attorney, arrange checks that are payable to your client to be payable jointly to you and your client, where upon receipt and after the client is promptly notified, atty and client should deposit the check in a trust account with clients endorsement and attys endorsement without recourse. The reason for endorsing w/o recourse is so that if the drawer stops payment or the check bounces, atty does not want to be liable as an endorser of that check. EXCEPTIONFORGED ENDORSEMENTS: under 4.201(a), a person is not liable on an instrument unless their signature is on the instrument, and if the persons signature was forged, their signature is not on the instrument for endorser liability. HYPO Problem 4.1: Nicholas Bulstrode came in this morning to discuss a forgery incident that recently occurred with respect to a 300 dollar check written by Dorothea Brooke. Dorothea wrote the check to Dr. Tertious Lydgate to pay for medical services. Bulstrode Bank honored the check, which now is in Nicholas possession. What happened was that a patient of Lydgate, Ladislaw, stole the check from Lydgates office and forged Lydgates endorsement on the check. Ladislaw then gave the check to Casaubon for a debt, and Casaubon deposited the check in his account at Wessex bank, which presented the check to Bulstrode bank for payment. Bulstrode promptly agreed to re-credit Dorotheas account. Bulstrode is galled at the prospect of taking a loss for the check and wants to know what to do. Note that Bulstrode bank honored the check, however, it has not been paid yet b/c Casaubaun and Wessex Bank were not entitled to enforce the instrument as it was forged. Because it has honored the check, Bulstrode would like to take the 300 out of Brookes account b/c she drew the check. But Bulstrode Bank cannot do that b/c under 4.401(a) this check was not properly payable b/c an item containing a forged endorsement (or forged drawers signature) is not properly payable. The item is not properly payable b/c Brooke authorized payment to the order of Lydgate, or to whom Lydgate further orders payment to be made. So, Bulstrode Bank will not recoup from Brooke, its customer, and it cant use endorser liability b/c item honored (dishonor required for endorser liability). Bulstrode then should look to presentment warranties it received under 4.208(a). Assuming, arguendo, that the item was paid, versus merely honored, Bulstrode Bank paid the draft in good faith. The person obtaining payment was Wessex Bank, and it, along with prior transferors, made the presentment warranties to Bulstrode Bank. Of the four presentment warranties, the first may be triggered. That is, that the warrantor is a person entitled to enforce the draft. The warrantors here are Wessex Bank, Casaubon, and Ladislaw. Note that 3.301(iii) does not apply b/c none of these persons are a person not in possession of the instrument who is entitled to enforce the instrument under 3.309 (lost or stolen) or 3.418(d) b/c all were in possession of the draft. Also, 3.301(ii) does not apply b/c that involves a nonholder in possession who has the rights of a holder under the Shelter rule (which involves someone who took from a transferor who had the rights to enforce in a voluntary transfer). This is a stolen check with a forged endorsement; therefore, this was not a voluntary transfer. Is Casaubom or Wessex a holder of the instrument for 3.301(i)? To be a holder it must be a person in actual possession of the instrument that is

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bearer paper (e.g., payable to cash) or payable to the order of the person in possession. Here, Casaubom and Wessex were both in actual possession of the check. But neither are holders b/c to be a holder post-issuance of order paper, the instrument must be negotiated to the putative holder. Neither Casaubom or Wessex took the instrument by negotiation b/c only an endorsement by Lydgate himself (the proper payee who became holder b/c order paper was issued to him) would have effectuated a negotiation (now if this were bearer paper, than a negotiation could have taken place whether voluntary or not provided actual possession changed), and here there was a forged endorsement. Similar to chain of title being broken, once the check was stolen from Lydgate, b/c this is order paper, a negotiation could not have taken place. Therefore, if neither took by negotiation than neither became holders and neither are entitled to enforce the instrument under 3.301. Wessex Bank has ML then breached the presentment warranty it made to Bulstrode Bank that it was a person entitled to enforce the instrument under 4.208(a)(1). But Casaubom and Ladislaw also made and breached the same presentment warranty b/c 4.208(a) states that every previous transferor of the draft makes the presentment warranties. Thus, Bulstrode Bank can pick among Wessex, Casaubom, and Ladislaw for breach of presentment warranty under 4.208(a)(1). Wessex will seek reimbursement from its own customer Casaubom by revoking its provisional settlement and charge-back under 4.214 b/c never a final settlement for the item as Bulstrode Bank eventually dishonored the check. Casaubom can then use the transfer warranties against Ladislaw under 3.416. Ladislaw transferred the check to Casaubom b/c there was a change in possession and it was for the purpose of giving Casaubom the right to enforce the check. Ladislaw ML breached 3.416(a)(1) (b/c no right to enforce), 3.416(a)(2) (b/c not all signatures on the instrument, i.e., forging Lydgates endorsement, are authentic and authorized), but 3.416(a)(3) does not apply b/c there has been no alteration. ((3.416(a)(4) was ML also breached b/c the instrument is subject to a defense or claim in recoupment that can be asserted against the warrantor, Ladislaw, b/c hes a thief who forged Lydgates endorsement; therefore, if Ladislaw sought to enforce the instrument, it would be subject to defenses.)) HYPO Problem 4.2: in the above problem, what if Bulstrode noticed the forged endorsement and dishonored the check? The most obvious answer is Wessex, under 4.214 could revoke its provisional settlement given to Casaubom and charge back the account. But if Casaubom does not have enough in his account for a complete charge back, Wessex can go after Casaubom under the transfer warranties of 3.416. Casaubom transferred the check to Wessex bank (depositary) when he deposited the check in his account. Can Wessex go after Ladislaw if Casaubom is broke? Under 4.207s transfer warranties, Wessex could not b/c Ladislaw is not a customer of Wessex Bank. But Wessex can go after Ladislaw under 3.416 b/c it applies to all persons and here, even though Ladislaw was not the one who transferred the check to Wessex Bank, 3.416 provides that if a transfer is by endorsement, the warranty runs in favor of all future transferees. The fact that Ladislaw forged the endorsement does not preclude Ladislaw from liability under the transfer warranties. Under 3.403 Ladislaws forging of Lydgates signature is ineffective except that its treated as Ladislaws signature for purposes of pinning liability on him. Here, then, Wessex and Casaubom could go after Ladislaw for the transfer warranties of 3.416(a) (1) (entitled to enforce), (2) (unauthorized signatures), and ML (4) (defense warrantor). HYPO: suppose Ladislaw stole the check but Lydgate had endorsed the check by merely writing his name on the back? The analysis changes b/c the check is endorsed in blank and now payable

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to bearer, which means anyone in possession is a holder under 1.201(b) and under 3.201(b) the check can be negotiated by mere change in possession. If Ladislaw is a holder, than, under 3.301, Ladislaw is entitled to enforce the instrumenteven though he is a thiefand the presentment and transfer warranties of person entitled to enforce is not breached (but some of the other warranties may be). Forged Drawers SignaturesRisk of Loss Generally on Payor Banks 1) A time-honored rule, dating to the famous case of Price v. Neal (1762), holds that a 2) Payor bank bears the loss if it fails to notice a forged drawers signature and honors check 3) Regardless of the payor banks exercise of care; 4) Now, under the UCC, the general rule is the same in that such a check is not properly payable 5) Thus the payor bank had no right to charge the drawers account; there are two exceptions 6) that allow the payor bank to shift that loss to some earlier party in the collection process a) [MISTAKE] First, UCC 3.418(a)(ii) where a payor bank i) pays or accepts a draft on the mistaken belief that the signature of the ii) drawer of the draft was authorized, the payor bank may recover the amount iii) from the person to whom or for whose benefit payment was made, or iv) in the case of acceptance, may revoke the acceptance. NEGLIGENCE NOT A BAR: this right is not affected by failure of the payor bank to exercise ordinary care in paying or accepting the draft. KILLERGOOD FAITH & FOR VALUE/RELIANCE: this remedy is not available against a person (banks included) who took the instrument in (1) good faith and for value, or (2) who in good faith changed position in reliance on the payment/accept. Ordinarily, the payor bank will not be able to prove bad faith or failure to pay value. HYPO: if the depositary bank (the person to whom the payor bank made payment) took the check from the forger knowing it was a forgery, the payor bank could recover from the depositary bank. b) [PRESENTMENT WARRANTY] Second, UCC 4.208(a)(3) i) imposes warranty liability on the presenting bank and from any previous transferor ii) if the transferor had knowledge that the signature of the drawer was unauthorized, iii) and knowledge is more stringent than mere notice b/c iv) knowledge means actual knowledge (here that the signature was forged). NUANCE: a payor banks exercise of care is relevant on forged drawers signatures only when the payor bank has raised the issue of negligence under 3.406 on the customer, whereupon customer can shoot back under 3.406(b) for comparative negligence. EXCEPTIONForged Drawers SignatureSignature by Representative 3.402 1) If under the law of agency the represented person would be bound by the 2) Act of the representative in signing either the name of the represented person or 3) That of the representative, the signature is the is the 4) authorized signature of the representative. CHECKS: if the check identifies the represented person, the agent who signs on the signature line does not have to indicate agency status to preclude the agents liability. HYPO Problem 4.3: Before he leaves, Bulstrode asks about another problem arising out of a

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check written on an account that Dorothea Brooke has at another bank (Wessex Bank). It appears that some unknown person stole a check from Dorotheas checkbook and issued the check by forging her signature, and it made it payable to Lydgage. Lydgate, tricked by the forger, agreed to cash the check for the forger. After Lydgate deposited the check in an account he has at Chettam Bank, Chetham, the depositary bank, forwarded the check for collection through its correspondent Bulstrode Bank, a collecting bank. Chettam included the following legend as part of its indorsement: Without recourse and Without Any Warranty Whatsoever. Wessex Bank (the payor bank) dishonored the check and returned it to Bulstrode Bank. Recognizing that he has no right to pursue Dorthea, Bulstrode wants to know if he has any basis for recovering from Chettam Bank, Lydgate, or the forger. Note that this is not a case of a forged endorsement, but a forged drawers signature. Cheatum transferred the check to Bulstrode b/c it was delivered with the purpose that Bulstrode enforce the check. Although not explicitly, Cheatum surely negotiated the check to Bulstrode b/c w/o a negotiation, Bulstrode could not become a holder entitled to enforce the check. B/c this was order paper, negotiation could occur by endorsement and change of possession. So, the question of endorser liability arises b/c the item was dishonored (an element for endorser liability). But there can be no endorser liability imposed against Cheatum under 3.415(a) b/c Cheatum successfully disclaimed endorser liability under 3.415(b) by endorsing the check without recourse. Lydgate, as the payee though can be held liable for endorder liability b/c he endorsed the check to his bank, Cheatum (the depositary bank) upon deposit (signing name on back) and there are no facts indicating he endorsed w/o recourse. What though can Bulstrode also assert against Cheatum? Transfer warranties, specifically 3.416(a)(2) that all signatures on the instrument are authentic and authorized, and possibly 3.416(a)(1) that Cheatum is a person entitled to enforce the instrument. ((I think 3.416(a)(1) is not breached b/c this is a forged drawers signature versus a forged endorsement. The payee, Lydgate, was the actual payee whos endorsement to Cheatum, who then endorsed to Bulstrode was effective for a negotiation to make a holder and therefore entitled to enforce b/c the thiefs signature as drawer is ineffective but for enforcement against the thief to make the signature treated as thiefs actual signature. That is, the payee of such a check and further endorsees of that check may enforce the check against the thief, and, therefore, the banks that the check is transferred to and the payor bank that the check is presented to is entitled to enforce the instrument as well as it was negotiated making them holders.)) Cheatum will argue that not only did it disclaim endorser liability (w/o recourse) but also any warranty whatsoever. This will not work b/c 4.207(d) states that the transfer warranties cannot be disclaimed w/ respect to checks. Could Bulstrode go after the unknown thief of the check who forged Dorotheas signature as a drawer? Yes, the thief could be held liable for transfer warranties (warrantor entitled to enforce the item; all signatures are authentic and authorized; and the item is subject to a defense of not properly payable if warrantor tried to enforce the instrument b/c stolen and forged drawor signature); endorser liability, but only if the thief made herself the payee and then endorsed the check; and drawer liability, yes, drawer liability b/c as described supra, the forgers signature is effective for purposes of pinning her with liability. HYPO Problem 4.4: referring to the preceding problem, what rights would Wessex Bank (the payor bank) have had if it had honored the check, but then re-credited Dortheas account when the fraud was discovered? Remember that payor banks generally face the risk of loss on forged drawers signatures.Wessex did the right thing with re-crediting Ds account b/c the check was not properly payable under 4.401. Can Wessex use the transfer warranties against Bulstrode

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(collecting bank) and/or Cheatum (depositary bank)? No b/c the check was not transferred to Wessex, it was presented to it as a payor bank. So, under the presentment warranties Wessex can go after Bulstrode, and Wessex. Under 4.208(a)(1), was Bulstrode a person entitled to enforce the check? This is not a case of a forged endorsement preventing a valid negotiation (b/c need proper payee for a valid endorsement for negotiation of order paper) so as to make the transferee a holder, and therefore entitled to enforce the instrument. Bulstrode has not breached 4.208(a)(1) b/c it was entitled to enforce the instrument even though the check was issued with a forged drawers signature. The reason is that Lydgate, the payee of the forged check, was the actual payee and therefore Lydgates endorsement was proper as a holder of this order paper to transfer it to Cheatum, who then endorsed to Bulstrodethere has been no break in chain of title for valid endorsements for a negotiation to make a holder who is entitled to enforce the check against the thief in this case, whos signature, under 3.403 is treated as that of the drawer. So, does Wessex have any means of redress? There is no evidence for 4.208(a) that any warrantor had actual knowledge that the drawers signature was forged. Endorser liability is not available against Bulstrode b/c Wessex, the payor bank, honored the check. That leaves 3.418 as the only means of recourse for Wessex, which will allow Wessex restitution against the person to whom payment was made or for someone who benefited from that payment if Wessex was mistaken as to the authenticity of the drawers signature; however, this sword does not cut against those who acted in good faith and took the check for value, or changed their position in reliance. Here, there are no facts that Bulstrode or Cheatum or Lydgate did not give value for the check and there is seemingly no evidence that any of them acted in bad faith (except that may get the banks on the definition of good faith that requires commercial standards of fair dealing, e.g., if there control procures were inadequate relative to industry standards). So, Wessex is left with pursuing restitution under 3.418(a) against the thief. HYPO Problem 4.5: BD asks you about a problem with CL, who carries signed checks in her wallet completed except for amount and name of payee. One of her checks was stolen and completed for 1k and cashed at Nazareth State Bank, and honored by Darrows bank FSB, which is the payor bank w/ no one noticing the problem. Carol has come to Darrow, claiming that check should not have been honored. What are FSBs options? There is no forged drawers signature here. Were any presentment warranties breached under 4.208(a)? Not (a)(1) b/c there was no forged endorsement to preclude a proper negotiation for order paper. ML the thief made it out to cash to make it bearer paper which allows negotiation through change of possession only to qualify someone as a holder and entitled to enforce. Or the thief could have made it to himself and endorsed it which would not be a forgery b/c it was issued to him as payee. But under 4.208(a)(2) has there been an alteration of this instrument? Yes, b/c under 3.407(a)(2) this was an unauthorized addition of words and numbers to an incomplete instrument. Therefore, this presentment warranty was breached, but the problem comes in FSB trying to recovery against Nazareth Bank b/c of the limitation on damages under 4.208(b) for breach of presentment warranties. That is, FSB can recover the amount paid less any amount owed to it by the drawer of the check b/c of the payment. Here, the amount was 1k and Carol was the drawer, and Carol is liable to FSB for 1k under 4.401(d)(2), which provides a payor bank authority to charge back a customers account the amount of an altered item per its original terms, or per the terms so altered, if the bank paid the item to a holder (here, Naz bank was a holder) of the instrument in good faith. So, while there was a breach under 4.208(a)(2) for alterations, there can be no recovery under 4.208(b) b/c of the amount owed to FSB by its customer, Carol.

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HYPO Problem 4.6: this time, FSBs customer, Carol, wrote a check for 1k to a supplier, but at some point in the collection process, the amount was altered to 10k. FSB did not notice the skillful alteration and he assumes he can only charge Carol for 1k. FSB wants to know how it can recover the remaining 9k. FSB can charge her 1k under 4.401(d)(1) that allows a bank to charge a customers account for an altered check it paid in good faith according to the original terms of the altered item. As to the remaining 9k FSB honored on the altered check, FSB can go after collecting banks (which includes the depositary bank) under breach of presentment warranty 4.208(a)(2) that warrants no alterations. As to damages, FSB can recover 9k (amount paid by FSB on the altered check less what FSB charged back against Carol, its customer, under 4.401(d)(1)) from collecting banks. Preventing Forgeries in the Forward Collection ProcessPositive Pay Systems 1) Positive pay systems rely on software that the customer uses to provide an 2) electronic record of all authorized checks; the customer transmits that record to its bank 3) over a phone line each day; the banks sorters are designed to recognize any check drawn 4) on such a positive-pay account and to route each such check for comparison with the 5) information provided by the customer in its previous daily transmissions; the bank honors 6) checks only if those transmissions indicate that the check actually was 7) issued by the purported drawer. NOT FAIL-SAFE: b/c the customers positive-pay employees could forge checks and include them in the transmissions, etc. AUTHORITY: arrangements are available by K varying the effect of the UCC under 4.103(a). IF NOT ON LIST: if an item is not on the list provided by the customer, the bank may dishonor the check even if ultimately the customer wanted the check honored. Risk of Loss in the Checking SystemSpecial Rules Re: negligence, bank statement rule, theft by employees, and imposters Conversion of Instrument (COA) UCC 3.420 A lawful holder of a check can sue for conversion of an instrument 1) under the CL of conversion as applied to personal property; and/or 2) An instrument is also converted a) if taken by a transfer, other than by negotiation, from a person not entitled to enforce, or b) if a bank (depositary, collecting, or payor bank) makes or obtains payment w/ respect to the instrument for a person not entitled to enforce or receive payment. GOOD FAITH NOT A DEFENSE: that a converter took the instrument in good faith, from a person whom he believed to be a holder of the instrument, does not matter for conversion b/c this is basically strict liability. EFFECT: This covers cases in which a depositary or payor bank takes an instrument bearing a forged endorsement. It also covers cases in which an instrument is payable to two persons and the two persons are not alternative payees, e.g., a check payable to John and Jane Doethe check can be negotiated or enforced only by both persons acting jointly, thus neither payee acting w/o the consent of the other is entitled to enforce the instrument and if John endorses the check and Jane does not, the endorsement is not effective to allow negotiation of the check, therefore if John deposited the check into Johns account, Depositary Bank is liable to Jane for

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conversion of the check if she did not consent to the transaction. EXCEPTION: an action for conversion of an instrument may not be brought by a) the issuer or acceptor of the instrument; or b) the payee or endorsee who did not receive delivery of the instrument either directly or through delivery to an agent or co-payee. DEFENSENegligence Substantially Contributing to Forgery or Alteration UCC 3.406 1) If a person fails to exercise ordinary care, and such failure substantially contributes to an 2) Alteration of an instrument or to the making of a forged signature on an instrument, 3) That person is precluded from asserting the alteration or forgery 4) Against a person who, in good faith, pays the instrument or takes for value or for collection. COMPARATIVE NEGLIGENCE AGAINST BANK: if the person (bank) asserting the preclusion (1) fails to exercise ordinary care themselves in paying or taking the instrument and (2) that failure contributes to loss, the loss is (3) allocated between the person precluded and the bank asserting the preclusion according to the extent to which the failure of each to exercise ordinary care contributed to the loss. Std ordinary care: (this is a fact-intensive inquiry) In the case of a person engaged in business, ordinary care means a) Observance of reasonable commercial standards, b) prevailing in the area where person is located, c) With respect to the business in which the person is engaged; In the case of a bank that takes an instrument for collection or payment (a) by automated means, reasonable commercial stds dont require the bank to (b) examine the instrument if the failure to examine does not violate the (c) banks prescribed procedures and the banks procedures do not vary (d) unreasonably from general banking usage. PROCEDURE FOR INSPECTION OF INSTRUMENTS: Case law has fleshed out two levels for determining whether a bank has reasonably commercial procedures for the inspection of instruments: (1) banks will set a floor in terms of amount of an instrument for inspecting the authenticity of signatures and alterations; (2) banks will set a percentage of instruments that will be examined that fall below the floor amount for inspection to randomly inspect for fraud for the general public to understand they cant get away from it all. EFFECT: if this defense is successfully raised, the legal effect is that the instrument is treated as never altered and any alleged forgery was not a forgery. In essence, a forged endorsement is treated as a valid endorsement meaning the depositary bank was constructively dealing with a lawful holder, and therefore taking the instrument by transfer and obtaining payment for a person entitled to enforce the instrument. SAFEGUARD PRESUMPTION: if a person negligently safeguarded check, a presumption arises that such negligence substantially contributed to the forgery or alteration. Enforcement of Lost, Destroyed, or Stolen Instrument 3.309 A person who is not in possession of an instrument, and therefore not a holder, but who owns the instrument, is entitled to enforce the instrument if the following three elements are met 1) The person was in possession and entitled to enforce it when loss of possession occurred; 2) The loss of possession was not the result of a transfer by the person or a lawful seizure; and

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3) The person cannot reasonable obtain possession of the instrument b/c the instrument a) Was destroyed, b) Its whereabouts cannot be determined, or c) It is in the wrongful possession of an unknown person, or d) A person that cannot be found be found, or is e) Not amendable to SOP. BURDEN: a person seeking enforcement of an instrument under this section must prove the terms of the instrument and the persons right to enforce the instrument. EXCEPTION: a person trying to enforce an instrument under this section may be precluded from asserting it is in the wrongful possession of an unknown person if they were negligent under 3.406(a) in the safeguarding of the instrument and substantially contributed to the loss. Problem 5.1: Cliff Janeway, a book-dealer friend of yours. He tells you that he is in Seattle and that yesterday he received a $200k check as a finders fee for locating some rare books and manuscripts for an eccentric collector. He just got off the plane and has realized that he left the check on the seat of the airplane. Does he have anything to fear if a third party takes the check, forges his indorsement, and cashes it? Cliff fears a person will come into possession of that check and forge endorsement and deposit or cash the check. If this occurs, what can Cliff do? Sue the actual tortfeasor, depositary, any collecting banks, and the payor bank, for conversion under 3.420. Section 3.420 allows Cliff to sue the actual tortfeasor under CL conversion. Section 3.420 also allows Cliff to sue the banks in the collection process if the check is taken by transfer other than negotiation from someone not entitled to enforce, or if a bank makes payment w/ respect to the instrument for a person not entitled to enforce. If a depositary bank and other collecting banks were transferred the check, it would not be by negotiation if the check has a forged endorsement. The thief would not be a holder and therefore not entitled to enforce the instrument. As to the payor bank, where Cliff has an account, if it honored the check, it would be paying or obtaining payment for someone not entitled to enforce the instrumentnamely all the transferor banks and the thief. ML he will sue the payor bank b/c it is geographically convenient. But the payor bank will argue in defense under 3.406(a) it paid the instrument in good faith and Janeway is precluded from asserting the endorsement was forged b/c Janeway failed to exercise ordinary care, and that such negligence substantially contributed to the theft of the check and the forged endorsement. On these facts alone, Janeway ML was negligent and that his negligence substantially contributed. But more facts are needed, e.g., whether there was an emergency landing. If the bank raises 3.406(a) negligence to preclude Janeway from asserting a forgery, Janeway under 3.406(b) can counter with an assertion that the bank was comparatively negligent in paying the instrument and that such failure contributed to loss, and therefore the loss should be allocated between the person precluded and the person asserting the preclusion to the extent to which the failure of each to exercise ordinary care contributed to the loss. The bank may failed to exercise ordinary care b/c maybe bank knows this is a thief; or, that the payee is Janeway, and the bank had to have an endorsement from Janeway, therefore the bank should have asked for some identification, especially on a 200k check. Further, for reasonable commercial standards, on large checks, most banks ML have a stringent control procedure and if bank did not have such a procedure, it may not have followed reasonable commercial standards. These ML get Janeway past MSJ. As an ancillary matter, Janeway is still the owner, but not the holder anymore (b/c not in possession), and may be able to enforce the instrument through stolen under 3.309, but the payor

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bank can argue again negligence under 3.406 and that weve already paid the instrument, so, our obligation to pay the instrument is discharged under 3.310. However, the collector who issued the check may go to bat for Janeway (even though not required if item paid b/c than he can argue may obligation to you is discharged under 3.310) and argue the item was not properly payable and have his bank re-credit his account leaving that bank with the option of suing collecting banks for breach of presentment warranties, e.g., forged endorsementthus not entitled enforce. Imposters UCC 3.404(a) (risk of loss generally on victim of fraud, i.e., the drawer) 1) If an imposter (by use of the mails or otherwise) is successful in inducing an instrument to be 2) Issued to the imposter, or to a person acting in concert with the imposter, 3) By impersonating the payee of the instrument (or a person authorized to act for the payee), 4) An endorsement of the instrument a) by any person in the name of the payee is b) effective as the endorsement of the payee c) if the endorsement is made in favor of a person who, in good faith i) pays the instrument, or ii) takes it for value, or iii) takes it for collection. Std endorsement: an endorsement is made in the name of a payee if 1) made in a name substantially similar to that of the (impersonated) payee; or 2) the instrument, whether or not endorsed, is deposited in a depositary bank to an account in a name substantially similar to that of the payee. EFFECT: the instrument becomes properly payable b/c endorsement is constructively valid. DEFENSECOMPARATIVE NEGLIGENCE (3.404(d)): if a person (bank) paying the instrument or taking it for value or for collection fails to exercise ordinary care in paying or taking the instrument and that failure contributes to loss resulting from payment of the instrument, the person (victim) bearing the loss may recover from the person (bank) failing to exercise ordinary care to the extent the failure to exercise ordinary care contributed to the loss. False Intent of Interest to Payee, and Fictitious Payees UCC 3.404(b) 1) If a person whose intent determines to whom an instrument is payable does not intend the person identified as payee to have any interest in the instrument; or (1) 3.110 provides that the person to whom an instrument is initially payable (2) is determined by the intent o the person, whether or not authorized, (3) signing as, or in the name or behalf of, the issuer of the instrument; and (4) if the signature of the issuer is made by automated means, the payee (5) is determined by the intent of the person who supplied the name or identification (6) of the payee, whether or not authorized to do so. 2) The person identified as payee is a fictitious person, . . . the following rules apply until the instrument is negotiated by special endorsement: (a) Any person in possession of the instrument is its holder (entitled to enforce). (b) An endorsement by any person in the name of the payee is effective as the endorsement of the payee if endorsed in favor of a person who, in good faith: (i) Pays the instrument, or (ii) Takes it for value, or

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(iii) Takes it for collection. Std endorsement: an endorsement is made in the name of a payee if 1) made in a name substantially similar to that of the (impersonated) payee; or 2) the instrument, whether or not endorsed, is deposited in a depositary bank to an account in a name substantially similar to that of the payee. DEFENSECOMPARATIVE NEGLIGENCE (3.404(d)): if a person (bank) paying the instrument or taking it for value or for collection fails to exercise ordinary care in paying or taking the instrument and that failure contributes to loss resulting from payment of the instrument, the person (victim) bearing the loss may recover from the person (bank) failing to exercise ordinary care to the extent the failure to exercise ordinary care contributed to the loss. One way to show negligence like this would be for a depositary bank taking a check for deposit w/ only one signature when the depositary agreement requires two signatures. EXCEPTIONFORGED DRAWERS SIGNATURE & 3.406: if the instrument has a forged drawers signature, 3.404(b) will not apply to shift the loss to the victim of the fraud unless the victim is also negligent under 3.406 in safeguarding the checks substantially contributing to the forgery. The reason is if the owner was not negligent, than owner will not be precluded from raising the argument of forgery of drawers signature and if owner can prove the drawers signature was forged than there was never an issue meaning the instrument was never born rendering moot (1) the issue of whether the person in possession is a holder for 3.404(b)(1), and (2) the effectiveness of the forged endorsement under 3.404(b)(2). POLICY: the general rule is the payor bank takes the loss for a forged drawors signature b/c banks are to know a customers signature, but b/c theres instances where even if the bank examines the item theres a good forgery, 3.406 and 3.404 shift the loss to the customer versus the payor bank; but there is comparative negligence for customer to share risk w/ payor bank. HYPO Comment 2, Case 1, 3.404: Treasurer is authorized to draw checks in behalf of Corporation. Treasurer fraudulently draws a check of Corporation payable to Supplier Co., a non-existent company. 3.404(b) applies b/c Supplier Co. is a fictitious person and b/c Treasurer did not intend Supplier Co. to have any interest in the check. Under 3.404(b)(1) Treasurer, as the person in possession of the check, becomes the holder of the check. Treasurer endorses the check in the name Supplier Co. and deposits it in Depositary Bank. Under 3.404(b)(2) and (c)(i), the endorsement is effective to make Depositary Bank the holder and therefore a person entitled to enforce the instrument. HYPO Comment 2, Case 2, 3.404: same facts except that Supplier Co. is an actual company that does business with Corporation. If Treasurer intended to steal the check when the check was drawn, the result is the same as above. 3.404(b) applies b/c Treasurer did not intend Supplier Co to have any interest in the check. It does not make any difference whether Supplier Co. was or was not a creditor of Corporation when the check was drawn. If Treasurer did not decide to steal the check until after the check was drawn, the case is covered by section 3.405 (employer responsibility for fraudulent endorsements by employees) rather than 3.404(b), but the result is the same (see comment 3, case 6, 3.405 (look for ***)). HYPO Comment 2, Case 3, 3.404: Checks of Corporation must be signed by two officers. President and Treasurer both signa check of Corporation payable to Supplier Co., a company that does business w/ Corp but Corp does not owe money at this time. Treasurer knows that no money is owed to Supplier Co. and does not intend that Supplier Co. have any interest in the check. President believes that money is owed to Supplier Co. Treasure obtains possession of the check after it is signed. 3.404(b) applies b/c Treasurer is a person whose intent determines to

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whom an instrument is payable and Treasurer does not intend Supplier Co to have any interest in the check. Treasurer becomes the holder of the check and may negotiate it by endorsement in the name Supplier Co. HYPO Comment 2, Case 4, 3.404: Checks of Corporation are signed by a check-writing machine. Names of payees of checks produced by the machine are determined by information entered into the computer that operates the machine. Thief, a person who is not an employee or other agent of Corporation, obtains access to the computer and causes the machine to produce a check payable to Supplier Co., a non-existent company. 3.404(b)(ii) applies. Thief then obtains possession of the check. At that point, under 3.404(b)(1) Thief becomes the holder of the check b/c Thief is the person in possession. Under 3.301 Thief, as holder, is the person entitled to enforce even though not have title and is in wrongful possession. Thief indorses the check in the name Supplier Co. and deposits the check in an account in Depositary Bank which Thief opened in the name Supplier Co. Depositary Bank takes the check in good faith and credits the account. Under 3.404(b)(2) and (c)(i), the endorsement is effective. Depositary bank becomes the holder and the person entitled to enforce. The check is presented to the drawee bank for payment and payment is made. Thief then withdraws the credit to the account. Although the check was issued w/o authority given by Corporation, the drawee bank is entitled to pay the check and charge Corps account if there was an agreement w/ Corporation allowing the bank to debit Corporationps account for payment of checks produced by the check-writing machine whether or not authorized. The endorsement is also effective if Supplier Co is a real person. In that case, 3.404(b)(i) applies. Under 3.110(b) Thief is the person whose intent determines to whom the check is payable, and Thief did not intend Supplier Co to have any interest in the check. When the drawee bank pays the check, there is no breach of warranty under presentment warranty 4.208(a)(1) b/c Depositary Bank was a person entitled to enforce the check when forwarded. HYPO Comment 2, Case 5, 3.404: Thief, who is not an employee or agent of Corporation steals check forms of Corporation. John Doe is president of Corporation and is authorized to sign checks on behalf of Corporation as drawer. Thief draws a check in the name of Corporation as drawer by forging the signature of John Doe. Thief makes the check payable to Supplier Co. with the intention of stealing it. Whether Supplier Co. is a fictitious person or real person, Thief becomes the holder of the check and the person entitled to enforce it. Thief deposits the check in an account in Depositary Bank which Thief opened in the name Supplier Co. Thief either endorses the check in a name other than Supplier Co or does not indorse the check at all. Under section 4.205(a) a depositary bank may become holder of a check deposited to the account of a customer if the customer was a holder, whether or not the customer endorses. Remember, 3.404(c)(ii) treats deposits to an account in a name substantially similar to that of the payee as the equivalent of endorsement in the name of the payee. Thus, the deposit is an effective endorsement of the check. Depositary Bank becomes the holder of the check and entitled to enforce the check. If the check is paid by the payor bank, there is no breach of the first presentment warranty b/c Depositary Bank was a person entitled to enforce the instrument when it was forwarded for payment and, unless Depositary Bank knew about the forgery of Does signature, there is no breach of the presentment warranty that the warrantor has knowledge that the drawers signature was unauthorized. B/c this was a forged drawers signature the payor bank is not entitled to charge back Corporations account unless negligence under 3.406 can be shown or the payor bank can prove up the bank statement rule in 4.406. Employers Responsibility for Fraudulent Endorsement by Employee UCC 3.405

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1) 2) 3) 4) 5)

For the purposes of determining the rights and responsibilities of a person (bank) who, in good faith, pays an instrument or takes or for value or for collection, if an employer entrusted an employee w/ responsibility w/ respect to the instrument and the employee or a person acting in concert w/ the employee makes a fraudulent endorsement a) in the name of the employer to instruments payable to the employer, and/or b) in the name of the payees of instruments issued by the employer 6) the endorsement is effective as the endorsement of the person to 7) whom the instrument is payable if it is made in the name of that person, 8) which includes an endorsement a) made in a name substantially similar to the name of that person; or b) the instrument, whether or not endorsed, is deposited in a depositary bank to an account in a name substantially similar to the name of that person. Employee: includes an independent Ktor and employee of an independent Ktor retained by the employer. Fraudulent Endorsement: means (1) for an instrument payable to the employer, a forged endorsement purporting to be that of the employer; or (2) for an instrument issued by the employer, a forged endorsement purporting to be the person identified as the payee. Responsibility: for instruments means authority (1) to sign or endorse on behalf of the employer, (2) to process instruments received by the employer for bookkeeping, for deposit to an account, or for other disposition, (3) to prepare or process instruments for issue in the employers name, (4) to supply information determining the names or address of instruments to be issued in the name of the employer, (5) to control the disposition of instruments to be issued in the name of the employer, or (6) to act otherwise w/ respect to instruments in a responsibility capacity. EXCEPTION: responsibility does not include authority that merely allows an employee to have access to instruments or blank or incomplete instrument forms being stored or transported or are part of the incoming or outgoing mail, or similar access. DEFENSENEGLIGENT BANK: if the person (bank) paying the instrument or taking it for value or for collection fails to exercise ordinary care and that failure contributes to loss resulting from the fraud, the person (employer) bearing the loss may recover from the person (bank) failing to exercise ordinary care to the extent the failure contributed to the loss. EFFECT: the risk of loss for fraudulent endorsements by employees who are entrusted w/ responsibility w/ respect to checks should fall on the employer rather than the bank that takes the check or pays it, if the bank was not negligent in the transaction. POLICY: Employers are in a better position to avoid the loss by care in choosing employees, supervising them, and in adopting measures to prevent forged endorsements on instruments payable to employer or fraud in the issuance off instruments in the name of the employer. Courts look to a few factors in determining adequate controls: (1) careful hiring, (2) vigilant supervision procedures (e.g., more than one person should be responsible for depositing checks and reconciling bank statements); and (3) periodically, review the accounting done by staff. WHEN DOES 3.404(b) APPLY INSTEAD OF 3.405?: (???) I. 3.404(b) and 3.405 both apply to situations where an employee has responsibility of checks, but 3.405 will apply, and 3.404(b) will not, where at the time an employee who has authority to issue checks on behalf of an employer (whether manually or has control of entering the names of payees for check-writing machines), i.e., whose intent determines to whom the check is payabledraws a check the employee does not intend to

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steal (but later does). But 3.404(b) will apply, and 3.405 will not, where such an employee intended to steal the check at the time the check was drawn. II. 3.405 does not apply to fictitious payees. In a situation that might trigger 3.405, if there is a fictitious payee, the analysis is only proper under 3.404(b)(ii). HYPO Comment 3, Case 1: Janitor, an employee of Employer, steals a check for a very large amount payable to Employer after finding it on a desk in one of Employers offices. Janitor forges Employers endorsement on the check and obtains payment. Since Janitor was not entrusted w/ responsibility w/ respect to the check; 3.405 does not apply. 3.406, for negligence, might apply: the issue would be whether Employer was negligent in safeguarding the check. If not, Employer could assert that the endorsement was forged and breing an action for conversion against the depositary or payor bank per 3.420. HYPO Comment 3, Case 2: X is Treasurer of Corporation and is authorized to write checks on behalf of Corporation by signing Xs name as Treasurer. X draws a check in the name of Corporation and signs Xs name as treasurer. The check is made payable to X. X then endorses the check and obtains payment. Assume that Corporation did not owe any money to X and did not authorize X to write the check. Corporation is bound as drawer of the check b/c X had authority to sign checks on behalf of Corporation. This result flows from agency law and section 3.402(a). Section 3.405, this section, does not apply b/c there is no forged endorsement. X was payee of the check so the endorsement is valid under 3.110(a). HYPO Comment 3, Case 3: the duties of Employee, a bookkeeper, include posting the amounts of checks payable to Employer to the accounts of the drawers of the checks. Employee steals a check payable to Employer which was entrusted to Employee and forges Employers endorsement. The check is deposited by Employee to an account in Depositary Bank which Employee opened in the same name as Employer, and the check is honored by the drawee bank. The endorse is effective as Employers b/c Employees duties include processing checks for bookkeeping purposes. Thus, Employee is entrused w/ responsibility w/ respect to the check. Neither Depositary Bank nor the drawee bank is liable to Employer for conversion of the check. The same result follows if Employee deposited the check in the account in Depositary Bank w/o endorsement. Under 3.405(c) deposit in a depositary bank in an account in a name substantially similar to that of Employer is the equivalent of an endorsement in the name of Employer. HYPO: Comment 3, Case 5: the computer that controls Employers check-writing machine was programmed to cause a check to be issued to Supplier Co. to which money was owed by Employer. Employee is an accounts payable clerk whose duties include entering information into the computer. Employer fraudulently changes the address of Supplier Co. in the computer. The check was mailed to the address Employee entered. Employer obtained possession of the check, endorsed it in the name of Supplier Co and deposited it in an account which Employee opened in the name of Supplier Co. The check was honored by the drawee bank. The endorsement is effective under 3.405(b) b/c Employees duties allowed Employee to supply information determining the address of the payee of the check. An employee that is entrusted with duties that enable the employee to determine the address to which a check is to be sent controls the deposition of the check and facilitates forgery of the endorsement. The employer is held responsible. The drawee may debit the account of Employe. There is no breach of presentment warranty for being a person entitled to enforce by Depositary Bank under 4.208(a)(1). HYPO Comment 3, Case 6 (***): Treasure is authorized to draw checks in behalf of Corporation. Treasurer draws a check of Corporation payable to Supplier Co. a company that sold goods to Corporation. The check was issued to pay the price of these goods. At the time the

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check was signed Treasured had no intention of stealing the check. Later, Treasurer stole the check, endorsed it in the name of Supplier Co. and obtained payment by depositing it in an account in Depositary Bank in the name Supplier Co. The endorsement is effective under 3.405(b), and note that 3.404(b) does not apply to this case as it would if Treasurer intended to steal the check at the time the check was drawn, but the result would be the same b/c under 3.404(b)(i) Treasurer did not intend for Supplier Co to have any interest in the check and under 3.404(b)(1) Treasurer would become the holder and under (b)(2) the endorsement is effective. HYPO Comment 3, Case 7: Checks of Corporation are signed by Treasurer in behalf of Corporation as drawer. Clerks duties include the preparation of checks for issue by Corporation. Clerk prepares a check payable to the order of Supplier Co. for treasurers signature. Clerk fraudulently informs Treasurer that the check is needed to pay a debt owed to Supplier Co. No money is owed to Supplier Co and Clerk intends to steal the check. Treasurer signs the check and returns it to Clerk to mail. Clerk does not endorse the check but deposits it to an account in Depositary Bank which Clerk opened in the name of Supplier Co. The check is honored by the drawee bank. Section 3.404(b)(i) does not apply b/c Clerk, under 3.110(a), is not the person whose intent determines to whom the check is payable. If Supplier Co. is a fictitious person section 3.404(b)(ii) applies. But the result is the same. Clerks deposit is treated as an effective endorsement of the check. The drawee may debit the account of Corporation and there is no breach of presentment warranty of entitled to enforce. HYPO Problem 5.2: Sir Roderick Spode, a client that Bertie Wooster referred to you operates a womans clothing store. His business processes a large number of incoming checks (paying for items that he has shipped to customers all over the country) and outgoing checks (paying for supplies, materials, and payroll). He has never had any losses from theft, but is worried about the possibility. He tells you that he has a lot of customers and workers in and out of his shop all the time. Because he has only a single very large room for his business, it is hard to keep his checkbook and blank checks in a completely inaccessible location unless he removes all of those materials from the office entirely. Spode wants to know what he needs to do to be sure that he is not stuck w/ any losses if somebody steals some blank checks. Consider the following scenarios and decide whether Spode would have any liability in any of those scenarios. a. August (Gussie) Fink-Nottle, an employee who packages outgoing shipments (but has no check writing authority) picks up one of Spodes blank checks, makes it out to himself, and forges Spodes signature as drawer. Gussie then indorses the check and deposits it in his bank. After withdrawing the funds from his account, Gussie then disappears. If Gussies bank pays the check, first recognize the check is not properly payable b/c it has an unauthorized drawers signature. But the bank can argue that Spode is precluded from arguing forgery b/c he was negligent under 3.406 in safeguarding the checks, which substantially contributed to the loss, and such preclusion, if successful, would make the check properly payable. There is case law holding negligent safeguarding of checks creates a presumption that substantially contributed to forgery. b. Stephanie (Stiff) Byng comes to Spodes office and claims to be Madeline Basset, a supplier to whom Spode owes money (whom Spode has not met). Spode issues a check to Madeline Basset and gives it to Stiffy, who indorses the check in Madelines name and cashes it. First, note 3.406 negligence may apply to preclude Spode from arguing forged endorsement. Second, and more pertinent, Stiff is impersonating the payee, Basset, of the check and under 3.404(a), for imposter situations, an endorsement by any person in the name of the payee is effective as the actual endorsement of the payee provided the endorsement is in favor of a person

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who, in good faith, pays the instrument or takes it for value or for collection. Therefore, this check is properly payable b/c under the law its an effective endorsement. Here, there was an endorsement in the name of the payee b/c Stiff signed the endorsement as Basset (clearly substantially similar to the impersonated payee). But Spode, under 3.404(d), may not have to take the full loss if he can show that a bank that paid or took the instrument for value failed to exercise ordinary care in paying the instrument to the extent that such failure contributed. This would be the case, e.g., the bank teller taking the check from Stiff should have noticed under the circumstances that this looks like different handwriting versus that of the purported payee. Or, maybe, the bank opened an account in Bassets name with Stiff impersonating Basset and failed to check identification to see if the person was actually Basset. c. Same facts as question a but instead of writing the check to himself, Gussie writes a check to Madeline Basset, intending to give the check to Gussies friend Harold (the stinker) Pinker. Pinker forges Bassets endorsement and then cashes the check. Under 3.110(a) the payee is determined by intent of the person actually signing the check, and, the person actually signing this check is Gussie, and Gussie does not intend for Basset (the named payee) to have an interest in the check. Gussie intends for Pinker to take the check. Therefore, Pinker, who is in possession of the check is its holder under 3.404(b)(1), and Pinkers endorsement, under 3.404(b)(2) is effective as the endorsement of Basset. The risk of loss is on Spode. Section 3.406 negligence is also relevant in that negligent in failing to safeguard the checks. Because this case started with a forged drawers signature, if Spode can show he was not negligent in safeguarding the checks, than he cannot be bound by the forged drawers signature and the forged endorsement under 3.404(b)(2). Now, if he was negligent under 3.406 in safeguarding the checks, than he will be precluded from asserting the forged drawers signature was forged, and if that is true, than under 3.404(b) the endorsement was not forged, unless Spode can make an argument of comparative negligence against the bank under 3.404(d). d (very good hypo). Now, Gussie, after stealing the check from Spode, makes the check out to Catsmeat Potter-Pirbright (a wholly fictitious character). Pinker indorses the check in Potter-Pirbrights name and deposits it in an account that Pinker maintains in Catsmeats name. This is the fictitious payee rule in 3.404(b)(ii) and its effect is that when the payee is a fictitious person, here Catsmeat, (1) any person in possession is a holder and therefore entitled to enforce the instrument, and (2) an endorsement by any person, here Pinker, in the name of the payee is effective as if real in favor of a bank who, in good faith, pays the instrument or takes for value or for collection. When Pinker deposited the check, under 3.404(c)(ii) that was an effective endorsement for 3.404(b)(2) b/c it was deposited in an account named substantially similar to the payee of the instrument. Therefore, the endorsement is treated as effective and Spode will take the loss unless it can show that the forgery of the drawers signature was false. If Spode can show the drawers signature was false than note that the depositary bank became the holder and the person entitled to enforce the instrument and will present the check to the drawee (payor) bank. Unless the payor bank can show that its customer, Spode was negligent under 3.406, or the bank statement rule applies under 4.406, precluding Spode from arguing forgery, the payor bank cannot charge back Spodes account and is left w/o a breach of a presentment warranty b/c depositary bank was a person entitled to enforce for 4.208(a)(1) and unless payor bank can show that the depositary bank knew the drawers signature was unauthorized, it also has no presentment warranty breach under 4.208(a)(3). But if the payor bank can show that Spode was negligent than Spode will take the loss in full under 3.404(b) b/c endorsement treated as real, unless of course Spode can show that the payor bank was partly negligent under 3.404(d).

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e. Instead of writing the check to himself, Gussie, this time assuming he is responsible for issuing checks in Spodes office, writes a check to Madeline Basset, intending to give the check to Gussies friend Harold (the stinker) Pinker. Pinker forges Bassets endorsement and then cashes the check. Under 3.402(a), Gussies signature as agent for his principal, Spode, is considered the authorized signature of the represented person, whether Gussie signs his name or Spodes name provided the check identifies the represented person whose account the check is drawn from. This means the check is properly payable under 4.401 and it also means this is not a case of a forged drawers signature. Under 3.404(b)(i), Gussie did not intend that Basset have any interest in the check, therefore, under (b)(1) Pinker is the holder and under (b)(2) the endorsement by Pinker in Bassets name is effective as if Basset endorsed it. Spode then takes the loss fully unless he can show under 3.404(d) comparative negligence of a bank in the collection process in paying or taking the check for value or for collection. f. Same facts as in question d, but Pinker stole the check and used Spodes fax signature machine to sign the check. Spodes account agreement stated any signature using that machine would be treated as authorized by Spode. Under 4.103(a) this machines signature is effective b/c 4.103 parties may vary effect of the provisions of article four by agreement as they had here. 3.404 comment 2, case 4 talks about signing checks through a check writing machine, and not surprisingly, the corporation will take the loss. Either way, the signature is good on the check b/c of bank/customer agreement. 3.404(b)(ii) will get him on the endorsement for fictitious persons i.e., catsmeat is a fictitious person, or otherwise in 3.304(b)(i). g. Gussie is also responsible for depositing incoming checks. In that capacity, Gussie forges Spodes endorsement on an incoming check payable to Spode and deposits the check in Gussies account. 3.405 applies to this situation of an employee fraudulently endorsing a check payable to the employer. We are told that Gussie is responsible for depositing checks, and is that responsible for this section? Yes under 3.405(a)(3)(ii). Gussie than endorsed in Spodes name on the incoming check and deposited the check in Gussies account. The endorsement is fraudulent b/c Gussie signed the payees name, Spode, purporting it to be authentic. The endorsement is effective as authentic under this rule. Spode takes the loss and cannot under 3.420, complain to the depositary or payor bank that it was converted. Under 3.405(b) Spode may have a chance to get some of the $ back if he can show (1) a bank failed to use ordinary care in the processing of the check, and (2) that failure contributed to the loss. h. Gussies last task is to maintain a daily list of checks authorized to be written. The list is processed early in the afternoon each day to produce the checks indicated on the list. In an effort to defraud the bank, Gussie adds names to the list that reflect fictitious persons or close friends of Gussie willing to participate in the scheme. He then intercepts the checks after Spode writes them, indorses them in the name of the payees, and deposits them in his account. This is the positive pay situation, that is, Gussie prepares checks to be signed off by Spode and enters fake persons or friend that he does not intend to have an interest in the check. Section 3.405 does not apply to fictitious payees, therefore, under 3.404(b)(ii), and (b)(1) and (2) Gussie is the holder and the endorsements are effective. 3.405 would ML also apply to make the forged endorsement effective b/c Gussies task is ML responsibility under 3.405(a)(3)(iv) (to supply information determining the names or address of payees of instruments to be issued in the name of the employer). But again, 3.405 would only apply to those payees not fictitious. By extension, the drawee bank may debit the account of Spode for the amount of the check and there is no breach of presentment warranties for person entitled to enforce for 4.208(a)(1) b/c the endorsement forged by Gussie is effective as if the true payee indorsed the check.

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Bank Statement RuleCustomers Duty to Discover and Report Unauthorized Signatures or Alteration UCC 4.406 (a banks defense to items not properly payable) 1) A bank that sends or makes available to a customer a bank statement showing 2) Payment of items for the account shall either return or make available to the customer 3) The items paid or provide information in the statement 4) Sufficient to allow the customer reasonable to identify the items paid, and 5) If the bank does not return the items, it shall provide in the statement the 6) Telephone number that the customer may call to request an item or a legible copy. Std sufficient information: if item described by item number, amount, and date paid. DUTY OF BANK: a bank is not under a duty to send a statement of account or the paid items to the customer, but if a bank does not send a statement, or does send a statement and fails to provide sufficient information, the customer does not have any duties immediately below meaning the bank has no right to assert the customer is precluded from asserting forgery or alteration against an improperly paid item. TWO DUTIES OF CUSTOMER [4.406(c)]: if a bank makes available a statement, the customer must, with each individual item (check), 1) exercise reasonable promptness in examining the statement for unauthorized alterations and/or forged drawers signature (but not forged endorsements; the customer has no real chance to inspect forged endorsements); and Reasonable promptness: reasonable promptness is not defined, but the customer and bank can define reasonable promptness in an agreement, and in one case an agreement setting reasonable promptness to 20 days to examine a bank statement was not manifestly unreasonable under 4.103 (variation). The 30 day limit in 4.406(d)(2) below is neither the definition nor the limit on what qualifies as reasonably prompt for 4.406(c). 2) promptly notify the bank if the customer a) actually discovers the forgery or alteration, and b) should reasonably have discovered the unauthorized payment. EFFECT OF CUSTOMERS FAILURE OF BREACH OF DUTIESPRECLUSION: if a bank proves the customer failed, w/ respect to items in a certain (first) statement, to comply with his/her duties, the customer is precluded from asserting against the bank: 1) [4.406(d)(1)] The customers unauthorized signature or any alteration on the items in that certain statementif the bank also proves that it suffered a loss by reason of the failure; and 2) [4.406(d)(2)] The customers unauthorized signature or alteration by same wrongdoer on any other item paid in good faith by the bankif the payment was made a) before the bank received notice of the unauthorized signature or alteration, and b) after the customer has been afforded a reasonable period of time, not exceeding 30 days, c) to examine the certain (first) statement w/ forged or altered items and notify the bank. EFFECT: 4.406(d)(2) will protect a bank only if it has paid an item in good faith after the customer has had a reasonable time, not exceeding 30 days, to examine the original first statement. To be safe, a bank should wait 30 days from the time the first original statement was made available to pay an item. IF 4.406(d)(2) NOT APPLY: if a bank has not afforded customer a reasonable time (not exceeding 30 days) under 4.406(d)(2) to examine the first original bank statement reflecting altered or forged drawers signatures, than the items in the

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subsequent statements should be examined instead under 4.406(d)(1), not (d)(2). CUSTOMERS DEFENSE TO PRECLUSIONCOMPARATIVE NEGLIGENCE [4.406(e)]: even if the customer is otherwise precluded from asserting forgery or alteration under 4.406(d), if the customer can prove that the bank failed to exercise ordinary care in paying the item and that such failure contributed to loss, the loss is allocated between the customer precluded and the bank asserting the preclusion to the extent each party is at fault. CUSTOMERS DEFENSE TO PRECLUSIONLACK OF BANK GOOD FAITH [4.406(e)]: if customer proves the bank did not pay the item in good faith, 4.406(d) preclusion will not apply. BANKS ACE IN THE HOLEFAILURE TO GIVE NOTICE OF UNAUTHORIZED DRAWERS SIGNATURES OR ALTERATIONS W/IN ONE YEAR [4.406(f)]: 1) If the customer fails to notify the bank of the customers unauthorized signature 2) On, or alteration of, any item w/in one year after the statement or items are 3) Made available to the customer, the customer is precluded from 4) Asserting against the bank such unauthorized signature or alteration, and as 5) 4.406(f) indicates, this is a bar to assertion of such claims without regard to 6) care or lack of care of either the customer or the bank. EFFECT/SCOPE: the notice requires w/in a reasonable time by 4.406(d)(2) is to prevent further unauthorized actions by the same wrongdoer, and failure to furnish such notice within the reasonable time not exceeding 30 days bars recovery on items paid subsequently to the first item or items being made available to the customer for a reasonable time. This notice in 4.406(f) bars recovery not just on subsequent items but on all items with alterations or unauthorized drawers signatures. EXCEPTIONDEFENSE FOR CUSTOMER: although 4.406(f) does not expressly so state, the bank should not be permitted to assert this preclusion if the customer proves the bank paid the items in bad faith. EXCEPTIONNO PRESENTMENT WARRANTIES: if there is a preclusion under 4.406(f), the payor bank may not recover for breach of presentment warranties under 4.208. This means the customers (payor) bank cannot, after 4.406(f) is triggered, be nice and credit the customers account and then go after the banks in the collection process for breach of presentment warranties. NOT A SOL, BUT A STATUTE OF REPOSE: The one-year period in 4.406(f) is not a SOL. This is more like a statute of repose, i.e., if the customer does not notify bank w/in one year, customer loses his COA. 4.406(f) can be looked at as a condition precedent to preserve the customers COA. VARIATION BY AGREEMENT: the 1-year period prescribed in 4.406(f) is commonly shortened by agreement between the customer and bank. In one case, the bank and customer agreed to shorten the 1-year period in 4.406(f) to 60 days. BANKS RETENTION OF RECORDS (7 years): if the items are not returned to the customer, the person (bank) retaining the items shall either retain the items or, if the items are destroyed, maintain the capacity to furnish legible copies of the items until the expiration of seven years after receipt of the items. A customer may request an item from the bank that paid the item, and that bank must provide in a reasonable time either the item or, if the item has been destroyed or is not otherwise obtainable, a legible copy of the item. A bank shall provide, on request and w/o charge to the customer, at least two items or a legible copy of the items w/ respect to each statement of account sent to the customer.

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EXCEPTIONREMEMBER: do not use the bank statement rule from 4.406 if there is another loss allocation provision that might shift the entire loss from the bank to the customer, and the most useful is 3.406 negligence. ---HYPO: Bar exam problem 8 from handout. Clarence employed Bobbie as secretary/bookkeeper. Part of Bobbies job was to gather the bills once a week, prepare for Clarences signature the checks to pay the bills, record them on the stubs in the checkbook, and mail out the checks. She was not authorized to sign checks. Clarences bank, Bank, regularly sent out monthly bank statements at the end of each month and Clarence would receive them on the 3rd day of the following month. Bank would list on the statements the paid checks showing check number, date of payment, and amount. For the type of account Clarence had, Bank did not return the cancelled checks w/ the statements. Clarence would customarily review and reconcile the statements w/in 2 weeks after receipt. On June 1, 2002, Clarence left on an extended vacation and returned on August 30, 2002. When he returned, he found a letter of resignation from Bobbie. On October 2, 2002, Clarence reviewed the May 31, June 30, July 31, and August 31 bank statements that had been received in his office on June 3, July 3, August 3, and September 3, respectively. He became suspicious when he noticed the following four checks, each in the amount of $2500 that had not been recorded on the check stubs: Check no. 100, paid by Bank on May 15; Check no. 200, paid by Bank on June 15; Check no. 300, paid by Bank on July 15; and Check no. 400, paid by Bank on August 15. When he called Bank on October 2 to inquire about those checks, he learned that they were all payable to Bobbie. Bobbie had forged Clarences signature as drawer. Bank only examined signatures on items in excess of 5k. Bank credited his account w/ 2500 for check no. 400 paid on August 15 but refused to credit any of the other amounts. Did Bank breach any of its duties to Clarence under the UCC? Bank did not have an affirmative duty to send a bank statement, however, b/c Bank chose to send a statement, Banks duty under 4.406 was to provide sufficient information reasonably to allow Clarence to identify items that have been paid. Information is sufficient in this respect if the items are identified by amount the date paid, and item number. Here, this duty of Bank appears to be satisfied. Now, if checks have a forged drawers signature, the payor bank takes the risk of loss to discover forged checks not properly payable (but if Bobbie was authorized to issue checks on behalf of Clarence, these signatures would not be forged drawers signatures, but effective). What defenses may be available? On point is the bank statement rule from 4.406 relating to a customers duties upon receipt of a bank statement. But before we get to the bank statement rule in 4.406, banks should explore whether a customer was negligent under 3.406 first. Under 3.406, if Clarence failed to exercise ordinary care and if that failure substantially contributed to making of forged signatures, he is precluded from asserting that he didnt sign these checks or Bobbie didnt have authority to sign, and if can show that, you dont need 4.406. What facts point to in making a case for negligence? First, although there are no facts indicating otherwise, Clarence should have been prudent in his hiring practices, e.g., checking criminal backgrounds. Next, more facts are needed on Clarences office controls for the safeguarding of checks. We know Bobbie didnt have authority to sign checks, but what kind of access did he have to blank checks. Clarence should have agreed with Bank that two signatures are required for honoring a check. And, theres the question of whether he was smart in taking a three-month

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vacation and the arrangements he left in place to pay bills. If Clarence is held negligent, he will, under 3.406(b) assert Bank was comparatively negligent. Although the facts are sketchy, discovery on the following matters would help in determining Banks comparative fault (ordinary care in the case of a bank observing reasonable commercial standards does not require the bank to examine the instrument if the failure to examine does not violate the banks prescribed procedures and the banks procedures do not vary unreasonably from general banking usage): whether the bank had a set of procedures for examining items, and if so, what is it, and whether the bank followed their own procedures. That Bank only examined checks exceeding 5k may be an unreasonable procedure, but there are two levels cases identify for reasonable commercial standards on inspection procedures of instruments, and Bank has met the first, that is, it has set a floor on the amount of checks that are always inspected, here 5k, and second, that there is a percentage of checks below the floor checks randomly. Here, the Bank could be criticized for not having a set percentage of checks to examine even if they fall below 5k; however, more facts are needed. Before 4.406 ordinary care is examined, an inquiry must be made into whether Bank paid the item in good faith to trigger the 4.406 defense of precluding Clarence from asserting forgery or alteration. Good faith under 1.201(a)(20) requires honest in fact and the practice of reasonable commercial standards and fair dealing. There are no facts suggesting Bank failed to follow reasonable commercial standards or engage in unfair dealing. Accordingly, assuming 3.406 negligence does not preclude Clarences assertions of forgery or alteration, Bank should look to the bank statement rule of 4.406(c) to do the same. Under 4.406(c) because the bank provided a statement to Clarence, he had two duties: first, to exercise reasonable promptness in examining the statement for forged drawers signatures or alterations; second, if Clarence found an alteration or forged drawers signature, he must promptly notify the bank. While Clarence did promptly notify the bank, that notification was not made until October 2, which, in comparison to the September 2 bank statement was ML reasonably promptly examined meaning that with regard to the August 15 check, Clarence did not fail his duty under 4.406(c) allowing Bank to preclude Clarence from asserting forgery or alteration under 4.406(d). But in comparison to the August, July, and June statements, Clarence was ML did not exercise reasonable promptness in examining his statements. Therefore, Clarence failed his duty under 4.406(c) as to the May-July statements meaning that the May 15, June 15, and July 15 checks trigger 4.406(d) if Bank is successful when Clarence asserts his account should be credited for items not properly payable. As to the certain original statement of June 3, the May 15th check must be analyzed under 4.406(d)(1) (but note 4.406 goes statement by statement, meaning that if Bobbie wrote one forged check on May 15, another on the 20th, and another on the 25,th than b/c these checks are all in the first certain statement, 4.406(d)(1) would apply, not 4.406(d)(2) for alterations and forgeries by the same wrongdoer). 4.406(d)(1) makes it so that Clarence is precluded from asserting forgery or alteration on check 100 if Bank also proves that it suffered a loss by reason of Clarences failure to inspect reasonably promptly. Bank suffered a loss b/c by the time Clarence discovered check 100 was unauthorized by forged drawers signature Bank could do little in the way of redress. Bank also suffers a loss if it re-credits Clarences account b/c no presentment warranties were breached as this was a forged drawers signature leaving Bank with no redress against transferor banks in the collection process. Under 3.418, banks have a limited opportunity for restitution against persons paid by mistake to avoid unjust enrichment. The opportunity is limited b/c this restitution is not available if the person paid by mistake changed position in good faith on reliance of the payment. Here, Bobbie was ML not in good faith b/c

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good faith requires, as a subjective prong, honesty in fact. But that aside, check 100 was paid in May, leaving over three months for the amount of that check to be spent. Therefore, Banks argument is b/c of Clarences failure, Bank lost any opportunity of meaningful restitution under 3.418 for check 100, and tangentially, Bank lost any opportunity of preventing the fraudulent checks 200, 300, and 400. For the remaining checks, 4.406(d)(2) applies, precluding Clarence from asserting forgery or alteration on any other items (those forged subsequent to check 100) b/c the same wrongdoer was involved, and the Bank paid the items in good faith before it received notice from Clarence after Clarence had a reasonable period of time to examine his statements, not exceeding 30 days, to examine the first certain statement. Regarding check 200, is Clarence precluded? The issue is whether Bank paid check 200 before Clarence was afforded a reasonable time, not exceeding 30 days, to examine the first original statement that arrived June 3 that reflects check 100. Bank paid check 200 on June 15. 4.406(d)(2) only guarantees a reasonable time, not 30 days. ML, 12 (June 3 to June 15) days was not a reasonable time b/c Clarence usually didnt examine his statements until 2 weeks after receipt. 12 days is still within two weeks to examine the statement reflecting check 100. Therefore, check 200 must be examined under 4.406(d)(1), not (d)(2). But for the 3rd and 4th checks hes past the reasonable time to examine the statement of June 3 b/c 30 days had passed from the date of receipt of that statement meaning that Clarence is precluded from asserting forgery or alteration absolving the bank from a technically improper payment of checks 300 and 400. But remember Bank voluntarily credited Clarences account for 2500 for check 400 paid August 15. There are two approaches to this dilemma. First, under 4.406(d)(2) Clarence keeps the 2500, meaning that Clarence is credited 5k total (2500 for check 100 and 2500 for check 400). Second, outside article 4, this was a voluntary payment (gift?) and there is no indication that restitution under 3.418 would apply. Finally, Clarence has two shots to avoid loss. First, that under 4.406(e) the bank failed to exercise ordinary care in paying the checks, which contributed to the loss and if that is so, the loss is allocated between customer and the bank. Ordinary care is defined in terms of reasonable commercial practices under 3.103(a)(7) (which applies to article 4) with regard to the procedures utilized in the banking industry (rather than what a reasonable person would have done under the circumstances). Further, last sentence of 4.406(e) shows that if Clarence can show the bank did not pay the items in good faith, there is no preclusion. The Consumer Credit-Card System The credit-card system involves five major participants: 1) Purchaser (Customer): holds the credit card. 2) Issuer (Bank): the bank that issued the credit card who commits to pay for purchases that the cardholder makes in according with the agreement between the issuer and the cardholder. What that means, among other things, is that the merchant that accepts a credit card ordinarily gets paid even if the cardholder ultimately fails to pay its bills. 3) Merchant: makes a sale on the strength of the relationship between the issuing bank and the purchaser. 4) Merchant Bank (Acquirer): acquires the transaction from the merchant and obtains payment from the issuer. 5) The System (usually Visa or Mastercard): lurking behind the above four parties to the transaction is the network under which the card has been issued. CONSUMER TRANSACTIONS ONLY: the rights available under TILA apply only to

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consumer transactions, not (1) transactions primarily for business, commercial, or agricultural purposes, or to the government, (2) transactions in securities or commodities accounts by a broker-dealer registered with the SEC, and (3) transactionseven if consumerin which the total amount financed exceeds $25,000.00. But TILA does apply to consumer transactions in which the total amount exceeds 25,000.00 if the transaction involves a security interest in realty, or in personal property used or expected to be used as the principal dwelling of the consumer. NOT CHECKS NOR DEBIT CARDS: the following rules do not apply to checks or debit cards. Law Applicable to Consumer Credit-Card System 1) The principal legal regulation of the credit-card system comes form the federal 2) Truth-in-Lending Act (TILA) and from 3) Regulation Z (12 C.F.R. Part 226), promulgated by the Federal Reserve under TILA. NO DIRECT UCC: no UCC article generally applicable to credit-card transactions. Cardholders Challenge of Payment of Credit Card Charges by Asserting Claims and Defenses Against Merchant Against Issuer Instead TILA 170 (Reg Z 226.12(c)) 1) A card issuer (bank), in an open end consumer credit plan shall be subject to 2) all claims (other than tort claims) and defenses arising out of any credit card transaction 3) if the following three conditions met: a) Purchaser made a good faith attempt to resolve problem w/ merchant who honored card; b) The amount of the initial transaction exceeds $50.00; and c) The initial transaction occurred i) in the same state according to the mailing address provided by the customer, or ii) within 100 miles from such address (merchants love this condition). NUANCE: Questions arise for the same state or 100 mile condition for internet and phone orders. Where do such transactions occurthe purchasers work station or the sellers main office? This is a good question. EFFECTCHARGE BACK: when a cardholder raises a valid defense against the issuer under TILA 170(a), the issuer can charge back the challenged slip to the acquirer (merchants bank): the issuing bank sends an item through the Visa network, seeking to recover the appropriate funds from the acquirer and, if all goes as it should, receives a credit from the Visa clearinghouse in the daily entry into the issuing banks bank account at its Federal Reserve bank. Similarly, the acquirers agreement with the merchant allows the acquirer to charge back the same transaction to the merchant. Thus, the acquirer removes the funds from the merchants account (just as it would remove the funds from a dishonored check that the merchant had deposited). In the end, the merchant bears the burden of obtaining payment from the disgruntled cardholder. OVERALL: if customer has a problem with a transaction and has a defense against the merchant, the customer can instead assert that defense against the issuer if the above conditions met. EXCEPTIONS TO THE SECOND AND THIRD CONDITION TO TRIGGER 170(a): if the following circumstances apply, a customer need only attempt a good faith resolution with the merchant to utilize TILA 170 and challenge payment of the statement with the issuer: any transaction in which the person/entity/merchant honoring the credit card a) is the same person as the card issuer; b) is controlled by the card issuer; c) is under direct or indirect common control with the card issuer; d) is a franchised dealer in the card issuers products or services; or

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e) has obtained the order through a mail solicitation made by or participated in by the card issuer in which the cardholder is solicited to enter into such transaction by using the credit card issued by card issuer (i.e., issuer benefits from mail). i) Thus, if the issuing bank did not participate at all in the mail order to use the issued card, the purchaser must still prove up all three conditions. ii) A good example of participation in this context is a credit-card statement that includes an advertisement soliciting the use of your credit card. EXCEPTIONALREADY PAID STATEMENT: the cardholders right under TILA 170(a) is only a right to withhold payment from the issuer; it does not include a right to seek a refund form the issuer or the merchant. Accordingly, the right dissipates as the cardholder pays off the creditcard balance generated by the transaction in question (see TILA 170(b) (limiting challenge right to the amount of credit outstanding with respect to the transaction)). But theres an issue of how much of the item in the statement must be paid, e.g., if 3k charge and only paid the minimum charge, how much of that charge is allocated to the line item at issue? This is an issue. FINALITY OF PAYMENT: the credit-card system distinctively gives the consumer a right to cancel payment that is much broader than the consumers rights in nay of the competing systems. For example, with checking, the consumer technically has the right to stop payment on a check, but that right is effective only if the consumer acts before the check is honored by the payor bank, which will be at most a matter of days and might be hours for local checks. Similarly, as we will see w/ debit cards, debit card payments are final at the moment of sale, leaving the consumer no later opportunity to stop payment. In the credit card system, however, the issuing banks obligation to pay does not become final at the time of initial payment to the acquirer (merchants bank). Rather, TILA 170 grants a cardholder the right to withhold payment on the basis of any defense that it could assert against the original merchant. For example, suppose that Cliff Janeway uses a credit card to purchase some books as a gift for a friend, relying on the merchants assurance that the books are rare first editions. If Cliff later discovers that the books in fact are note first editions, TILA 170(a) allows Cliff to refuse to pay the charge on his creditcard account. Specifically, he can assert against the issuer his ordinary K-law defense that the goods fails to conform to the underlying sales K. NOT DELINQUENT: Reg. Z 226.12(c) provides that if the cardholder validly withholds payment, the issuer shall not report that amount as delinquent until the dispute is settled or judgment is rendered. HYPO: in Hyland v. First USA Bank, plaintiffs traveled to Greece and purchased a rug on their Visa issued by First USA Bank. Plaintiffs alleged that the carpet dealer in Greece made certain express warranties regarding the authenticity of the carpet and breached those warranties under UCC 2.313(a). But plaintiffs chose not to sue the carpet dealer in Greece directly. Instead, plaintiffs alleged that under TILA 170 they are permitted to assert against Bank, as card issuer, the claim for breach of warranty that they are entitled to assert against the carpet dealer. The Bank asserted that under TILA 170(a)(3) it cannot be held liable form the loss of the carpet b/c the transaction did not occur in the state of, or within 100 miles of, Plaintiffs mailing address. The court held for the bank and noted in the present case, Plaintiffs purchased the carpet in Greece, a foreign country that is neither the same state nor within 100 miles of the Plaintiffs mailing address. Therefore, the allegations in Plaintiffs complaint do not satisfy the geographical limitation provided by 170(a)(3). HYPO Problem 6.1 (TILA 170; Reg Z 226.12(c)): Ben Darrow from FSB showed you a

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bizarre letter yesterday. The letter is from one of FSBs cardholders and describes a $475 bike that the cardholder recently purchased using an FSB Visa card. The bikes gear-shifting mechanism does not function properly and asks FSB to refund to the customer the amount shown on the customers current Visa statement for the purchase of the bike. Ben states Why should I care whether the stupid bike works? If she doesnt like it, let her take it up w/ the merchant. My only job is to make sure I pay the merchant for her charges and then make sure she pays me. Is the customer entitled to a refund? TILA 170 goes to this and provides that the customer may assert any defense (or claim, except tort claims) it may have against the merchant against the issuing bank if three conditions are met. First, the customer must, in good faith, attempt to resolve the dispute with the merchant. The facts are unclear on this condition being met but in minor charges, banks will take a customer at his word. Second, the amount of the initial transaction exceeds $50.00. Here, this condition is satisfied b/c the bike was $450.00. Third, the initial transaction took place in the same state as the mailing address previously provided by the cardholder or was within 100 miles from such address. Regarding this condition, Ben Darrow should determine where the charge was made and if it was within the same state of the purchaser or within 100 miles of the purchasers address, he should charge back the merchant and allow the merchant and the card-holder work it out. If purchasers address is outside this condition, Ben Darrow should send a courteous letter to purchaser that bank has no right to withhold payment from merchant under circumstances and the K w/ the card network. HYPO Problem 6.2: Ben then asks you how would be able to respond to a cardholders defense in cases where the cardholder asserts those defenses. How am I supposed to prove that her mountain bike works? Ben does not have to inquire whether the bike works or not b/c the three conditions for TILA 170(a) do not turn on the actual working condition of a service or product. HYPO Problem 6.3: Jodi Kay from CountryBank calls to discuss an article that she read that reports that a client of hers named CompUPlus recently filed for BR in the face of rampant consumer complaints about a new line of laptop computers. Jodi thinks that she is in good shape b/c she has never made any loans to the client (she says). The only service that she has provided has been as an acquirer (merchants bank) processing CompUPluss mail-order credit-card sales. Those sales frequently have been substantial: 150k over the last three months. Does that relationship put her employer, CountryBank, at Risk? The risk is if more customers, shortly before and after BR is filed, validly challenge payment against their issuing banks under TILA 170, those issuing banks will charge back ending with a charge back against CountryBank. CountryBank then will remove the funds from CompUBanks account . . . but if theres been a BR, the automatic stay will prohibit the removing of those funds. That is the danger, and b/c this was a mail-order transaction, there is the risk that purchasers challenging payment need only show a good faith attempt to resolve any problems with their laptops with CompUPlus to challenge payment. But this risk does not seem likely because there are no facts showing the CountryBank participated in the mail-order soliciting the use of their CountryBank credit card. HYPO Problem 6.4: McCarver runs a computer-services company and needs to pay his suppliers $10K w/in the next week or he will go out of business. He wants to use a personal consumer MasterCard with a $10K limit and then dispute the charges to defer payments indefinitely to the issuer (maybe claim that the goods are defective). Will this work? Ethically, M is attempting to use the dispute mechanisms of TILA to cheat the system. As a lawyer, assisting him would subject us to professional discipline. Legally, as a threshold matter, even if M had a good faith dispute regarding the quality of products purchased, M could not assert a defense he had against

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suppliers against his issuer under TILA 170 b/c 104(1) precludes from TILA, credit extended primarily for business purposes. Additionally, even if McCarver were to attempt to dispute a charge under TILA 170(a)(1) he would first have to make a good faith attempt to resolve the problem. It appears that McCarver does not have a good faith dispute with the suppliers, but is trying to use the card to gain an advantage because he doesnt have enough money to pay his suppliers. The best advice for M is to advance cash on the credit card and pay the suppliers with that money. When he receives the credit card bill, he should not lie, but pay the minimum payment until his financial condition improves. Credit Card Deposits are not Items under 4.104(a)(9) for provisional settlement rules of 4.214(a) or final payment rules under 4.215(e), nor are they Checks for Reg CC. 1) Item means an instrument or a promise or order to pay money 2) handled by a bank for collection or payment, 3) but the term does not include a payment order governed by a) Chapter 4Aautomated clearinghouse payments and/or commercial wire transfers; or b) Credit or debit card deposits (slips). REG CC: credit card deposits arent checks for purposes of availability of funds rules. EFFECT: although banks (e.g., acquirers) can set such rules like a 45 day period between the time of deposit of a credit card receipt and availability of such funds, practically, such a policy will cost the bank customers b/c customers are not likely to use a bank where they are unable to retain the use of their money for 45 days. HYPO Problem 6.5: Cliff Janeway has a problem with Bulstrode Bank, the acquirer that clears credit-card transactions for him. Cliff found out this morning that Bulstrode has bounced several checks of Cliffs during the last week. Cliff is pissed b/c the checks should have been covered by funds deposited into his account several days earlier in the form of credit-card receivables from his business. Bulstrode explained that it adopted a new police with respect to credit-card services. Under that policy, Bulstrode places to place a hold on Cliffs credit-card deposits for 45 days after the date Cliff deposited them to protect against the possibility that Bulstrode will be obligated to disgorge funds to card issuers if cardholders challenge any of the relevant transactions. Cliff asks isnt there a law required the bank to release the funds in just a few days; can Bulstrode do this? The answer is yes. Credit card deposits are not included in the definition of item under 4.104(a)(9) and are thus not subject to the provisional settlement rules of 4.214(a) or final payment rules under 4.215(e). So, there is no law that prevents Bulstrode from setting the policy in this problem (and ML set this policy for the same concerns expressed in problem 6.3 where acquirers are faced with the problem of a charge-back from the issuer because of a valid TILA 170(a) challenge and the merchant than having no money to remove to itself because of the merchants insolvency or worse, bankruptcy). The bottom line is there is no positive law forbidding Bulstrodes policy regarding waiting 45 days to credit a purchasers account as an acquirer for credit card receipts, but such a policy is not good business. Error and Fraud in Consumer Credit Card Transactions The credit-card system is subject to error and fraud in two general areas: (1) erroneous charges and (2) unauthorized charges. CONSUMER ONLY: TILA 104 states generally that these following rules do not apply to the extension of credit primarily for business, commercial, or agricultural purposes. As shown below, however, there is an exception for employee use of company cards.

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Cardholder TILA 103(m) 1) Any person to whom a credit card is issued or 2) Any person who has agreed w/ the card issuer to pay obligations arising from the issuance of a credit card to another person (e.g., an employer who issues company cards to employees). Unauthorized Charges TILA 133 (Reg Z 226.12(b)) A cardholder shall be liable for the unauthorized useuse by a person other than the cardholder who doesnt have actual, implied or apparent authority for the use and the holder receives no benefitof a credit card only if all of the following are met: 1) The credit card is accepted; 2) The liability is not in excess of $50.00; 3) The issuer gives adequate notice to the cardholder of the potential liability; 4) The issuer has provided the cardholder w/ a description of a means by which the issuer may be notified of loss or theft of the card, which description may be provided on the face or reverse side of the credit card statement; 5) The unauthorized use occurs before the issuer has been notified that an unauthorized use of the credit card has occurred or may occur as the result of loss, theft, or otherwise; and i) A card issuer has been notified when the cardholder has taken steps reasonably required in the ordinary course of business to provide the issuer with the pertinent information, whether or not the issuer does in fact receive such information. Notification may be given in person, by telephone or in writing. 6) The issuer has provided a method whereby the user of such card can be identified as the person authorized to use it (e.g., requiring the cardholders signature on the back of the card so merchants can compare the signatures if necessary). BURDEN: the issuer has the burden of proof to show that the use was authorized or was unauthorized and meets the above conditions under TILA 133(a). EFFECT: the $50 dollar limit is an absolute ceiling even if the cardholder is negligent or knows of the theft and never notifies the issuer of the theft (unlike checks where the owner of the check may be precluded for negligent safeguarding of checks under 3.406). But cardholders are encouraged to give notice to the issuer when it loses its credit card b/c the cardholder can cut off liability (even below the $50 threshold) by sending notice to the issuer before the issuer has been notified of an unauthorized use or that such loss may occur as a result of loss, theft, or otherwise. POLICY: the risk of loss is clearly put on issuers and merchants b/c they are in a better position to develop technologies to prevent credit-card fraud and have done a good job with signatures, asking for identification, holograms, pictures on the cards of the holders, software that flags unusual spending patterns for individual cardholders, etc. EXCEPTIONif state law or an agreement between a cardholder and the issuer imposes lesser liability than that provided in this paragraph, the lesser liability shall govern. HYPO Problem 7.1: When Cliff Janeway returned home in Denver this weekend, he called to tell you that he has discovered that he lost his Iridium Master-Card, which has a 20k limit. It now has been more than a week since he lost it. What should he do? First, remember that under TILA 170, any defense Cliff has against a merchant who honored his stolen card in the hands of a thief Cliff may assert against the issuer of his card. But Cliff also has significant protection under TILA 133 for unauthorized charges. That is, even if all of the conditions for customer liability

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on unauthorized charges are triggered, Cliffs maximum exposure is 50 dollarseven if Cliff knows of the theft and fails to report the loss of the card to his issuer. Here though, no facts show that any unauthorized charges have occurred yet. Therefore, if Cliff notifies the issuer right now, he will face NO liability because any unauthorized charges will come after the issuer receives notification of the theft of the card. Remote Credit Card TransactionsNot Per Se UnauthorizedRisk on Merchant 1) Merely b/c a merchant engages in remote transactions (e.g., phone or mail orders) 2) W/o an actual slip signed by the cardholder does not render the use of a card 3) Unauthorized under TILA 103 (o) because to be unauthorized 4) It must be someone other than the cardholder w/o actual, implied, or apparent authority 5) With no benefit going to the cardholder. EFFECT: the above conditions for limited liability of $50.00 apply for unauthorized uses for consumer credit cards. This also means that TILA 170 applies and in remote transactions, its more likely that the transaction will take place beyond the state or outside 100 miles of the last provided address of the customer (assuming the transaction takes place at the merchants office; remember there is an issue with the situs of remote transactions for the same state/100 mile rule). RISK OF LOSS IN REMOTE TRANSACTIONS: In remote transactions, (sales by telephones or, increasingly, over the internet), the risk of loss is left w/ the merchant because merchants, versus issuers, are in a better position to ensure authorized transactions remotely w/ their own procedures. Thus, merchants not dealing face-to-face accept the risk that its customer subsequently may disavow the transactions. COMPARE RISK OF LOSS IN FACE TO FACE: in face-to-face transactions, the issuer bears the loss from unauthorized charges as long as the merchant following the requisite procedures (that is, verifying the signature and obtaining the appropriate authorization for the transaction). Thus, if the merchant incurs charges by accepting a card proffered by a thief, the network rules do not permit the issuer to pass those charges back to the acquirer or the merchant. HYPO Problem 7.2: Cliff says he is about to start selling books by mail order, in an effort to build volume for his business. He is worried about accepting payment by credit cards b/c the cardholders wont be signing any slips. Does that mean the cardholders will have a greater right to get out of the transactions? No, b/c although there will be no signed slip that does not mean the charge is unauthorized. Under TILA 103(o) an unauthorized use is a use of a credit card by a person other than the cardholder who does not have actual, implied, or apparent authority for such use and from which the cardholder receives no benefit. Therefore, the usual rules on unauthorized use will apply under TILA 133(a) (limiting liability to $50.00). Also to Cliffs advantage is TILA 170 will apply and for remote transactions this means the transaction will ML take place outside the state of the customers address or outside 100 miles thereof, i.e., if there is a problem w/ the merchandise and the customer wants to challenge payment of its credit card statement against the customers issuer, they cannot b/c of the 100 mile/same state rule leaving the customer only with redress against Cliff directly versus him having to face a charge back from the issuer to the acquirer and then to Cliff. HYPO Problem 7.3 (this will be on the final): Cliff planned to take a trip to London. Several weeks ago he bought tickets to fly to London on Great Atlantic Air. Yesterday Great Atlantic Air stopped flying. This mornings paper reports that the assets of Great Atlantic are being liquidated

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in bankruptcy. Cliff purchased his ticket on his MasterCard. Can he get the money back? Yes, and he has two optionsTILA 170 and 161. Under 170, Cliff can assert against his issuer, his anticipatory repudiation (failure of consideration) COA that would otherwise be asserted against Great Atlantic Air. Now, if Cliff has already paid the MasterCard item in his bill for the airfare (or possibly paid any part of it), than 170 is not an available option b/c 170 is not a right to a refund but a mere right to defend against payment. Business Credit Cards; Limits on Liability of Employees TILA 135 1) Even though generally these rules do not apply to business extensions of credit, 2) A card issuer and a business that provides cards to employee issued by the 3) Same issuer to ten or more of its employees may, by K, agree as to 4) Liability of the business w/ respect to unauthorized use w/o regard to the 5) Protections provided in TILA 133 (50 dollar ceiling), but in no case may such 6) Business or card issuer impose liability upon any employee w/ respect to unauthorized use 7) Beyond the protections provided in TILA 133. EFFECT: an employer may be subject to liability, by agreement w/ the issuerif there are 10 or more employees issued cards by the same issuerbeyond the protections of TILA 133, but the employees issued are not subject to liability beyond the 50 dollar limit in TILA 133. REMEMBER: if a business does not issue cards to 10 or more employees, than even if the business enters into an agreement to be bound for all amounts of unauthorized charges, that agreement is unenforceable under TILA 135 and the employer must be afforded the limited liability provisions of TILA 133no more than 50 dollars per card issued to employees. HYPO Problem 7.4: Ben Darrow from FSB meets you to discuss a problem w/ some credit cards that FSB recently issued. FSB has a program that provides credit cards for small businesses, but the cardholding small business must sign an agreement accepting responsibility for any unauthorized charges that are made w/ a stolen card. Ben got in an argument w/ Carol Long after a thief that stole three credit cards she has issued to her employees. Although Carol called Ben to report the theft by the end of the day, the thief already had charged about $500 on each of the three cards. Based on Carols agreement w/ FSB, Carol was not surprised to see the unauthorized charges on the statements for those charges. B/c she had agreed to accept responsibility, she proposed to deduct them from the next paycheck due to each employee whose card was stolen. One of the employees protested arguing that Carol could not make him pay an unauthorized charge on the credit card. In response to that claim, Carol called Ben. She wants to know if the employee is right. Moreover, if the employee is right, she things Ben should bear the charge, not her. What should Ben tell her? Remember that under 133(a)(1)(B), there is a 50 dollar limit on cardholder liability for unauthorized use. Who is the cardholder where the card is issued to a company for use by the companys employees? TILA 103(m) defines cardholder as any person to whom a card is issued or any person who has agreed w/ the card issuer to pay obligations arising from the issuance of a credit to another person. The second half of this definition applies in the situation of employee issued credit cards. Therefore, here, the cardholder is ML Carols business b/c the employees do not separately enter into agreements w/ card issuers. Relevant is TILA 104 that provides these rules on credit cards apply only for consumer transactions, and not the extension of credit primarily for business, commercial, or agricultural purposes. But these rules nonetheless apply b/c TILA 135 prescribes that businesses who issue

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cards to 10 or more employees from the same issuer may K w/ an issuer of what the liability will be for unauthorized use as to the business liability, but employee liability cannot be above the protections of TILA 133 ($50). Thus, Carols employee is correct; the max Carol can hold an employee liable for is $50.00 because there is only 5 business credit cards. And, while it may seem that Carol is on the hook under TILA 135 b/c she entered into an agreement that her business is liable for unauthorized charges. But Carol should be happy b/c this agreement is not valid under TILA 135 as Carol issued cards to less than 10 employees. B/c Carol only has 5 cards, her business and this relationship between business and bank does not qualify for the contracting for liability provision in TILA 135. Therefore, Carol must be afforded the limited liability provisions of TILA 133 ($50), which means the max she can be liable for is 50 dollars per card. Even if shed distributed to more than 10 employees, CL does not have ability to enter into this agreement that he required her to sign. Ben will take the loss except for $50 per card.

Cardholder negligence on unauthorized chargeexception to TILA 133 ($50.00 limit) 1) Although UCC 3.406 (negligence), and 4.406 (bank statement rule) 2) apply to negotiable instruments and not credit cards the 2d circuit in Minskoff held that 3) when a cardholder is negligent in examining credit card statements for unauthorized charges, 4) The negligent acts or omissions of a cardholder may create apparent authority 5) To use the card in a person who obtained the card through theft or fraud 6) Shifting the loss from the issuer to the cardholder. HYPO Problem 7.6: Roderick Spode then asks for your help where Fink, through Spodes negligence permitted Fink to obtain one of Spodes blank checks and issue the check fraudulently, but in the check book there was also a credit card. Fink used Spodes card to unlawfully withdraw 1000 from Bulstrode Bank (the bank that issued the card). B/c Bulstrode has not been able to locate Fink, the bank has come after Spode. Is Spode obligated for the charge? TILA 133 makes it so that Spode is not liable for more than a $50.00 unauthorized charge. And, there is nothing in the statutes or regulations for Bulstrode to argue that Spode should pay for the 1k from a lost or stolen credit card. But Bulstrode could argue that UCC 3.406, and 4.406 apply through Minskoff to credit cards meaning that if Spode was negligent in examining his statements and promptly reporting unauthorized charges to the issuer; therefore, the unauthorized charge of $1000.00 should be borne by Spode, not the issuer, Bulstrode. Correction of Consumer Credit Card Billing Errors (erroneous charges) TILA 161 1) If an issuer, w/in 60 days after transmitting a statementcardholders receipt not required 2) To the cardholders last provided address, receives a written notice from the cardholder that a) Identifies cardholder and account number, b) Indicates a billing error, and c) The reasons for the cardholders belief that the statement contains an error 3) The issuer must send a written acknowledgement within 30 days and must 4) Resolve the claim within two billing cycles (in no event later than ninety days) by either

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a) Correcting the error; or b) Sending a written explanation, after investigation, setting forth the reasons why the issuer believes there was no error; but if the cardholder alleges that the merchant failed to deliver the goods or services covered by the charge, the issuer cannot reject the claim w/o first conducting a reasonable investigation of whether there was performance. BILLING ERROR: includes not only (1) claims that the cardholder did not make the charge in question, but also (2) claims that the merchant failed to deliver the goods and services covered by the charge in question, and even (3) requests for additional clarification about the charge. EFFECT: once a billing error is timely asserted, the issuer must stop collection temporarily. HUGE ADVANTAGE OVER TILA 170: compared to TILA 170 (challenging payment to the issuer based on claims or defenses cardholder has against merchant), the cardholder is not precluded from pressing a billing error challenge if the cardholder has already paid the charges on the statement provided, of course, that the cardholder sends proper notice within 60 days. Thus, a cardholder should assert both TILA 170 and 161. UNJUST ENRICHMENT: if cardholder misses 60-day deadline, ask them informally to correct what is clearly their error, and if they dont, sue in restitution for unjust enrichment. HYPO: if Cliffs statement shows a charge for a purchase from Amazon.com, Cliff could use the billing-error procedures not only to press a claim that he never made the purchase, but also in cases where he did purchase the books so long as he can claim that the seller never delivered the books or that he wants further information justifying the charge. HYPO Problem 7.5: you were approached about a problem w/ Bertie, that when Bertie tried to use the card to pay for lunch yesterday, the restaurant refused the card and asked Bertie to speak on the phone to a rep from the card issuer. The issuer told Bertie he is behind in payments for the past three months in the amount of $4500.00. What happened is the issuer erroneously entered a $40 dollar charge as $4000 and Bertie moved three months ago and forgot to put in a change of address and missed the last three statements. When Bertie explained the problem to the issuer service rep, the rep told Bertie about a provision in the card agreement that except as otherwise provided by federal law, all entries that appear on any account statement produced by Issuer shall be final and conclusive, and Cardholder agrees to pay all such charges that Cardholder does not contest under federal law. What can Bertie do? Bertie cannot assert this was an unauthorized charge under TILA 133 to limit his liability to $50.00 b/c the charge was authorized and what resulted was a clerical error. Bertie also cannot use TILA 170 to assert a defense to the charge against the issuer that he would have against the restaurant that charged the $40 b/c the merchant performed; the problem was a clerical error. Thus, Bertie is left with TILA 161 to assert the overcharge of $3960 (4000-40) was a billing error, which this clearly was. But Bertie has a problem b/c the issuer transmitted the statement more than 60 days ago, and although it went to the wrong address, the issuer only has to send a statement to the last provided address and actual receipt by the cardholder is not required. So, even though this was clearly a billing error, Bertie is out of luck because he missed the 60-day notice period. But Bertie still has a shot w/ an action in equity for restitution under a theory of unjust enrichment. Informally, however, Bertie should advise the issuer (bank) that if not correct this egregious error on your part, Bertie, as a wealth man will take his business elsewhere. Debit Cards, Electronic Funds Transfers (EFT) & Reg E There are two types of debit cards: (1) pin-based, and (2) pin-less.

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Pin-based Debit Cards Network of Contracts While the consumer at the terminal, the terminal transmits an encrypted electronic signal (tagged w/ the customers PIN) to the payor bank over a telephone line. The signal requests a transfer of funds from the customers account to the credit of the merchant/payee. If the PIN matches the PIN for the designated account and if the account contains available funds, the payor bank can honor or dishonor the request. Under typical network rules (contract), the payor banks obligation to pay becomes final the moment that it transmits the message back to merchant. EFFECT: if a debit card is presented fraudulently or a pin is forged, the risk of loss is not on the merchant, but the bank or financial institution that issued the debit card. The reason is they are given the chance to honor or dishonor upon the electronic request for transfer of funds. Pin-less Debit Cards Pin-less debit cards are dual-purpose in that they can be used as a pin-based debit card and a credit card; the key difference between a credit-card transaction and a pin-less debit card transaction cleared through a credit-card network is finality; as a legal matter, if a dual purpose card is used as a debit-card, that is an EFT not governed by Reg Z and TILA, and from the consumers perspective payment is as a practical matter final at the time of transactions, and the consumer has none of the TILA-based rights to challenge payment at a later time. But if the card is used as a credit-card, than the TILA protections come into play. EFFECT: while the credit card transactions run through the credit card system, it is a debit transaction and TILA does not apply b/c these are electronic funds transfers. Liability of Financial InstitutionsActs of God, Technical Malfunctions, NSF 1) A financial institution is generally liable to a consumer for failure to make an 2) Electronic funds transfer in accordance w/ the terms and conditions of an account, 3) In the correct amount or in a timely manner when properly instructed unless a) The consumers account has insufficient funds, or 4) By a preponderance of the evidence the bank shows its action or omission resulted from an a) act of God or other circumstance beyond its control, and that it exercised reasonable care to prevent such an occurrence; or an b) ordinary malfunction known to consumer or merchant at the of an attempted EFT. EFFECT: if an act of God, and bank took reasonable care, bank is not liable; instead, the consumer bears the risk of loss. And, if there is an ordinary technical malfunction known to the consumer (or merchant) at the time of an attempted EFT, loss is on the (merchant or) consumer. There is no explicit rule in EFTA or Reg E that makes the merchant so liable if they know of the malfunction, but it makes sense if they are in a better position to avoid the loss. Four Rules For Unauthorized or Fraudulent Debit Transactions EFTA 909(a) 1) The First Rule ($50.00) a) If an unauthorized transfer is made on a debit card before the bank learns that the b) Card is stolen, the maximum a customer can be held liable for is $50.00, c) Even if his account contained $100k, for unauthorized transfers regardless of fault or d) diligence on the part of the consumer, meaning that a cardholder can be held responsible e) for the $50.00 before the consumer himself knows the card has been stolen. EFFECT: implicitly this rule also means the cardholder will not be liable at all if he

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notifies the financial institution before any unauthorized transactions occur. 2) The Second Rule ($500.00) a) If the consumer learns the card is stolen and does not notify the bank w/in two business b) Days of learning of the theft, any unauthorized transfers made in those first c) two business days before the bank learns the card is lost impose liability on the consumer d) up to $50.00 under the 1st rule; and, after two days have passed since the e) time consumer has learned of the theft, and has still not notified the bank, and f) unauthorized transfers occur before the bank learns of the loss of the car, g) than under 2nd rule, the consumer can be held liable up to $500.00 (including the $50) h) provided the bank shows that these transfers would not have occurred i) had the consumer notified the institution w/in that two-day period. EFFECT: assuming the customer was aware of the theft from the moment it occurred, the consumer would be liable for a total of $500.00 if $50.00 were charged on the first two days after the card was stolen and $500.00 on the third and fourth days. REMEMBER: the temporal focus is the time the consumer learns the card is lost, not the time the card was actually lost, or the time the consumer should have learned it was lost. 3) The Third Rule (unlimited) a) Notwithstanding the first and second rule, the consumer must review its statements to b) Identify unauthorized transactions that appear on the statements, and the consumer is c) Given 60 days to review the statements starting on the day they are sent; d) If the consumer fails to report an unauthorized transaction w/in that 60-day periodOr in extenuating circumstances such as extended travel or hospitalization, w/in a reasonable period of time under the circumstances e) The consumer bears responsibility, w/ no maximum dollar limit, for any f) unauthorized transaction that occurs after the 60th day of transmission of the statement g) that would have failed had the consumer reported the problem to the bank. EFFECT: consumer liability under the 3rd rule is entirely separate from rules one and two. s Std for unauthorized EFT: 1) means an EFT from a consumers account 2) initiated by someone other than the consumer w/o actual authority and 3) from which the consumer receives no benefit. EXCEPTION: unauthorized does not mean (1) initiated by a person other than the consumer who was furnished with the card by the consumer, unless the consumer notified the financial institution that such persons are no longer authorized; (2) initiated w/ fraudulent intent by the consumer or other persons acting in concert w/ the consumer; (3) a mere billing error by bank. HYPO Problem 8.1 (pin-based card): Cliff tells you that he just got off the plane and he left his checkbook on the seat next to him when he left the plane. In his checkbook was his debit card and attached to it was his PIN. His account has about $12,000. What should he worry about? He still has some significant protection. If he just exited the plane, Cliff can immediately call the financial institution and notify them of the loss of the card. If he notifies the bank first, before any unauthorized charges are made, he will not be liable for any charges. But if an unauthorized transfer is made before the bank learns the card is lost, Cliff is on the hook up to $50.00. B/c Cliff knows the card is stolen he will be liable up to $500.00 for any unauthorized transfers that occur more than two days after learning of the theft of the card if the bank still does not know of the loss of the card. Suppose on the day he lost it, a finder pulls a thousand out of his account and

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three days later the finder pulls out 5k? The max customer is on the hook is still $500.00, b/c its 50 dollars within the 2 days from theft, and then the rule two is 500 dollars or the greater of 50 plus the amount pulled out. HYPO Problem 8.2 (pin-based card): Bill operates grocery stores in Houston. His bank has proposed him using a pin-based debit card payment system at his stores. Bill hope that it will save him a substantial amount in bad-check expenses; he currently has to write off about 1.5 percent of all receipts that come in the form of checks. But Bill is skeptical about the proposal for two reasons. He doubts the reliability of the computer technology, and he has a policy of always when his banker claims to be doing something for his benefit. Bill wants to know whether he will face any significant risk if he starts to accept the cards. If people present stolen or forged cards, between the bank and Bill, the risk of loss is not on Bills store, but on the financial institution that issued the cards because as shown above, the network rules are a form of contract and bind issuers if they accept an electronic request for the transfer of funds. If the system malfunctions, the issuer is not liable for a failure of an EFT if it can show by a preponderance that an act of God occurred and bank took reasonable care to prevent a malfunction, or that it was an ordinary technical malfunction known to consumer or merchant at time of attempted EFT (e.g., consumer trying to use an ATM that is smoking). Therefore, Bills store would be responsible for a failed EFT if he knew there was a malfunction. Erroneous Debit-Card Transactions (Error in Billing) EFTA 908 1) If a financial institution, w/in 60 days from transmitting to a consumer a statement, 2) Receives oral or written notice from the consumer indicating the consumers 3) belief there is a billing error and the amount of the error, and his reasons for the belief, 4) the financial institution shall investigate and report back to the consumer 5) w/in 10 business days, and a) if an error is found, the financial institution must, w/in one business day of finding the error correct the error w/ interest if applicable; or b) Provisionally credit the consumers account w/in 10 days of the notice by the consumer pending its investigation, but the investigation can take no longer than 45 days from the receipt of notice from the consumer that there is a billing error; and (1) But an institution need not provisionally credit the consumers account if the institution requires but does not receive written confirmation w/in 10 business days of an oral notice of error. c) if the financial institution determines there was no error, it shall deliver to the consumer an explanation w/in 3 business days after the conclusion of its investigation, and must include notice to the consumer of his right to request all documentation. Std for billing error: means, inter alia, 1) an unauthorized EFT; 2) an incorrect EFT from or to the customers account (e.g., the ; 3) a computational error by the financial institution; TREBLE DAMAGES: available against financial institution if it did not act in good faith or did not have a reasonable basis for believing that the consumers account was not in error. HYPO Problem 8.3 (dual purpose pin-less debit card): Archie purchased a new printing press about a month ago. He is not satisfied w/ its performance. He wants to withhold payment but

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when be purchased, he did so w/ his dual-purpose pin-less debit card. His bank has told him it is too late and he could not challenge the transaction. His card can contains two features, a conventional credit-card feature (MasterCard), and a debit-card feature. He believes the merchant erroneously used the debit feature. Can Archie force the bank to refund the money to him? If this were a credit-card transaction, under TILA 170, Archie could challenge payment (provided he had not already paid the line-item in his credit-card statement for the printing press) against his bank on any grounds he would have against the merchant (e.g., breach of implied warranty). But b/c his card was not used as a credit card, but as a debit card, Archie can ML not rely on TILA 170. Archie can argue that this was an unauthorized EFT and limit liability under the first ($50.00) and second rule ($500.00), but this was an authorized EFT by the consumer. There does not appear to be a billing error. Archie is stuck w/ suing the merchant directly. HYPO Problem 8.4: luck has it that Archie calls a few weeks later to report that in reviewing his bank statements in connection w/ the immediate above transactions, he noticed quite a number of unauthorized transactions. The transactions go back over a year and total $3000.00. The thief took 250 a month. Archie remembers ordering a new card about a year ago and has just remembered that the card was taken in a mugging about a year ago. He entirely forgot to do anything about the lost card. For how much of the 3k is Archie responsible. Assume that the theft occurred on March 1, that n the first day of each month the bank mails a statement that includes all of the previous transactions, and that the thefts occurred in individual 250 transactions on the 15th of each month. As to the first rule for unauthorized EFTs, he will be liable up to 50 dollars because unauthorized transfers were made before the bank knew the card was stolen. Under the second rule Archie will be on the hook for 500 (subsuming the 50 from rule one) of the 3k because transfers were made after the second day Archie learned of the theft of the card and failed to notify the bank and the bank did not know of the loss of the card. If it werent for the third rule, Archie would only be liable for 500 of the 3k. But the statements sent by the bank implicate the third rule, which allows for unlimited liability. The third rule requires Archie to report an unauthorized transfer w/in 60 days from the time of transmission from the bank. B/c Archie failed to do so, than w/in the 60 days from the time he gets his statement, rules one and two make it so that he is liable for up to 500.00. But for unauthorized charges beyond the 60th day from the transmission of the statement, Archie will be liable for all unauthorized transmissions if the bank can show they would not have occurred but for the omission. As to the March 15th $250 unauthorized transfer, rule three is not triggered because its not until the April 1st statement that the unauthorized 250 dollar transfer will be reflected starting the clock on the 60 days (yet Archie is still responsible for the 250 b/c the first and second rules apply). As to the April 15th unauthorized EFT of 250, rule 2 makes it so that Archie will incur the liability, but rule three is not yet triggered. As to the May 15th 250 unauthorized transfer, the bank bears the loss under rules one and two b/c the 500 dollar limit on liability for rule two has been exhausted, and rule three is not yet implicated for this transfer b/c it has not been 60 days from April 1, the day the first statement was sent to Archie containing the unauthorized March 15th transfer. But as to the rest of the transfers (June 15Feb 15), the third rule is triggered placing the loss on Archie. Accordingly, of the 3k transfers, only $250 is borne by the bank, w/ the rest on Archie. HYPO Problem 8.5: Cliff visits you again and in reference to 8.1 after losing his pin activated debit card he immediately went to his bank to report the card stolen on Monday March 1, the same say he learned the card was stolen. Based on a review of charges that had been posted to

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his account, he reported a total of $1000 of unauthorized charges, all of which were used to buy beer and wine at a nearby liquor store. Assuming the problem was dealt with, he went about his business. Much to his surprise, 10 days later on March 11, Cliff was given a copy from one of his suppliers advising him that the supplier was canceling its K w/ Cliff b/c Cliffs bank had bounced the check Cliff had written to that supplier on March 6. Cliff discovered that the bank bounced the check on the morning of March 9 b/c it had not determined how to respond to Cliffs claim that the beer-and-wine debit-transactions were unauthorized. Does Cliff have a COA against the bank under 4.402 for wrongful dishonor of the March 6 check? For wrongful dishonor the bank must have a duty to credit his account when the check was presented. ML Cliff does not have a wrongful dishonor COA b/c a report to the bank of unauthorized transactions qualifies as an error in billing triggering the reporting and investigation procedures for billing errors. Once notice of an error is given, banks have 10 business days to investigate and report back to the consumer and to credit the consumers account w/in one business day from the time the bank figures there was an error. But a bank can, if it needs more time, provisionally credit a consumers account and take no longer than 45 days for investigation. The problem for Cliff is the bank has 10 business days from the date of notice given to the bank to make the provisional credit. The March 6 check was presented w/in that 10 day period. Therefore, the bank was not duty bound to credit his account until the 10th business day was about to expire. Automated Clearinghouse Payments (ACH) The ACH network is a nationwide computerized counterpart to the checking system, parallel to (but separate from) the networks used for transactions on credit cards or on debt cards. The network is used for electronic transfers between accounts at American financial institutions most commonly for automated deposits of salaries and for automated payments of recurring bills (mortgages, car payments, etc.). B/c the transfers are electronic, they are governed by the EFTA and Reg E to the extent they involve consumer accounts. To the extent they cover business accounts, they are governed by UCC article 4A (wholesale or commercial wire transfers). The network generally is governed by the Operating Rules issued by NACHA (National Automated Clearing House Association). Therefore, most of these problems are governed by private rules. ACH Terminology Credit Entry (electronically: heres your money): an order or request by the payor for the transfer of money to the account of a Receiver (i.e., a credit entry usually involves a customer directing his bank to push funds to the account of a receiver, a creditor); Debit Entry (electronically: pay me): an order or request by the payee for the withdrawal of money from the transaction account of a Receiver (i.e., a debit entry usually involves a creditor directing a communication to a customer, the receivers account to pay a bill). Banking Day: any day a DFI is open to public any time for carrying on substantially all banking functions. Thus, Sundays and Saturdays can be banking days under NACHA. Each ACH transfer involved (at least) five participants: Originator: the partner that makes the entry (or communication) initiating the transaction. In a credit transfer, that is the payor; in a debit transfer, that is the payee. Originating Depositary Financial Institution (ODFI): the financial institution of the Originator. Normally, this is the location of the account from which payment is to be made in a credit entry or the account to which payment is to be in a debit entry. 78

Automated Clearing House Operator or ACH Operator: the party that carries communications (and funds) from the ODFI to the RDFI. Except in the NY Federal Reserve District, this normally is the local Fed. In transfers between different Fed Districts, there will be an Originating ACH Operator and a Receiving ACH Operator. Receiving Depositary Financial Institution (RDFI): the financial institution of the recipient. Receiver: the party to which the entry is directed. In a credit transfer, that is the payee; in a debit transfer, that is the payor. Thus, the receiver does not indicate who is the payee.

Stop Payment (Cancel) of a Debit Entry NACHA 7.4 1) Customers generally pre-approve debit entries w/ their creditors, and to cancel, 2) A receiver must provide either written or oral notification to the RDFI 3) At least three banking days before the scheduled date of the transfer; 4) But an RDFI may honor a stop payment order w/in the three-banking-day limit, 5) And if it does so, the RDFI has no resultant liability or responsibility to any 6) Originator, ODFI, or other person having any interest in the entry. WRITTEN CONFIRMATION FOR ORAL: the RDFI may require that written confirmation of a verbal stop order payment be made w/in 14 days of a verbal stop order. If the RDFI requires such written confirmation, the verbal stop order payment will cease to be binding after 14 days. RECEIVER WITHDRAWAL: a receiver may withdraw a stop payment order by providing written notice to the RDFI. LONGEVITY: a stop payment order will remain in effect (1) for six months, (2) until payment of the debit entry has been stopped, or (3) until the receiver withdraws the stop payment order, whichever occurs earliest. HYPO Problem 9.1: Your bill for internet service each month is paid by automatic deduction from your bank account. You agreed to this when you signed up for internet service w/ your ISP and provided to them account information. a. What type of ACH entry is this? This is a debit entry b/c this is the payee (originator) requesting a transfer of money out of the account of the Receiver (i.e., the party to whom the communication is directed). b. If I live in Chicago and the ISP is located in Washington State (near the Seattle Fed), identify the parties to the transaction and the roles they would play under NACHA. The ISP, the payee, is the originator who makes a debit entry (communication) w/ his ODFI (originator depositary financial institution), and the ODFI will direct the communication to the Seattle Fed, the Originating ACH Operator, and the Seattle Fed will direct the communication to the Chicago Fed, the Receiving ACH Operator, and the Chicago Fed will direct the communication to the RDFI (receiver depositary financial institution) that will debit the account of the Receiver (me, the customer), and send the payment back the way the entry came. c. Assuming the next payment is due on Monday April 1, what would you need to do to cancel that payment, and what is the latest date on which you could act to do so in a timely manner? To stop payment on a debit entry, the receiver must provide written or oral notice to the RDFI at least three banking days before the scheduled transfer. Three banking days before Monday, April 1 must be determined by whether the RDFI is open any part of the day on Sunday, and Saturday for substantially all of its banking functions. If it is on Sunday, and Saturday than Friday, March 29 is three banking days before the scheduled transfer. But all is not lost if not meet the three-day notice requirement b/c NACHA 7.4 allows RDFIs to accept stop

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payment notices w/in the three banking days before the transfer, but they dont have to. General Rule on Reversal of Entries NACHA 7.1 1) Neither an originator nor an ODFI has the right to reverse or modify an entry, 2) once the entry has been received by the Originating ACH Operator, 3) unless the exception for erroneous entries immediately below applies. EFFECT: unless the entry is erroneous, to reverse an entry, make sure the originator or ODFI does so before the Originating ACH Operator receives the entry. ExceptionReversing Erroneous Entries (Undoing an entry) NACHA 2.5.1 1) A reverse entry may be made to correct an erroneous credit or debit entry, 2) But it must be transmitted in time, through the Receiving ACH Operator, 3) To reach the RDFI by midnight of the 5th banking day 4) following the Settlement Date of the erroneous entry. Std for erroneous entry: an entry that (1) is a duplicate of an entry previously initiated; (2) orders payment to or from the wrong receiver; or (3) orders payment in the wrong dollar amount. HYPO Problem 9.2: you pay credit-card bill through an internet bill-payment service offered by your bank, through which you direct your bank to pay bills using ACH transfers. You direct a transfer to pay a 7k credit-card bill in its entirety; the next day you change your mind. Is there anything you can do to prevent the payment from being made? This is a credit entrythe payor is pushing funds to the receiver, the payee. The general rule in NACHA 7.1 is reverse entries are not allowed after the Originating ACH Operator has received the entry. Here, the decision to change mind about the entry was the next day. ML, the entry has already been transmitted to the Originating ACH Operator. There is an exception in NACHA 2.5.1: reverse entries can be made for erroneous entries w/in a time frame. Theres no error w/ this entrymerely buyers remorse. When an entry considered paidCrediting of Originators Accounts by Receiver 4.4.4 1) A receiver must credit the Originator w/ the amount of an entry credited to the Receivers 2) Account as of the Settlement Date; now, the Receiver shall have a reasonable period of time 3) After the entry is credited to the Receivers account to process and post the amount of the 4) Credit to the originators account or return the entry to the RDFI. EFFECT: Payment considered made when funds reach the receiver even if not processed yet. SETTLEMENT DATE: the date an exchange of funds w/ respect to an entry is reflected on the books of the Federal Reserve Bank(s). HYPO Problem 9.3: using the same system, you pay your monthly mortgage payment. The system shows it has made an ACH transfer w/ a settlement date of April 1 (due date for mortgage payment). Still, you receive a notice a week later from your mortgage company advising you that it has imposed a $10 late charge b/c the payment in fact had not been processed until April 2. The notice states your mortgage company takes two days to process ACH payments and thus all mortgage payments made by ACH must be transmitted two days in advance of the date on which the mortgage payment is due. What can you do? Demand the late fee cancelled b/c a receiver must credit originators account for an entry on the settlement date even if not processed yet. Wrongful DishonorRight to Return Entry; Debit Entry is an item for UCC 4.402

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1) An RDFI may return an entry for any reason, meaning in general, an RDFI 2) cannot be held liable for a wrongful dishonor of an entry; but the definition of entry, 3) states that each debit entry shall be considered an item under UCC Article 4 and that 4) Article 4 shall apply to debit entries except where the application is inconsistent w/ NACHA, 5) in which NACHA shall control; UCC 4.104(a)(9) defines item narrowly to mean 6) an instrument or promise or order to pay money handled by a bank for collection, and that 7) item does not include a payment order under Article 4A or a credit or debit card slip. EFFECT: the definition of entry that debit entries are items under article 4 is ML inconsistent w/ article 4s definition of an item b/c it excludes article 4A payment orders, which basically is an ACH for commercial purposes. Importantly, though, this definition of entry in NACHA makes it possible to argue that 4.402 wrongful dishonor applies for a wrongful return (dishonor) of a debit entry. POLICY: if this were not the meaning, a bank may, for no reason at all, even if negligent or malicious, return a debit entry causing substantial injury to the account holder. WEIRD EXCEPTION: 5.1.3 states that an RDFI may not return an entry b/c it is a credit, debit, or zero dollar entry or is a particular type of credit, debit, or zero dollar entry (??????). NUANCE: ML an RDFI not return a credit entry b/c thats money coming in. HYPO Problem 9.4: your bank mistakenly honors a check that is not properly payable from your bank account, which has the effect of depleting funds in your account. As a result, the regularly scheduled debit entry to pay your car payment is returned unpaid by your bank. The car lender repossesses your car, which causes a variety of expenses. Is your bank liable for wrongful dishonor of a debit entry? UCC 4.402 permits recovery for all damages proximately caused by a wrongful dishonor of an item. And, NACHA defines entry to mean a debit entry is to be considered an item under article 4. Therefore, good argument can use 4.402 against the bank. Receivers Right to Re-credit on Unauthorized Debit Entries NACHA 7.6.1 1) Analogous to the bank statement rule in UCC 4.406, an RDFI must promptly credit the 2) Amount of a debit entry to a receivers account if a) Receiver sends RDFI a written affidavit that the debit entry was not authorized; and b) This affidavit is sent to RDFI w/in 15 calendar days from the date the RDFI sends or makes available to the Receiver a bank statement relating to the debit entry. EFFECT: if you miss the 15-day requirement, you dont have the right to a re-credit, but bank may do so for good customer relations (goodwill). HYPO Problem 9.5: your bank statement shows a debit entry for $2100 for payment to Bank of America but you dont own a home and dont make regular mortgage payments. How quickly must your bank return the $2100 to your account? Promptly, if you sent a written affidavit explaining the debit entry was not authorized w/in 15 calendar days of the RDFI making available a bank statement relating to the debit entry. Wholesale or Commercial Wire Transfers, a/k/a funds transfers UCC Article 4A SCOPE: article 4A applies to commercial, not consumer electronic transfers covered by the EFTA and the NACHA rules above. Article 4A Only Applies to Credit Transfers (Not Debit Transfers)

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1) Funds transfers are divided into two categories determined by whether the 2) instruction to pay is given by the person making payment or the person receiving payment; a) if the instruction is given by the person making payment, that is a credit transfer; b) if the instruction is given by the person receiving payment, that is a debit transfer; 3) Article 4A governs credit transfers and excludes debit transfers. Important Definitions Funds Transfer: the series of transactions, beginning w/ the originators payment order, made for the purpose of making payment to the beneficiary of the order. Usually, funds transfers involve the Federal Reserve Bank system. The term includes any payment order by the originators bank or an intermediary bank intended to carry out the originators payment order. A funds transfer is completed by acceptance by the beneficiarys bank of a payment order for the benefit of the beneficiary of the originators payment order. Originator: the sender of the first payment order triggering the funds transfer; Beneficiary: the person to be paid by the beneficiarys bank. Sender: the person giving the instruction to the receiving bank. Payment Order: the senders instruction to a receiving bank, transmitted orally, electronically, or in writing, to pay, or to cause another bank to pay, a fixed or determinable amount of money to a beneficiary if The instruction does not state a condition of payment other than the time of payment; & The receiving bank is to be reimbursed by the sender; Receiving Bank: the bank that initially receives the senders payment order; a payment order is issued when it is sent to the receiving bank. Originators Bank: The receiving bank that was issued the payment by the originator if originator not a bank; or the originator if the originator is a bank. Beneficiarys Bank: the bank identified in a payment order in which an account of the beneficiary is to be credited. Intermediary Bank: a receiving bank other than the originators or beneficiarys bank. Payment by Originator to Beneficiary; Discharge of Underlying Obligation 4A.406 1) The originator pays the beneficiary at the time the payment order is 2) accepted by the beneficiarys bank in an amount equal to the 3) amount of the order accepted by the beneficiarys bank. EFFECTDISCHARGE: if such payment is made to satisfy an obligation, the obligation is discharged to the extent of the amount of the payment order. Acceptance of Payment Order 4A.209 1) A receiving bank other than benfs bank accepts a payment order when it executes the order; 2) A beneficiarys bank accepts a payment order at the earliest of the following three times a) [Paid or notified beneficiary] When bank pays the beneficiary, or notifies beneficiary of receipt of the order, unless (a) The notice indicates that the bank is rejected the order or that (b) funds may not be w/drawn or used until receipt of payment from the sender;

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b) [Beneficiary Bank Paid in Full] When the bank receives payment of the entire amount of the senders order, per 4A.403(a)(1) or (2), which provides (1) Payment occurs, if the sender is a bank, when the receiving bank receives final settlement (through a Fed Reserve Bank or through a funds transfer system); or (2) Payment occurs, if the sender is a bank and has (i) credited the receiving banks account, or (ii) credited an account of the receiving bank at another bank, when the credit is withdrawn (or, the receiving bank learns the credit can be withdrawn by midnight of the day on which the credit can be withdrawn). c) [Implied Acceptance] At the opening of the next funds transfer business day of the beneficiary bank following the payment date of the order if, at that time (1) the amount of the senders order is fully covered by a (2) withdrawable credit balance in an authorized account of the sender or (3) the beneficiary bank has otherwise received full payment from the sender, unless (a) the order was rejected before that time or is rejected within (i) one hour after that time, or (ii) one hour after the opening of the next business day of the sender following the payment date, whichever time is later. EFFECT: if the beneficiarys bank does not accept the order, the underlying obligation is not paid, i.e., not discharged, meaning the beneficiary can sue on the obligation. NO DUTY TO ACCEPT: a receiving bank has no duty to accept a payment order unless the bank makes an agreement, either before or after issuance of the payment order, to accept it, or acceptance is required by a funds transfer system rule (e.g., fed-wire). Fedwire Funds Transfers 4A.209(b)(2), Comment 6 1) Section 4A.209(b)(2) (the second out of three options above for acceptance) results in 2) Automatic acceptance of payment orders issued to a beneficiarys bank by means of 3) Fedwire b/c the Federal Reserve account of the beneficiarys bank is credited and 4) Final payment is made to that bank when the payment order is received 5) Out of the senders account w/ the Fed. Execution of a Payment Order 4A.301 1) A payment order is executed by the receiving bank when it issues a payment order 2) Intended to carry out the payment order received by the bank; 3) A payment order received by the benfs bank can be accepted but cannot be executed. Obligation of Beneficiarys Bank Once Payment Order is Accepted 4A.404 1) If a beneficiarys bank accepts a payment order, regardless of whether it has been paid, 2) the beneficiarys bank is obliged to pay the amount of the order to the beneficiary, and 3) Payment is due on the payment date of the order, but if acceptance occurs on the 4) Payment date after the close of the funds transfer business day of the bank, 5) Payment is due on the next funds transfer business day. BANKS EXPOSURE: if the beneficiarys bank refuses to pay after demand by the beneficiary and notice is given to the bank that consequential damages may arise from the refusal, the beneficiary may recover damages resulting to the extent the bank had notice, unless the bank proves it did not pay b/c of a reasonable doubt concerning the beneficiarys right to payment.

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BANK CANNOT DISCLAIM EXPOSURE: the right of a beneficiary to receive payment and damages under 4A.404 may not be varied by agreement or a funds transfer rule. NOTICE IF TO AN ACCOUNT: if the payment order instructs payment to an account of the beneficiary, the bank is obliged to notify the beneficiary of receipt of the order before midnight of the next funds transfer business day following the payment date. Notice may be given by first class mail or any other reasonable means. If the bank fails to give the required notice, the bank is obliged to pay interest to the beneficiary on the amount of the payment order from the day notice should have been given. No other damages are recoverable. Rejection of a Payment Order 4A.210 1) A payment order is rejected by the receiving bank by a notice of rejection transmitted to the 2) Sender orally, electronically, or in writing; the notice need not use any particular words and 3) Is sufficient if it indicates that the receiving bank is rejecting the order or 4) will not execute or pay the order; rejection is effective when the notice is given by 5) reasonable means, and if there is an agreement between sender and receiving bank 6) on the means to be used to reject a payment order establishes what is reasonable 7) and any means not complying w/ agreement are unreasonable unless no significant 8) delay in receipt of the notice from the use of the non-complying means. EFFECT: rejection of a payment order precludes a later acceptance of the order. EXCEPTION: acceptanceunder any of the above three methodsof a payment order precludes a later rejection of the order. HYPO Problem 10.1: Nick has a problem related to a payment from Walter Bray. Bray owed Nick 100k on a promissory note; the entire sum was due to Nick on April 1. Accordingly, on Monday March 30, Bray asked his bank (Gride Natl Bank) to send a wire transfer to Nicks account at Cheeryble State Bank. Gride sent a telex to Cheeryble executing Brays request on the morning of Tuesday March 31, calling for payment to Nick on April 1. Pursuant to a preexisting agreement between Gride and Cheeryble, Cheeryble was entitled to obtain payment for that order from Grides account at Cheeryble. At the time, that account contained more than enough funds. Unfortunately, the Nick order was misplaced. Accordingly, Cheeryble did not accept or reject the order and not notify Nick that the payment from Bray had come in by wire. On Friday, April 3, the Comptroller of the Currency closed Gride and appointed the FDIC receiver to supervise the winding up of Grides affairs. B/c Gride had withdrawn all of its funds late Thursday afternoon, no funds remained in the Gride account at Cheeryble. a. Now its April 6, five days late; can Nick pursue Bray for the 100k? Or, is he entitled to payment from Cheeryble? As a preliminary matter, Bray is the originator of the funds transfer because he sent the payment order to Gride, which is the originators bank because it is the receiving bank and the originator is not a bank; Cheeryble is the beneficiarys bank, where the beneficiary, Nick, keeps his account. Also, Brays payment order is effective even if it was sent orally (or electronically, or written). Gride executed Brays payment order by issuing another payment order by telex to Cheeryble, instructing money to be put in Nicks account. Cheeryble therefore is the beneficiary bank and the receiving bank of the second payment order from Gride. When Cheeryble puts the money in Nicks account that is not another payment order. Whether Nick can sue Bray is answered by 4A.406. In 4A.406(a), an originator, here Bray, paid Nick, the beneficiary at the time the payment order was accepted by Cheeryble, the beneficiary bank, up to the amount of the payment order. Before we decide whether Cheeryble

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accept the payment order from Gride, did Gride accept the payment order? Yes, b/c under 4A.301, Gride bank executed the payment order when it issued a payment order intended to carry out the payment order it received from the originator, Bray. Cheeryble, as the benfs bank, cannot execute a payment order, but can accept a payment order. Cheeryble can accept the payment order in three ways, and if cant find one of the three Nick can sue Bray. Acceptance has not occurred under the first option b/c Cheeryble has not paid Nick nor notified him of the receipt of the order. Acceptance under the second option has not occurred b/c Cheeryble has not yet received payment of the entire amount from the sender of the payment order, which is Gride Bank, b/c Gride has not finally settled w/ Cheeryble, or credited Cheeryble account at Gride or another bank. Under the third option, Cheeryble has accepted the payment order if, at the opening of the next funds transfer business day following the payment date of the order (Wednesday, April 1), which was Thursday, April 2, if, at that time, the amount of the senders (Grides) order is fully covered by a withdrawable credit balance in an authorized account of the sender or the bank has otherwise received full credit from the sender, Gride, unless Cheeryble rejected the order before Thursday morning or is rejected (i) within one hour after business commences on Thursday, or (ii) one hour after the opening of the next business day (Friday) of the sender, Gride, following the payment date, whichever is later. Here, acceptance occurred under the third option b/c Gride had an account at Cheeryble w/ sufficient funds from which Cheeryble could pay itself at the opening of business on Thursday (even though Gride removed its funds later on that afternoon). Although Cheeryble has accepted the payment order, which means as a matter of law Nick has been paid, he has not seen any money yet. But under 4A.404(a) Cheeryble, as the beneficiary bank, b/c it has accepted the payment order, is obliged to pay the amount of the payment order to the beneficiary, Nick. b. How would your answers to Nick differ if the teller at Cheeryble had rejected the payment order from Gride immediately after receiving it (assuming no breach in agreement between Cheeryble and Gride)? Under 4A.210(a), to reject a payment order, Cheeryble must send a notice of rejection to the sender, Gride, orally, written, or electronically indicating rejection (particular words not required). B/c rejected immediately, no implied acceptance, b/c must reject before accept. If rejected, Cheeryble not obligated to pay Nick; Nick must sue Bray. c. How would your answers to Nick change if the payment to Cheeryble had been made by Fedwire instead of through an agreement that Cheeryble debit Grides account w/ Cheeryble? If the payment order came through Fedwire, than Cheeryble would have, as the beneficiarys bank, automatically accepted the order b/c comment 6 of 4A.209 tells us that the Fed account of the beneficiary bank, here Cheeryble, is credited and final payment is made to that bank when the payment order is received out of the Feds account for Gride. Thus, he is entitled to payment from Cheeryble b/c it has accepted the payment order unless it can show reasonable doubt to his entitlement. Cancellation and Amendment of Payment Order 4A.211 1) A sender of a payment order may cancel or amend the order transmitted to the receiving bank 2) Orally, electronically, or in writing; the notice of cancellation or amendment is effective 3) If received by the receiving bank at a time and in a manner affording the receiving bank a 4) Reasonably opportunity to act on the notice before the bank accepts the payment order; 5) After a payment order has been accepted, cancellation or amendment of the order is 6) Not effective unless the receiving bank agrees or a funds transfer system rule 7) Allows cancellation w/o agreement of the bank.

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UNILATERALLY: comment 3 states if the receiving bank has not yet accepted the order, there is no reason why the sender should not be able to cancel or amend the order unilaterally. FEDWIRE EXCEPTION: if payment order went through fed-wire, too late b/c auto-acceptance. HYPO Problem 10.3: Bertie has continued his search for the perfect antique silver cow creamer. Todays problem arose yesterday at lunch when Bertie saw an advertisement in which one Galahad Threepwood offered a particularly elegant silver cow creamer for only $450,000. Bertie immediately called Threepwood and told him he wanted the creamer. He then called his banker and directed him to send a 450k wire to Threepwood for the purchase price (using his general business account). This morning, Bertie discovered the creamer could not be worth more than 75k. He wants to stop payment on the wire. Berties bank sent the wire last night (be means of a bilateral agreement between the banks) and Threepwoods bank has received the wire, but not yet notified Threepwood or taken any other actions. Can you cancel the wire for Bertie? This looks like a consumer transfer governed by EFTA, but ML not b/c out of a business account and very expensive. Under 4A.211, Bertie can cancel the wire but the notice of cancellation (oral, written, or electronic) is not effective unless the receiving bank receives the notice at a time and manner affording in time to act before accepting the order. It appears that Threepwoods bank has not yet accepted the payment order. Liability for Late or Improper Execution or Failure to Execute Payment Order 4A.305 1) If a funds transfer is completed but execution of a payment order by the receiving bank 2) Is late or improper or fails resulting in delay in payment to the beneficiary, 3) The bank that made the mistake or failed to execute is obliged to pay interest to ether the 4) Originator or the beneficiary for the period of delay caused by the improper execution, 5) And the bank is liable to the originator for its expenses in the funds transfer and for 6) Incidental expenses and interest losses resulting from the improper execution. CONSEQUENTIAL DAMAGES: not permitted unless the bank has agreed to liability for such damages in an express written agreement. HYPO Problem 10.4: Ben has a problem; a wire-transfer request that Carol Long submitted, asking the bank to transfer $750k from her checking account. She explained to Ben that she was transferring the funds out of her account at FSB to Wells Fargo because Wells Fargo provided 8% interest per annum. Ben neglected to send the wire, and its too late to send the wire until tomorrow morning. He wants to know whether the potential damages will be greater than the interest she would have earned had the wire gone out on time. Not unless FSB has agreed, in writing to be liable for consequential damages beyond incidental expenses and lost interest. Premature Acceptance or Execution of Payment Order by Originators Bank 4A.209(d) 1) A payment order issued to the originators bank cannot be accepted until the payment date 2) If the bank is the beneficiary bank, or the execution date if the bank is 3) Not the beneficiarys bank; if the originators bank executes the originators payment order 4) Before the execution date or pays the beneficiary of the originators payment order 5) Before the payment date and the payment order is subsequently cancelled, 6) The bank is liable on the payment order but may recover from the beneficiary any payment 7) Received to extent allowed by the law governing mistake and restitution. HYPO Problem 10.5: Ben received a payment order by electronic mail this morning (April 6)

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from Matacora Realtors, an account holder at his bank. The message asked FSB to make a 500k payment to a designated account of Jasmine Ball that is also at FSB. Darrow immediately sent back a message accepting the order, deducting the funds from Matacora Realtors account, and called Jasmine to tell her funds were availableshe came down and took the money. Matacora called a few minutes later and canceling the Ball payment order. Darrow noticed that the payment order actually read: Transmission date: April 6; Payment Date: April 8. Darrow is concerned b/c he is not sure he can recover the funds from Ball. Does Darrow have to return the funds to the account of Matacora? Yes, b/c under 4A.209(b), by paying Ball and notifying her, FSB has accepted the payment order, albeit prematurely. As the originators bank, it was not supposed to accept (as both originators and beneficarys bank) or execute (only as originators bank) until the payment date or execution date respectively, and is liable on the acceptance to Ball but must replenish Matacoras account and may go after Ball on restitution. Error in Wholesale/Commercial Funds (Wire) Transfers Misdescription of Beneficiary 4A.207 1) Non-existent or unidentifiable person: a) if, in a payment order received by the beneficiarys bank, the name, bank account b) number, or other identification of the beneficiary refers to a c) nonexistent or unidentifiable person or account, no person has rights d) as a beneficiary of the order and acceptance of the order cannot occur e) even if the beneficiary bank credits an account, etc. 2) Misidentified Name or Account Number: a) If a payment order received by the beneficiarys bank identifies the beneficiary both by b) Name and account number and the name and account number identify different persons, (1) The bank may rely on the account number as the proper identification of the beneficiary if the beneficiarys bank doesnt know of the mis-description or uses a fully automated funds transfer system; the bank is not duty bound to determine whether the name and number match; EXCEPTION [4A.207(c)]: if a beneficiarys bank accepted a payment order and pays the person identified by account number, and there is an inconsistency between the account number and name of beneficiary 1. If the originator is a bank, the originator is obliged to pay its order; 2. If the originator is not a bank and proves the person identified by account number was not entitled to payment, the originator is not obliged to pay its order, unless: a. The originators bank proves the originator, b. Before acceptance (i.e., execution) of the originators order c. Had notice that payment of a payment order might be made by the d. Beneficiarys bank on the basis of identifying or account number e. Even if it identifies a person different from the named beneficiary. PROOF: the originators bank makes satisfies the burden of proof if it proves the originator, before the payment order was accepted (i.e., executed by the originators bank), signed a writing stating beneficiarys bank may pay on account number. EXCEPTION TO EXCEPTIONRESTITUTION [4A.207(d)]: to

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prevent unjust enrichment, if originator obliged to pay the order to a person not entitled to payment b/c paid by account number, the originator has the right to recover from that person to the extent allowed by the law governing mistake and restitution; and, if the originator is not a bank, and is not obliged to pay, the originators bank has the same right to recover. (2) If the bank learns the name and number identify different persons, no person has rights as beneficiary except the person paid by the beneficiarys bank if that person was in fact entitled to receive payment from the originator. If no person has rights as beneficiary, acceptance of the order cannot occureven if the beneficiary bank goes through the motions for acceptance. HYPO Problem 11.1: Bounderby comes in and has a problem w/ a 500k payment that he asked his bank (Cheeryble Brothers) to send to Harthouse. Bounderby provides to you a printout of the payment order he sent to Cheeryble. That order identified Harthouse by name and indicated the funds should be sent to Harthouses account at Barclays, identified in the order as account number 002131. Promptly upon receipt of the order, Cheeryble debited Bounderbys account for the amount of the order and executed the order by sending a payment order directly to Barclays in Chicago. Barclays, in turn, accepted the order by depositing the funds in its account number 002131. Unfortunately, that account belonged not to Harthouse, but to Gradgrind. a. Can Bounderby recover the funds from Cheeryble? Note that Bounderby is the originator of the payment order, w/ Cheeryble as the originators bank that accepts the payment order by executing another payment order to the beneficiarys bank, Barclays, who accepted the payment order by paying the purported account number of the intended beneficiary, Harthouse. 4A.207(a) does not apply b/c this is not a case of nonexistent or unidentifiable beneficiary. 4A.207(b)(1) applies that where the name and account number do not match, and the bank does not know of the mis-match (or uses a fully automated funds transfer system), the bank can rely on the account number and is not under a duty to determine the accuracy of the account number. Under 4A.207(c)(2), Bounderby, as the originator, who is not a bank, will not have to pay the order if he can prove that Gradgrind was not entitled to payment, which would leave Cheeryble as the party bearing the risk of mis-identification, unless Cheeryble, as the originators bank can prove that Bounderby, before Cheeryble accepted the payment order by executing another payment order to Barclay, had notice that Barclays, the beneficiarys bank, may accept the payment order on the basis of account number 002131, regardless of any mis-match. If Cheeryble can prove this by showing Bounderby signed a writing stating this risk before Cheeryble accepted the payment order from Bounderby. The chances of Bounderby receiving such notice is high b/c banks are not stupid. b. If Bounderby cannot recover the funds from Cheeryble, can he recover the money otherwise? Yes, b/c 4A.207(d) allows for recovery from a person not entitled to payment but rightfully paid by the beneficiary bank by account number to the extent the law of mistake and restitution applies (to prevent unjust enrichment). c. How would your answer change if you discovered that Barclays recognized the discrepancy before it accepted the payment order from Cheerbyle? If the beneficiarys bank learns of the conflict, than no one has rights as the beneficiary unless the person in fact entitled to payment is paid. Here, the wrong beneficiary was paid, therefore, if no one has beneficiary rights, acceptance cannot occur, even if the beneficiary bank goes through the motions. If the payment order could not be accepted, Bounderby is not obliged to pay the order and the

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beneficiary bankBarclaysis stuck w/the loss if it pays the wrong person though it can ML get restitution. Erroneous Execution of Payment Order (e.g., duplicate payment orders) 4A.303 1) A receiving bank that executes a payment order by issuing a payment order in an amount a) Greater than the amount of the senders order, or b) Issues a payment order in execution of the order and then issues a duplicate order, 2) The benfs bank is entitled to be paid the amount of the order, from the originators bank, 3) although erroneously too much, but the originators bank is entitled to then recover from the 4) beneficiary the excess payment received under the law of mistake and restitution. Problem w/ RestitutionChange of Position 1) Restitution is not allowed if the recipient justifiably changed their position 2) Reasonably relying on the receipt of funds, especially if the funds were ultimately 3) Owed to the recipient; in fact, case law interpreting NY law holds that 4) Reasonably reliance and change of position is not required if the recipient 5) In fact was owed the money, and in that case, the originators bank is subrogated 6) To the rights of the beneficiary against originator. EFFECTSUBROGATION: In the natural order of funds transfers, if the beneficiarys bank accepts the erroneous payment order, the beneficiarys bank is entitled to receive the full (although erroneous) amount of the order from Originators Bank, but the originators bank is entitled to receive only the intended amount from the originator. Originators Bank is entitled to recover the overpayment from beneficiary if restitution applies. But if restitution does not allow originators bank to recover from beneficiary b/c beneficiary was entitled to the overage, originators bank is subrogated to the rights of the beneficiary against the originator. This means the originators bank does not have to re-credit the account of the originator for the full amount. HYPO Problem 11.2: Ben from FSB has a problem w/ a recent wire transfer sent for one of FSBs customers. Ball sent FSB an e-mail requesting a wire transfer for 100k to an account of Long at the Second National Bank (SNB) of Muleshoe. A novice clerk at FSB processed the request and accidentally duplicated the transaction and sent two identical $100k transfers. FSBs processing system automatically deducted funds from Balls account for both orders. Ball called to complain later that day. Ben called SNB when he noticed the problem. SNB told him that it had received the funds and notified Ms. Long, but she had not yet removed the excess money. a. First, can Darrow force SNB to send the extra 100k back to FSB? ML not. SNB, the beneficiarys bank, has accepted the payment order in two ways: paying Ms. Long, and notifying her that her account has been credited. Because SNB has accepted the payment order, under 4A.211, the payment order cannot be cancelled or amended w/o the consent of SNB or a funds transfer rule permits a unilateral cancellation after acceptance (but no facts show that). b. If not, can FSB recover the excess funds from Long? Under 4A.303, FSB can recover the excess payment from the duplicate order under the law of mistake and restitution from the beneficiary, Long. But FSB may have trouble in seeking restitution from Long if Long was in fact owed 1 mil from Ball b/c Long may have changed her position on the payment. c. If FSB has no right to recover the excess funds from SNB or Long can FSB retain all of the funds that if debited from Balls account to pay for the orders? If in fact Carol was entitled to keep the money, than Balls obligation, in part, to Longl was discharged. This means FSB

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does not have to re-credit Balls account. Fraud, System Failure, and International Issues in Funds Transfers (wire transfers) Security Procedure 4A.201 1) A procedure established by an agreement between a customer and a receiving bank to 2) Verify a payment order or notice amending or canceling an order is truly the customers, or 3) Detecting error in the transmission or the content of the payment order or communication. OPTIONS: a security procedure may require the use of algorithms or other codes, identifying words or numbers, encryption, callback procedures. EXCEPTION: a comparison of a signature on a payment order or communication w/ a specimen signature is not by itself a security procedure. Effect of Authorized and Verified Payment Orders through Security Procedures 4A.202 1) If bank and customer have agreed the authenticity of a payment order, cancellation, or 2) amendment of a payment order, will be verified by a security procedure, 3) a payment order received by the receiving bank is effective as the order of the customer, 4) whether or not actually authorized, if a) The security procedure is commercially reasonable, and b) The bank accepted the payment order in good faith in compliance w/ security procedure. Question of commercially reasonable security procedure: a question of law for the court. EFFECT: protects banks against customers blaming the bank for fraudulent payment orders. CANNOT BE VARIED: 4A.202(f) provides that the rights and obligations for this rule may not be varied by agreement. Thus, even if the bank and customer agree the bank will not be liable for unauthorized payment orders per a mechanism that is not a security procedure, e.g., merely checking signatures against an authorized specimen signature, the agreement is unenforceable. HYPO Problem 12.1: Ben from FSB wants to discuss a funds transfer services agreement he is negotiating w/ his customer Long. FSB, recently acquired by an out-of-state bank, currently is marketing to its customers a newly developed AccuWire system that uses sophisticated encryption and multiple passwords to provide a high degree of security in wire transfers. Long was not interested. She said she trusts her employees completely, believes her workplace to be secured, and has no interest in an out-of-state banks security procedure. Long tells Ben to draw up an agreement that FSB is authorized to act on any written instruction it receives that appears to reflect a signature that matches the specimen signature that she provided the bank. Does this agreement expose Ben or FSB to any significant risks? Under 4A.201, a mere comparison of a signature to a specimen signature is not, w/o more, a security procedure. This is important b/c under 4A.202(b), a bank can protect itself from the risk of accepting a fraudulently payment order if between the bank and the customer there is an agreement to verify orders by a security procedure. W/ this arrangement, if the security procedure is commercially reasonable and the bank accepts a payment order in good faith compliance w/ the security procedure, than an order that passes the security procedure will be considered effective even if not actually authorized by the customer. (Commercial reasonableness is a question of law.) Therefore, Ben would be welladvised to negotiate w/ Carol to implement a recognized security procedure to trigger, for FSB, the protections of 4A.202(b). B/c even if they agree to the mere checking of signatures, which will absolve FSB from liability, the agreement between them is ML unenforceable b/c 4A.202(f)

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states the rights and obligations in 4A.202 may not be varied by agreement. Choice of Law 4A.507 Unless the parties have previously agreed, or a funds transfer rule provides for the choice of law, the following rules apply 1) As between the sender and the receiving bank, the law of the JD in which the receiving bank is located governs. 2) As between the beneficiarys bank and the beneficiary, the law of the JD in which beneficiarys bank is located governs. 3) The issue of when payment is made per a funds transfer by the originator to the beneficiary is governed by the law of the JD in which the beneficiarys bank is located. THRESHOLD: know that forum selection and choice of law are threshold issues to funds transfer disputes. SCOPE: if the first rule applies, and the receiving bank is in London, than English law governs. Letters of CreditArticle 5 1) A letter of credit is nothing more than a letter from a financial institution (the issuer) 2) promising to pay a stated sum of money upon the receipt of specified documents; 3) the prospective payor goes to a bank and asks it to issue a letter of credit to the 4) prospective payee; the principal reason that a seller seeks a letter of credit from the buyer is 5) to obtain a particular firm assurance that payment will be forthcoming if the seller in fact 6) ships the goods called for by the sellers contract w/ the purchaser; 7) For the letter of credit to give the seller a satisfactory assurance of payment, the 8) conditions of the issuer need to be as objective as possible; thus, payment ordinarily is 9) not conditioned on the sellers satisfaction of the terms of the underlying K, 10) but is conditioned instead on the sellers presentation of a request for payment together w/ 11) specified documents that ordinarily are available only if the seller satisfied the K; the 12) specified documents are compiled and presented as a draft. Formal Requirements for Letter of Credit 5.104 1) A letter of credit, confirmation, advice, transfer, amendment, or cancellation may be issued 2) In any form that is a record and is authenticated a) By a signature; or b) In accordance w/ the agreement of the parties or standard practices. EFFECT: neither this section, nor the definition of letter of credit in 5.102(a)(10) require inclusion of all the terms that are normally contained in a letter of credit for an undertaking to be recognized as a letter of credit under Article 5. And, no particular language is required for an instrument to be a letter of credit if it is intended by its language to create an obligation suspect to the independence principle and payable against a strictly complying document presentation. TYPICALLY: a LOC normally includes the amount available, the expiration date, the place where presentation should be made, and the documents to presente to entitle a person to honor. Letter of Credit (LOC) 5.102(a)(10) 1) A definite undertakingsatisfying the above formal requirementsby an issuer to a 2) beneficiary at the request or for the account of an applicant or, in the case of a

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3) financial institution, to itself or for its own account, to honor a documentary presentation 4) by payment or delivery of an item for value. EFFECT: If the payee presents conforming documentsdraftper the LOC, the issuer is obligated to pay regardless of whether the applicant would be happy about that or not. DOCUMENT: a draft, document of title, certificate, invoice, or other statement or representation of fact, law, right, or opinion (i) presented in a writing and is (ii) capable of being examined for compliance w/ the terms and conditions of the LOC. These may not be oral. ISSUER (5.102(a)(9)): a bank or other person that issues a letter of credit, but does not include an individual who makes an engagement for personal, family, or household purposes. BENEFICIARY: a person who under the terms of a LOC is entitled to have its complying presentation honored. The term includes a person to whom drawing rights have been transferred under a transferable LOC. Incorp. of Uniform Customs and Practices for Documentary Credits (UCP) 5.116(c) 1) A LOC may incorporate by reference any rules of custom or practice, such as the UCP, 2) To which the LOC is expressly made subject, the UCP will govern, unless the 3) UCP provisions conflict w/ the nonvariable provisions in article 5 (5.103(c)). EXAMPLE: 5.103(c) provides an invariable provision that the parties may not, by agreement, generally excuse liability or generally limiting remedies for failure to perform obligations. E.g., a practice provision purported to free a party from any liability unless it were grossly negligent, or that the practice generally limited the remedies one party may have against another. That disclaimer will ML be ineffective as cutting against an invariable provision in 5.103(c). NUANCE: article 5 has few invariable provisions. UCP IN TEXAS: Texas recognizes UCP articles incorporated by reference in a LOC. UCP art. 47 (a) and (d): Date Terminology for Periods of Shipment 1) The words to, until, till, from and words of similar import applying to 2) Any date or period in the LOC referring to shipment will be understood to include the date; 3) The terms beginning, middle, or end of the month shall be construed respectively as 4) the 1st to the 10th, the 11th to the 20th, and the 21st to the last day of such month. HYPO Problem 13.1: Kay called this morning about a LOC problem arising from a LOC her bank has issued, which states that it will provide payment for goods shipped from the end of February 1998. She received a draft his morning including an invoice for goods shipped on February 21, 1998. She tells you that the LOC incorporates the UCP by reference. Can the draft comply? Yes, the draft complies. UPC art. 47(a) provides that from referring to any date or period in the LOC referring to shipment will be understood to include the date mentioned, and 47(d) provides the end of a month shall include the 21st to the last day of such month. Here, the draft shows shipment from the 21st of February 1998 and is therefore included. UCP art. 39(a) Allowances in Credit Amount, Quantity and Unit Price 10% Allowance 1) the words about, approximately, or similar expression used in connection w/ the 2) amount of the LOC or the quantity or the unit price stated in the LOC are to be 3) construed as allowing a difference not to exceed 10% more or 10% less than the 4) amount or the quantity or the unit price to which they refer.

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Consideration Not Required for LOC 5.105 1) Consideration is not required to issue, amend, transfer, or cancel a 2) LOC, advice, or confirmation. EFFECT: A LOC is a contract in the sense that it is a promise by the issuer that if the correct documents (draft) are submitted on-time, the issue will pay a particular sum. But the LOC is an obligation independent from the underlying obligation between the parties. And, while its to be expected that the issuer will require some form of remuneration, it is not expected that the beneficiary will know what the issuers remuneration was or whether it was received. The issuer is still bound to perform as promised. APPLICANT REIMBURSES ISSUER: between the issuer and the applicant of the LOC, when the issuer honors the LOC, the applicant and issuer will include a contractual obligation on the applicant to reimburse the issuer. Confirmer; Directly Obligated on a LOC 5.102(a)(4) 1) Confirmer is a nominated person (bank) who undertakes, at the request or 2) w/ the consent of the issuer of the LOC, to honor a presentation under a LOC; and, under 3) 5.107(a), a confirmer is directly obligated on a LOC and has the rights and obligations of an 4) issuer to the extent of its confirmation, (thus, the issuer can be called the confirmer, and 5) the letter of credit, can be called the confirmation.) BROAD RIGHT TO REIMBURSEMENT [comment 1 to 5.107]: a confirmer that has paid in accordance w/ the terms and conditions of the LOC is entitled to reimbursement by the issuer even if the beneficiary committed fraud. The confirmer must present to the issuer conforming documents, but the presentation need not be made before the expiration date of the LOC. But whether the confirmer is reimbursed is not relevant to the confirmers direct obligation on the LOCit must now pay the LOC on a correct draft presented. NOMINATED PERSON [5.102(a)(11)]: person whom the issuer (a) authorizes to pay, accept, or give value under a LOC; and (b) undertakes by agreement or custom to reimburse. But a nominated person who is not a confirmer is not obligated to honor or give value for presentation. ADVISER [5.102(a)(1)]: a person who, at the request of the issuer, a confirmer, or another adviser, notifies the beneficiary of a LOC, and undertakes only to accurately advise the terms of the credit; the LOC is enforceable as issued even though an advice of credit may be inaccurate. HYPO Problem 13.2: Cliff is frustrated b/c he is having trouble collecting on a letter of credit for a large shipment of books that he just sent overseas. When he submitted a draft on the letter of credit, the confirming bank (second bank) told him that it was not obligated to pay Cliff b/c the issuing bank (First Bank) had closed. Thus, second bank would not be able to obtain any reimbursement if it paid cliff. Accordingly, the officer at second bank argued, SecondBanks confirmation of Cliffs letter of credit was unenforceable for lack of consideration. Cliff wants to obtain payment. The officer is wrong about consideration b/c 5.105 provides that consideration is not required to issue, amend, transfer, or cancel a LOC, advice, or confirmation. And, a confirmer, under 5.102(a)(4) is a person (bank) who undertakes at the request or w/ the consent of the issuer to honor a presentation of a LOC. And, under 5.107 a confirmer is directly obligated on a LOC, such that Cliff can treat the confirmer, Second Bank, as if it were the issuer, First Bank. Whether the confirmer is able to be reimbursed is not relevant to the confirmers obligation on the LOC and the presentation by Cliff of the necessary draft to be paid. Cliff can tell the officer to jump in a lake b/c the confirmer takes the risk of not being reimbursed.

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Issuers Rights & Obligations 5.108 1) STRICT COMPLIANCE [5.108(a)] a) An issuer shall honor a presentation thatper the standard practice of financial b) institutions that issue LOCsappears on its face strictly to comply w/ the terms and c) conditions of the LOC, and shall, unless otherwise agreed w/ the applicant, d) dishonor a presentation that does not strictly comply. Std: not only must the documents themselves appear to strictly comply, but also that the other terms of the LOC such as those dealing w/ the time and place of presentation are strictly complied with. 2) REASONABLE TIME TO HONOR [5.108(b), (c), (d)] a) An issuer shall have a reasonable time after presentation, but not beyond the b) 7th business day (of the issuer) after the date presented w/ draft i) to honor, or ii) if the LOC provides for honor to be completed more than 7 business days after presentation, to accept a draft or incur a deferred obligation; or iii) to give notice to the presenter of discrepancies in the presentation. c) And, failure to timely honor, or give notice of discrepancies is an d) Automatic or silent dishonor. PRECLUSION FOR FAILURE TO GIVE NOTICE: an issuer is precluded from asserting as a basis for dishonor any non-compliance w/ the presentation if timely notice of any discrepancies is not given before the expiration of the 7th business day after presentation or any discrepancy not stated in the notice (but this does not preclude an argument by the issuer of fraud, forgery, or expiration of the LOC). 3) ISSUERS RIGHT TO REIMBURSEMENT [5.108(i)] a) If an issuer has honored a presentation as permitted or required by article 5, the issue is b) Entitled to be reimbursed by the applicant in immediately available funds c) not later than the date of its payment of the funds, but is d) precluded from restitution for honoring a presentation w/ discrepancies e) apparent on the face of the presentation, i.e., honoring w/o agreement f) a presentation not strictly compliant w/ the LOCs terms and conditions. Remedies for Wrongful Dishonor 5.111(a) 1) If issuer wrongfully dishonors or repudiates its obligation under a LOC before presentation, 2) And does not have a valid defense for dishonor, e.g., no strict compliance, the beneficiary 3) presenting may recover from the issuer the amount to pay per the LOC, or specific 4) performance called for, and may recover incidental, but not consequential damages, 5) and reasonable attorneys fees and other litigation expenses may be awarded to the 6) prevailing party in an action in which a remedy is sought. EFFECT OF AUTOMATIC DISHONOR: if an issuer fails to act w/in a reasonable time after presentation (7 days following date of presentation), that is considered an automatic dishonor, and b/c of the preclusion against the issuer on arguing non-compliance for failure to give notice w/in that time of any discrepancies in the presentation, wrongful dishonor is triggered and the beneficiary can recover the amount of the LOC or specific performance under 5.111(a). HYPO Problem 13.3: Ben has a problem regarding a LOC. FSB mis-filed a draft presented on a

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LOC and thus failed to respond to it. The beneficiary presented a draft on January 5, 1998. FSB did nothing until the beneficiary wrote in early February and repeated its demand for payment. Reviewing the LOC, it called for payment based on documents covering a shipment of 100 cases of Llano Estacado wine at a price of around $140 per case. The draft seeks payment of $120 per case. Is FSB obligated to pay on the LOC? Under 5.108, an issuer has a reasonable time after presentation to honor but no more than 7 business days after the date of presentation; if the issuer takes more than the 7 days, the presentation is considered automatically dishonored. Wrongful dishonor under 5.111(a) allows the beneficiary to recover the price of the LOC unless the issuer has defense, such as the presentation not strictly complying w/ the terms and conditions of the LOC. Here, the price is at around 140/case, and the draft sought 120/per case. Under UCP art. 39(a), terms like around allow for a 10% difference in unit price in reference to the stated price. Here, 10% of 140 is 14 dollars, meaning the unit price may come in between 126 and 156/case, but 120 is more than a 10% difference. But 5.108(c) precludes issuers from arguing non-compliance if they do not honor or send notice of discrepancies w/in a reasonable time, not to exceed 7 business days of the issuer following the date of presentation. Therefore, the automatic dishonor has sort of turned into an automatic honor and FSB must pay the amount of the LOC under remedies for wrongful dishonor under 5.111(a). Subrogation of Issuer to Beneficiarys Right upon Honoring a Presentation 5.117(a) 1) An issuer that honors a beneficiarys presentation, or is forced to pay on a LOC, 2) For, e.g., wrongful dishonor, is subrogated to the rights of the beneficiary to the same extent 3) as if the issuer were a secondary obligor of the underlying obligation owed to the beneficiary 4) and of the applicant to the same extent as if the issuer were the secondary obligor of the 5) underlying obligation owed to the applicant. POLICY: preventing unjust enrichment. HYPO Problem 14.1: remember the problem above where FSB failed to make a timely response to a draft on a 12k LOC issued by FSB (dealing w/ cases of wine around $140/case). As the facts of that problem indicated, the draft did not comply w/ the requirements of the LOC. Assume that FSB received a 12k deposit from the applicant at the time that FSB issued the LOC. If FSB is forced to pay 12k to the beneficiary, e.g., by failing to timely honor or give notice of discrepancies resulting in silent wrongful dishonor, can FSB keep the 12k to reimburse itself? Yes, under the subrogation principle in 5.117(a), and even if there was no deposit, the issuer, FSB, could recover the 12k from the applicant. Material Fraud or Forgery 5.109 1) HONORING FORGED OR MATERIALLY FRAUDULENT PRESENTATION [5.109(a)] a) If a presentation on its face strictly complies w/ the LOC, but a required document is b) Forged or materially fraudulent, or honor of the presentation would facilitate a c) Material fraud by the beneficiary on the issuer or applicant: i) The issuer shall honor the presentation if honor is demanded by (1) Nominated person who has given value in good faith w/o notice of forgery/fraud; (2) Confirmer who has honored its confirmation in good faith; (3) Holder in due course of a draft drawn under the LOC taken after acceptance by the issuer or nominated person. ii) The issuer, in good faith, may honor or dishonor the presentation in any other case. 2) INJUNCTION BY APPLICANT [5.109(b)]

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a) If an applicant claims a required document is forged or materially fraudulent or that b) Honor of the presentation would facilitate a material fraud by the beneficiary, a court c) may temporarily or permanently enjoin the issuer from honoring a presentation, if i) The injunction is not prohibited by law; ii) Beneficiaries, issuers, or nominated persons who may be adversely affected by the injunction are adequately protected; iii) All of the conditions to entitle a person to an injunction in this state have been met; & Texas Elements for Temporary Injunction (a) No adequate remedy at law; (b) Necessary to preserve the status quo; (c) threat of imminent harm if not for the injunction; (d) Irreparable harm if not for the injunction; (e) Likelihood of prevailing on the merits; iv) The applicant is more likely than not to succeed under its claim of forgery or material fraud and the person demanding honor does not fit into the circumstances above that require an issuer to honor such a presentation. Std for material fraud: (1) in a traditional commercial transaction, material fraud exists where there has been essentially no performance of the underlying contract; (2) if the controversy involves the quality of the performance (i.e., were the goods and service conforming), material fraud is not involved unless the performance, according to Sztejn, is so lacking as to be virtually worthless (e.g., if old, damaged, worthless goods were provided or rubbish was sent). FRAUD AT THE TIME OF PERFORMANCE: for this fraud, no need to show CL tort of fraud. Only that at the time of performance (versus at the time of entering the K), the beneficiary took advantage of the situation by intending to capture undeserved profits. CL TORT OF FRAUD: CL tort of fraud of misrepresentation requires (1) a promise to perform, (2) w/ intent to defraud at the time the promise was made. This is hard to prove. Offering Issuer Indemnity when an Injunction Cannot Issue in the case of Fraud/Forgery 1) When the applicant cannot prove the elements necessary for an injunction under 5.109(b), 2) A good tactic is pleading with the issuer to defer consideration of a presentation by 3) Offering the issuer indemnity if they are sued for wrongful dishonor under 5.111 4) And w/ the time bought, convince the issuer of the fraud or forgery so that they will be 5) Justified, in good faith, in dishonoring the presentation under 5.109(a)(2). BOND: a good way to offer indemnity is through posting a bond in the amount of the LOC, and a little extra for incidental expenses of the beneficiary and maybe some for attorneys fees. HURDLE: biggest hurdle is even if a bond for a comfortable indemnity is secured, banks loathe dishonoring their own obligations and a LOC is the banks obligation. . HYPO Problem 14.4: Friday afternoon a desperate call comes in from Archie Moon. He tells you that he has just received a shipment from Malay Ink Co of what should have been four barrels of expensive indigo ink. The barrels contain ordinary black printers ink, that has only the value of the ink he ordered. Archie is concerned b/c he obtained a 75k LOC to the shipper and is worried his bank will proceed to pay a draft on the LOC. His banker told him that she had received a draft on the LOC and that it appeared to be in order. The bank declined Archies request to defer consideration, and said that in the ordinary course of business the bank would honor the draft Monday morning. There are three choices. First, demand to examine the draft b/c

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ML a discrepancy can be found for strict compliance w/ the terms or conditions of the LOC. If that can be done, press the bank that under 5.108(a) they must dishonor the presentation, and if hey do not, than they have no right to reimbursement and cannot claim restitution under 5.108(i). The second choice is Archie, as the applicant, may move a court for an injunction under 5.109(b) on the basis that the banks honor of the presentation would facilitate a material fraud by the beneficiary, Malay Ink, against the issuer, the bank, and applicant. Assuming the elements for a temporary injunction in Texas are met, the chief requirement for 5.109(b) is ML not met in this case; that is, Archie will ML not be able to show a material fraud will occur if draft honored. Here, there could have been a mistake in shipping, etc. CL tort of fraud would be hard to prove b/c have to show Malay Ink intended to defraud Archie at the time it contracted w/ Archie. But ML can show fraud in the common sense that at the time of shipping the ordinary ink, Malay Ink was trying to take advantage of the fact it was on the opposite side of the world to capture an undeserved profit. Nonetheless is that material fraud? The classic case of Sztejn holds a material fraud regarding the quality of performance occurs if what was delivered is of no value. Here, the ordinary ink is not wholly w/o value. What was shipped did not meet the K description for breach of K, but not material fraud to justify the court in issuing an injunction. The third choice is convincing the bank this is fraudulent by the disparity in quality of what was shipped versus what was ordered. Archie should be willing to offer the issuer/bank indemnity by posting a bond in the amount of 75k. This is a good tactic b/c Archie has a colorable claim for breach of warranty under 2.601 if he rejects the goods and ML Malay Ink will not travel to US for litigation. This is a good position for Archie b/c it puts the onus on Malay Ink to decide whether it will send the bargained for ink or take the risk of litigation in the US. HYPO Problem 14.5: Same facts as in 14.4 but assume the draft and supporting documents were presented to the issuer by the Bank of Hong Kong and that nobody at that bank had any reason to doubt the legitimacy of those documents or the underlying transaction. The analysis changes b/c under 5.109(a)(1)(A) and (B), even if a document in the draft is forged or materially fraudulent, or honor would work a material fraud, issuers shall honor the presentation if honor is demanded by a nominated person who has given value in good faith and w/o notice of forgery or fraud, or a confirmer who has honored its confirmation in good faith. The Bank of Hong Kong is either a nominated person, or a confirmer, and the banks show it paid Malay Inks presentation in good faith w/o notice of any fraud in the underlying transaction w/ Archie Moon. Thus, Archies bank must pay in this situation, and Archies bank, as the issuer, is entitled to reimbursement from Archie (unless, as the first choice above, can find a discrepancy in draft for strict compliance). Promissory Notes (A Credit Payment System) NATURE OF CREDIT SYSTEMS: we are no longer looking at order instruments by which a person can make a payment that is for all practice purposes immediate. In credit transactions, payment is not intended to be immediate. These are promises to pay by or over a period of time. In most cases, promissory notes are negotiable. Controlled Primarily By K Law 1) In drafting promissory note terms in commercial transactions, the general principles of K law 2) Govern, and the parties can define terms as they wish, even if different from UCC, etc., 3) Which is binding between the parties, and w/ commercial parties, the waiving of rights 4) Will also more likely be upheld versus a note involving a consumer.

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Promise 3.103 1) A promise is a written undertaking to pay money signed by the person undertaking to pay; 2) the obligors mere acknowledgement of the obligation is not a promise unless the obligor 3) also undertakes to pay the obligation. Promissory Note a Novation 1) Sometimes promissory notes are executed to resolve a prior dispute, intended as a novation, 2) Which is the extinguishment of an obligation by the substitution of a new one; a novation 3) takes place when, by agreement of the parties, a new performance is substituted for that of 4) the original obligation; novation may not be presumed; the intention of the parties controls; 5) The intention to novate may be shown by the character of the transaction, the 6) facts and circumstances surrounding it, as well as by the terms of the agreement itself. Merger Clauses Merger clauses are usually enforced between commercial parties. TYPICAL: This promissory note represents the final agreement between the parties any may not be contradicted by evidence of prior, contemporaneous, or subsequent oral or written agreements of the parties. Typical Terms Commercial Promissory Note 1) Statement of the promise for value received, usually worded to the order of, to make the note negotiable; 2) The component parts of the payment promised: a principal sum, a rate of interest, and usually an interest rate for late payments at the maximum lawful rate (lawful to preclude usury); 3) A definition section for terms, e.g., business day; 4) Choice of law, and usually a forum selection clause as well. 5) References and incorporation of the Texas Finance Code, the UCC, etc., which is smart, b/c it avoids resolution of disputes in an area w/o a code or case law as guidance. 6) Installment payments and how they are governed; the general rule is there is no right to prepay an installment obligation b/c bank is entitled to performance as agreed over time, therefore, if desired, the parties should include a pre-payment clause and a procedure for the payor to determine the allocation of pre-payments, e.g., to principal, b/c otherwise the payee will apply pre-payments as it wants to. 7) Acceleration and the circumstances justifying acceleration, and in Texas, unless waived, as the parties did in this note, to accelerate two notices must be given: first, a demand or presentment of the note to cure, and second, if after a reasonable time cure has not occurred, an actual notice of accelleration; 8) A provision on late charges; 9) A provision on attorneys fees. 10) A merger clause. HYPO Problem 15.1: Jude (a stonemason) calls you to help finalize the settlement of a dispute that he has w/ one of his customers. He recently completed a customer that had promised to pay $8,000 for the headstone. When the customer received the headstone, though, the customer insisted that it should have been made from green marble, rather than white marble. Feigning

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dissatisfaction, the customer refuses to pay. The customer has offered to settle by signing a promissory note for 6k, payable w/ 10% interest in 12 equal monthly installments. Jude wants to know whether the customers agreement will eliminate any of the customers defenses to payment? Consider 13 of the promissory note, which is a merger clause forbidding consideration of any prior or subsequent agreements of the parties. Merger clauses are usually enforced between commercial parties. So, Jude should try to draft the promissory note w/ Customer in such a way to reflect their understanding that it is a novation, extinguishing the original obligation of the Customer in place for this new one for 6k promissory note. And, if Customer will agree, include a merger clause. This does not ensure Customer will never sue or raise a certain defense the merger clause may enable Jude to MSJ out of any lawsuit. HYPO Problem 15.2: Jodi Kay has an issue w/ regard to a variable-rate promissory note held by CountryBank. The note calls for interest at the rate of the Prime Rate plus two percent per annum. The Prime Rate is defined as it is in 2(e) of the Promissory Note: the per annum rate of interest that Texas Commerce Bank, National Association announces from time to time as its prime lending rate . . . . Section 2(e) goes to provide that if there is a dispute as to what the Texas Commerce Bank prime rate is, the rate certified in writing by the president or any vice president or cashier of TCB shall be conclusive. She read in the newspaper that the Fed raised its interest rates yesterday, and she knows that the interest CountryBank pays on its funds will rise over the next few days. She is concerned b/c Texas Commerce Bank has been merged into Chase Bank and no longer announces a prime rate. She wants to know whether the interest payments due under the variable-rate note will remain constant now that Texas Commerce Bank no longer announces its own prime rate. If you read further on page 311, 2(e) provides if TCB stops publishing a prime rate, for whatever reason, the prime rate for the remaining term of the note shall be the interest rate set, in good faith, by the payee, that most effectively approximates the initial definition of prime rate. Thus, 2(e) allows Jodi Kay, the payee, in her good faith judgment and approximation of the intended definition of prime rate, to pick the prime rate. This is good transactional lawyer drafting anticipating and providing for contingencies. Fixed versus Variable Rate Loans 1) Interest on promissory notes can be calculated as a fixed rate or as a variable rate; in a 2) fixed-rate, the parties agree to a specific interest rate (e.g., 10% per annum) and the principal 3) balance on the note accrues interest at that fixed rate as long as any portion of the principal 4) remains unpaid; in a variable-rate note, the parties agree that the principal of the note will 5) bear interest at a floating rate that changes from time to time w/ market conditions, and 6) usually variable rates are set at a certain number of percentage points per year above 7) an objectively determinable reference rate, often the prime rate of a major bank in the area. WHO TAKES THE RISK: fixed-rate notes place the risk that rates will rise on the lender and the risk that rates will fall on the borrower. A variable rate note reverses the risk, so that the borrower loses if rates rise and the lender loses if rates fall. HYPO Problem 15.3: Bill Robertson (a friend that operates grocery stores) comes in to discuss a problem he has in obtaining financing for a new shopping center he is constructing. When Bill finishes construction, the income will come from long-term leases w/ rents that should provide a fixed return to Bill above the expenses of operating the shopping center. He does not wish to make a profit on the financing. He merely wants to make sure that once he obtains a loan, future

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fluctuations in the interest markets do not put him in a position where payments on the loan exceed the amount he is receiving from the leases that he already has in place. After Bill leaves, you ask your associate Tom McCaffrey to draft a promissory note for the transactions. Tom points out that Bill never said whether a fixed or variable interest rate. Tom wants to know which type of note he should use. Well, in reality, the lender drafts the note. But Bill ML wants a fixed rate note if he is averse to market fluctuations, which makes sense b/c his leases are long-term with fixed rental rates. Ideally, Bill wants to be in a position so that he can make his loan payment by collecting on any one of his leases. Credit Enhancement by Guaranty 1) A significant number of promissory notes are accompanied by a continuing guaranty, 2) Or just guaranty, a specialized K; by executing a guaranty, the guarantor, a surety, 3) or more formally a secondary obligor agrees to provide a backup source of payment 4) for the lender; the party that owes the money directly would be known as the 5) principal obligor or just as the principal; the creditor is known as the obligee. TYPICAL: the owner of a small corporation will borrow money making the corporation the principal obligor and the owner will sign as a guarantor. Lenders desire guarantees from shareholders b/c it protects the lender if the corporation filed for BR. But no matter how thorough the drafters of a guaranty, BR may still disrupt the rights of the creditor. CO-SIGNERSACCOMODATION PARTIES [3.419(a)]: an accommodation party is any party that signs (co-signs) a negotiable instrument for the purpose of incurring liability w/o directly benefiting from the value that the credit gives for the instrument. The accommodated party is the party for whose benefit the value was given, generally the principal borrower or issuer of the instrument. Under 3.605, an accommodation party is treated as a guarantor; the accommodated party is treated as the primary obligor. Article 3 (negotiable instruments) creates a set of implied guaranty obligations to deal w/ the rights of accommodation parties and accommodated parties. EXAMPLE: on pages 351-52 is a typical commercial form of a continuing guaranty. Freedom of K Largely Governs 1) The parties to a guaranty, like a promissory note, write their own rules and definitions 2) And lenders will usually want the guarantor to waive certain suretyship defenses 3) And usually its the case that guarantors are on the hook, from well-drafted boilerplate, 4) For not just the principal and interest, but attorneys fees incurred by the obligee in 5) Suing the principal and enforcing the guaranty. Terminating the Guaranty by the Guarantor 1) Most guarantees are written to follow the CL rule that a guarantor can terminate a 2) Guaranty w/ written notice provided to the lender (to be effective by date provided in K) 3) But only as to future transactions, and usually lenders will include in the guaranty that 4) The guarantor is still also liable for interest accruing on old debts and 5) Collection expenses, including reasonable attorneys fees. USUALLY DEFAULT: most guaranty forms provide that if termination occurs, that is a default on debts thereto incurred that are covered by the guaranty. Obligee (Creditor) Suing the Guarantor Directly

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1) Typically, creditors will insist on a paragraph in the guaranty allowing the creditor to 2) To sue the guarantor directly, w/o first enforcing the debt against the principal, and 3) Also the forms will provide the guarantor waives any right to require lender 4) to proceed against Borrower or any other party, to proceed against or exhaust any 5) security interest, or to pursue any other remedy in Lenders power.. EXAMPLE: The obligations of Guarantors are joint and several, and independent of the obligations of Borrower, and a separate action may be brought against Borrowers whether or not action be brought against Borrower and whether or not Borrower be joined in any such action. PERSONAL: even if, e.g., a SH sells the company off, if the former SH was the guarantor, than unless the guaranty K provides otherwise, he is still liable unless the creditor releases him. Extending the Automatic Stay in BR to Cover Guarantors In re F.T.L., Inc. 1) Generally, the automatic stay is available only to the debtor and not to 3rd party guarantors 2) But where the identity of the debtor and the third party are inexorable interwoven so that the 3) Debtor may be said to be the real party the obligee is going after, a BR court may exercise 4) Equitable JD to enjoin proceedings against non-debtor third parties; but the BR court will 5) Not step in unless the personal assets of the guarantor are 6) necessary for a successful reorganization. HYPO Problem 18.1: Lydgate is the guarantor of a large loan from Bulsrode Bank to MMC, Inc. MMC has closed its doors after protracted litigation w/ Bulstrode and has no remaining assets. Bulstrode spent 400k in legal fees pursuing MMC. Lydgate said he read his guaranty agreement (pages 351-52) and figured that Bulstrode cannot collect those legal fees from Lydgate. Lydgate explains that he has read 13 of the Continuing Guaranty carefully and understands that it allows Bulstrode to recover the litigation expenses of a suit against Lydgate, but not the expenses of a suit against MMC. Assume MMCs promissory note is identical to the one on 309. 1 of the guaranty states the guarantor is unconditionally liable for any and all indebtedness of MMC to Bulstrode. And, 2 defined indebtedness to include reasonable attorneys fees. 13 states the guarantor J&S agrees to pay reasonable attorneys fees by Lender in enforcing this guaranty, including proceeding in BR. Lydgate argues that the attorneys fees in 13 go to fees connected w/ an action against him, not the principal obligor, MMC, which is how the 400k was incurred. But 9 of the promissory note requires the principal to pay reasonable attorneys fees. Therefore, Lydgate is liable for the attorneys fees b/c 9 makes attorneys fees a liability of the principal, and 1 of the guaranty makes the guarantor unconditionally liable for all indebtedness of MMC to Bulstrode, and indebtedness under 2 in the guaranty includes attorneys fees. So, while 13 makes Lydgate liable for attorneys fees incurred in suing the guarantor, the above paragraphs and sections show he is also liable for attorneys fees incurred by Bulstrode suing MMC. HYPO Problem 18.2: CFB issued a 20 mil line of credit to Jaffe Inc., a business operated by Wendell and Carl. Although Wendell runs day-to-day affairs, Carl provides most of the capital for the business. CFB took a continuing guaranty from Carl. Wendell has been indicted, and is now missing. Carl wrote a letter to Mac (a loan officer at CFB stating I hereby terminate the guaranty that I have signed w/ respect to your loan to Jaffe Inc, and abjure any further liability whatsoever w/ respect to any future advances under that loan. CFB currently has 2 million outstanding on the line of credit, which is accruing interest at 13% per annum. And, CFB issued LOC backing up 10 million of short term commercial paper that Jaffe Inc issued almost two

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months ago. The commercial paper matures next week. If Jaffe Inc fails to pay the holders of the paper the 10 million, the holders of the paper will be entitled to payment on the LOC from CFB. Mac says Carl easily has the assets to pay the entire amount. Mac wants to know if the notice will limit Macs ability to pursue Carl for the amount CFB might have to pay on the commercial paper or subsequently accruing interest. 4 of the guarantee allows the guarantor to terminate the guaranty only as to future transactions and only if written notice is given to the Lender, and such notice is not effective until noon of the next business day following the date of actual receipt of the notice. 4 also provides that termination is not effective as to interest accruing on present debts and collection expenses, including reasonable attorneys fees. As to the 2 million outstanding, Carl is still liable b/c it is a past transaction, and he is liable for any accruing interest at 13% per annum on that 2 million. Carl is ML liable on the 10 million LOC b/c the issuance of the LOC occurred before the letter was sent and there is 4(a) that applies to this that termination does not jettison debts already incurred by the lender on behalf of the principal, e.g., LOC. HYPO Problem 18.3: Jude says he is having trouble w/ his business Obscure Wessex Headstones (OWH). Jude is the SH of OWH, a corporation. Jude has guaranteed OWHs 1.2 mil line of credit w/ Wessex Bank, which contains a provision similar to 8 of the promissory note. Over the last 6 mos, OWHs net monthly income has decreased from 20k to 2k. And, operating expenses have caused OWH to draw down its entire line of credit, so that it now owes Wessex the entire 1.2 million. OWH has only 10k in cash, and its current obligations include a 10k monthly payment due to Wessex on the first month and 8k in overdue bills from suppliers. Jude will feel terrible if he does not pay his suppliers b/c long time business relationships. He also tells you that he doesnt mind if he loses OWH business as long as he can keep the rest of his assets that includes a multimillion-dollar business syndicating walking tours of rural Britain. If Jude pays his suppliers, and stiffs the bank, the bank will ML consider him in default and under 8 of the promissory note, the Note becomes immediately due and payable, at the option of the Payee, or subsequent holder of the note, w/o presentment or demand or any notice of intent to accelerate, upon default in the payment of any sum hereon when due. Jude has waived his rights in Texas to the two notices owed to him before a credit can accelerate on default ((1) notice of default and presentment of note w/ reasonable time give to cure; (2) notice of acceleration if no cure w/in a reasonable time). Jude will be immediately liable for 1.2 million to the bank, and OWHs business assets are not worth 1.2 million on an on-going basis w/ only 2k a month. And, importantly, the bank does not have to pursue the business assets of OWH first b/c 6 of the guaranty form provides the obligation of the guarantor is J&S and independent of the obligations of the borrower and lender may sue guarantor w/o suing borrower. And, in 10 the guarantor waives any right to require lender (a) to proceed against Borrower or any other party, (b) to proceed against any security interest, (c) to pursue any other remedy in Lenders power. The other problem is if he pays the 10k to the bank, his suppliers will quit supplying and put him out of business and ML sue the company. But for the guaranty, he could put OWH in BR and allow the creditors to fight it out. But b/c there is a guarantee the bank will come after him personally unless he can argue In re F.T.L., Inc. that the automatic stay should be extended to cover him b/c his personal assets are reasonably necessary for a successful reorganization. You need to give him legal and common sense business advice to save his business. If not save the business, tell him to cut the loss and ask the bank if they will take a million dollars to settle the whole thing. HYPO Problem 18.4: Ben Darrow called and said one of his borrowers, Matacora was hit w/ a 1

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million dollar tort judgment. Matacora does not have enough assets to pay the judgment and is worried about his banks 250k loan. But he has a personal guaranty from Lassen, the owner of Matacora. Ben believes this judgment qualifies as a material adverse change in Matacoras financial condition. Ben should be advised not to worry too much unless Matacora fils for BR. Bud would then have to worry if In re F.T.L., Inc. would apply to extend the stay to cover Lassen as a third party guarantor, which it might if the court can find the identity between Lassen and Matacora are inexorably woven so that a suit by FSB against Lassen is a suit against the debtor, and Lassens assets are necessary for a successful reorganization. ML, Lassen could be convinced w/ his wealth to pay off the 250k loan in full and keep infusing capital into Matacora. Protections for Gaurantors. A guarantor has (1) rights against the principal; and (2) rights against the creditor. POLICY: a surety is a favorite of the law. Rights of Guarantor Against the Principal Right of Performance or Exoneration 1) The right of performance (or exoneration) allows the guarantor to sue the principal in order 2) To force the principal to perform the guaranteed obligation, usually by injunction, but 3) This is of little practice use b/c if principal not perform, its b/c principal is insolvent. Right of Reimbursement 1) This right, which is of practical value, entitles the guarantor to recover from the principal 2) any sums the guarantor pays to the creditor under the guaranty, and this, 3) like the right of performance, is implied in law, but parties can waive these rights. Right of Subrogation of Creditors Rights against Principal Obligor 1) Subrogation allows a guarantor forced to pay on its guaranty to recover 2) That payment by stepping into the shoes of the creditor and asserting against the principal 3) All of the rights that the creditor could have asserted against the principal. Waiver of these above rights 1) B/c the guarantors rights against the principal potentially interfere w/ the creditors rights 2) Against the principal, it is common for the lender to require in the guaranty form 3) A provision waiving the guarantors rights against the principal. Guarantees & Negotiable Instruments for accommodation (species of surety) 3.419 1) If an instrument is issued for value for the benefit of a party, that party is the 2) accommodated party, and another party to the instrument signs the instrument for the 3) purpose of incurring liability on the instrument w/o being a direct beneficiary of the 4) value given for the instrument, that person is an accommodation party, and the instrument 5) is thereafter considered signed by the accommodation party for accommodation. EFFECTSURETY: an accommodation party is always a surety. A surety, or guarantor, who is not a party to the instrument, however, is not an accommodation party. The accommodation party is obliged to pay the instrument in the capacity in which the accommodation party signs. ACCOMODATION IN WHAT CAPACITY: an accommodation party may sign the instrument as maker, drawer, acceptor, or indorser. For example, signing as an accommodation maker

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would be co-signing w/ your daughter on the note for her car. If sign as an accommodation endorser, you are subject to endorser liability in the collection process. NON-EXCEPTIONS: the obligation of the accommodation party may be enforced notwithstanding any statute of frauds and whether the accommodation party received any consideration for the accommodation. Presumed Accommodation Party 3.419(c) 1) A person signing an instrument is presumed to be an accommodation party if the 2) Signature is an anomalous endorsement or is accompanied by words indicating the signer is 3) Acting as surety or guarantor w/ respect to the obligation of another party to the instrument, 4) And they are liable in the capacity they sign in, e.g., maker, drawer, acceptor, or endorser. Std for anomalous endorsement: 3.205(d) provides an anomalous endorsement means an endorsement made by a person who is not the holder of the instrument (an anomalous endorsement does not affect the manner in which an instrument may be negotiated). A holder makes an endorsement principally to negotiate the instrument to make the transferee a holder. An endorsement by someone other than the holder are anomalous b/c the only reason a non-holder would endorse the instrument is to become liable on the instrument. HYPO: sign on an instrument as maker after principal signed it and next to your signature, put the words surety, the signer is presumed to be an accommodation party and liable as a maker. Accommodation Party Guaranteeing Collection (Not Payment) 3.419(d) 1) If the signature of a party to an instrument is accompanied by words indicating 2) Unambiguously that the party is guaranteeing collection rather than payment 3) Of the obligation of another party to the instrument, the signer is nonetheless obliged 4) To pay the amount due on the instrument to a person entitled to enforce only if a) Execution of judgment against the other party returned unsatisfied; b) The other party is insolvent or in insolvency proceedings; c) The other party cannot be SOP; or d) Otherwise apparent payment cannot be obtained from the other party. Accommodation Party Right to Reimbursement 3.419(e) 1) An accommodation party who pays the instrument is entitled to reimbursement from the 2) Accommodated party and is entitled to enforce the instrument against the 3) accommodated party (i.e., subrogation). EXCCEPTION: an accommodated party that pays the instrument has no right of recourse against, and is not entitled to contribution from, an accommodation party. ***When Surety Defenses against Principal Waived in Guaranty*** 1) When the only parties to a guaranty are the creditor and the guarantor, and the 2) Guaranty waives the guarantors rights of reimbursement and subrogation against the 3) Principal, the principal is not a party to the contract and cannot enforce the waivers 4) Against the surety unless the principal is an intended third party beneficiary 5) Of the waiver in the guaranty and usually thats not the case b/c 6) Such waivers are intended to benefit the creditor, not the principal. EXPRESS ASSIGNMENT FROM CREDITOR: also, the surety, if pays off creditor, even if waived defense rights against principal, should ask the bank for an express assignment of the

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banks rights against the principal on the obligation. Suretyship (guarantor) defenses against the creditor Rules releasing the guarantor, but can be waived in the guaranty or separate agreement. I. Impairment of Collateral 1) If the loan between the creditor and the principal is secured by collateral, and the creditor 2) Through misconduct impairs the value of the collateral, e.g., failing to file to perfect, 3) Than if the guarantor is pursued by the creditor, the guarantor has a defense to 4) Payment to the extent of the impairment of the collateral. POLICY: as between the principal and surety, if the surety pays, the surety has a right of subrogation to step into the shoes of the creditor, and if theres been impairment of collateral by the creditor, then once the guarantor steps into the shoes of the creditor, the creditor has taken away the guarantors right to reimbursement through the collateral. SAME DEFENSE GIVEN FOR ACCOMODATION PARTIES & ENDORSERS [3.605(e)]: If the obligation of a party to pay an instrument is secured by an interest in collateral and a person entitled to enforce the instrument impairs the collateral, the obligation of an accommodation party or endorser is discharged to the extent of the impairment. Std for impairment of collateral under 3.605(g): impairing value of an interest in collateral includes(1) failure to perfect or maintain perfection; (2) release of collateral w/o substitution of collateral of equal value; (3) failure to comply w/ applicable law in disposing of collateral. II. Extension of time granted to the principal obligor 1) If the creditor grants the principal an extension of time to pay, 2) The law generally gives a surety a discharge on his guaranty to the extent that he can 3) Prove the extension decreased the creditors ability to recover from the principal. SAME DEFENSE GIVEN FOR ACCOMODATION PARTIES & ENDORSERS [3.605(c)]: if a person entitled to enforce an instrument agrees to an extension of the due date of the obligation to pay the instrument, the extension discharges an accommodation party or endorser to the extent the accommodation party proves that the extension caused loss. III. Modification of the indebtedness other than an extension of time 1) If the creditor grants the principal a modification of the indebtedness other than the extension 2) of time, the law generally gives a surety a discharge on his guaranty to the extent that he can 3) Prove the extension decreased the creditors ability to recover from the principal. SAME DEFENSE PROVIDED TO ACCOMODATION PARTIES & ENDORSERS [3.605(d)]: if a person entitled to enforce an instrument agrees to a material modification of the obligation other than an extension of the due date, the modification discharges the obligation of an accommodation party or endorser to the extent the modification causes loss. HYPO: Suppose RFT defaults and the creditor does not to enforce its remedies against RFT immediately; instead, the creditor allows RFT to reinstate the loan, conditioned on an increase in the interest rate of 1% per annum. If RFT eventually fails to repay the loan and OmniBank pursues Carl, Carol could defend against Omnibanks claim by arguing that the amendment of the loan caused Carls exposure on the guaranty to be more than it otherwise would have been. For example, Carl might try to prove that Omnibank would have been paid in full if it had exercised its rights against RFT on the first default or that the outstanding balance would have

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been smaller if Omnibank and RFT had not raised the interest rate. If either of those things was true, Carl would have at least a partial defense to Omnibanks claim. IV. Creditor Release of the Principal 1) When the creditor completely releases the principal from liability, if the terms of the release 2) Indicate that the creditor intended to retain its right to pursue the guarantor, usually 3) Referred to as a reservation of rights, then the creditor retains its right to 4) Pursue the guarantor. SAME RULE PROVIDED FOR IN 3.605(b): the same as the CL rule but does not require an express reservation of rights by the creditor; that is, article 3 presumes the creditor did not intend to discharge the secondary obligation of the accommodation party or endorser. NUANCE: creditors will write the principals release w/ complex enough legalese so as not to tip their hand that they have made a reservation of rights to pursue the surety on the obligation. Defenses Require Notice to Party Entitled to Enforce for Accommodation Parties3.605(h) 1) An accommodation party is not discharged under the above defenses unless the 2) Person entitled to enforce the instrument knows of the accommodation party or has 3) Notice under 3.419(c) (anomalous endorsement) instrument was signed for accommodation. EXCEPTIONCONSENT/WAIVER: an accommodation party or endorser is not discharged under 3.605 if (1) consented to the event or conduct that is the basis of the discharge; or (2) the instrument or a separate agreement provides for waiver of discharge. But just like w/ surety defenses against principal being waived, if surety pays, ask the creditor for an express assignment of its rights against the principal obligor. HYPO Problem 19.1: Jude sold his company OWH to a new investor, Rick, who planned to put up the additional funds necessary to keep the business running. Unfortunately, the headstone business was not as profitable as Rick anticipated. Rick told Jude OWH will not make a payment on a loan to Wessex next week. Jude is the guarantor on the loan. Jude thinks he can use his personal assets to pay off the loan and use the business assets to keep the business running. W/o 11 of the guaranty (waiving all of the guarantors defenses), Jude would be in a good position b/c he could pay off the loan and sue OWH under subrogation and enforce any security interest the bank had in any of the OWH assets. But b/c of 11 in the guaranty, Judes plan is not good b/c if he pays off the loan as secondary obligor, he has no right of reimbursement or subrogation against the principal, OWH. Although that is not entirely correct b/c the only parties to the guaranty are Jude and Wessex Bank. Therefore, unless OWH is an intended third party beneficiary to the guaranty, which ML its not, once Wessex Bank is paid off, Wessex will have no good faith reason for enforcing its rights against Jude to benefit OWH. Another option for Jude is to ask Wessex Bank, once he pays them off, for an express assignment of the banks rights against OWH. Jude could have, once he sold to Rick, asked the bank for a release, but that is unlikely. Further, looking back, Jude should have conditioned selling the business to Rick on (1) Rick offering to the bank to be a second guaranty (and possible to release Jude), and (2) agree to indemnify Jude if OWH fails and Jude is pursued by Wessex Bank. HYPO Problem 19.3: Wessex made a loan to We-R-Red, Inc., w/ a guaranty from Venn, the sole SH of the borrower. The EPA has just sued the borrower for 75 million. Although the borrower assures Wessex the suit is w/o merit, Wessex is willing to release the borrower for 75% of the

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amount of the loan to the borrower. Wessex wants to release borrower for 75% of the loan and sue Venn, on the guaranty, for the remaining 25%. How can she proceed and not clue Venn in that he may still be on the hook? The CL states that a creditors release of the principal obligor does not release the surety if the terms of the release indicate the creditor reserves its right to pursue the surety for the obligation. She can do this w/ complex legalese in the release Venn signs so as not to tip Venn off that he may still be pursued as surety by Wessex. But doing so would not be good business for Wessex, even if not legally bound to counsel Venn b/c the bank will get a bad name if take advantage. Negotiable Instruments Seven requirements to make an instrument negotiable 3.104(a) 1) The obligation must be a written promise or order; PAPER NOT REQUIRED: the writing does not have to be on paper, e.g., a check written on the back of a shirt and sent to the IRS, only that its written. 2) The obligation must be unconditional; a) [FACTORS FOR CONDITIONAL] A promise or order is unconditional unless it states i) An express condition to payment (not need say this is a condition; look to effect), ii) That the promise or order is subject to or governed by another writing, or iii) That rights or obligations w/ respect to the promise or order are in another writing but a mere reference to another writing does not make it conditional. (1) Nor is a promise or order conditional if a reference is made to another writing for (a) A statement of rights w/ respect to collateral, prepayment, or acceleration, or (b) b/c payment is limited to resort to a particular fund or source USURY CLAUSES: some usury clauses state that no payments that are usurious need be paid; technically this may be a condition on payment, but these are regarded not as conditions but protections for both parties. ALLOCATION OF PAYMENT: allocation of payment provisions, e.g., 50% of this payment must be applied to principal and not interest, are not conditions b/c above it says not make conditions merely b/c a reference to rights regarding collateral, prepayment, etc. b) [COUNTERSIGNATURES] If a promise or order (usually a cashiers or travelers check) requires, as a condition to payment, a countersignature by a person whose specimen signature appears on the promise or order, that does not make it conditional. IF NO COUNTERSIGNATURE: if the required person fails to countersign, that is a defense to the obligation by the issuer, but the failure does not prevent a transferee of the instrument from becoming a holder. A FORGED COUNTERSIGNATURE: a forged countersignature is a defense to the obligation of the issuer to pay the instrument, and is included as a defense under 3.305(a)(2). These defenses are not effective against a HDC. POLICY: The countersignature is for the purposes of identification of the owner of the instrument; it is not an endorsement. FTC LEGEND: Under 3.106(d), if a promise or order contains a statement, required by applicable statutory or administrative lawusually a legend by the FTC stating the rights of a holder or transferee are subject to claims or defenses that the issuer could assert against the original payee, the promise or order is not thereby made conditional to preclude negotiability under 3.104(a), but if the

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promise or order is an instrument, there cannot be a HDC of the instrument. HYPO: a thief steals a travelers check and cashes it by skillfully imitating the specimen signature so that the countersignature appears to be authentic. The countersignature is not an endorsement. 3.106(c) provides that a lack of a countersignature does not prevent a transferee from becoming a holder. Thus, the merchant or bank that cashed the travelers check becomes a holder. The forged countersignature is a defense to payment, but not against a HDC (b/c not one of the 4 real defenses), and the merchant may be a HDC if 3.302 elements met. 3) The obligation must require payment of money; 4) The amount of the obligation must be fixed; a) An obligation can still be fixed notwithstanding the accrual of interest, administrative charges, and variable interests rates (but variable interest rates must be discoverable). 5) The obligation must be payable to bearer or order; a) An instrument is payable to bearer if it i) Payable to bearer, or to the order of bearer, or ii) otherwise indicates the person in possession is entitled to payment; or iii) Does not state a payee; or iv) States that it is payable to, or to the order of cash or otherwise indicates that it is not payable to an identified person. b) An instrument that is not payable to bearer is payable to order if it is payable i) To the order of an identified person, or ii) To an identified person or order. (1) The identified person or order can be written out to Matt Reed or order, which identifies the person to whom the instrument is made payable or person to whom the identified person further order payment to be made; thus, the drafter alternatively could write to Matt Reed or to whom he orders payment, but somewhere on the instrument must be the word order to make the instrument order paper and therefore negotiable. If the payment line read merely payable to Matt Reed w/ nothing else, that is not bearer paper b/c it identifies someone but its not order paper b/c the word order is not included and not negotiable b/c w/o order, the payee cannot make the promise payable to someone else. (2) Older case law, however, holds that an instrument is order paper if it is payable to [an identified person] or assigns. To be safe, include the word order. SPECIAL RULE FOR CHECKS: an order meeting the requirements of negotiability except the requirement that it be payable to order or bearer, and otherwise meets the definition of check (payable on demand and drawn on a bank, or a cashiers or tellers check) is nonetheless negotiable and a check. So, if it looks like a check otherwise, negotiability is not precluded if the technical definition of bearer or order language is missing or removed, e.g., someone scratching off to the order of and writing instead pay only to an identified person is still negotiable and a check. c) An instrument payable to bearer may become payable to order if specially endorsed (an endorsement by a holder identifying a person to whom it makes the instrument payable); d) An instrument payable to order may become payable to order if endorsed in blank (an endorsement by a holder that does not identify a person to whom instrument payable)

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6) The obligation must be payable on demand or at a definite time; a) Under 3.108, an instrument is payable on demand if it i) States its payable on demand or at sight, or indicate payable at will of the holder; or ii) Does not state any time of payment. b) An instrument is payable at a definite time if it is payable i) After a definite period of time, or ii) At a fixed date(s) (i.e., installment payments are definite), or iii) At a time(s) readily ascertainable when instrument issued, iv) Subject to the rights ofprepayment; acceleration; extension at the option of the holder; or extension after a specified act or event. 7) The obligation must not contain any extraneous undertakings by the person promising or ordering payment. ATTORNEYS FEES: a provision allowing for attorneys fees is usually not regarded as an undertaking extraneous to the obligation to pay money by the issuer. WAIVERS: that an issuer must waive rights or defenses in the instrument is not usually regarded as an extraneous undertaking provided they are waived at the time of issuance and not an undertaking to be performed in the future. POLICY: negotiability makes instruments more liquid (i.e., easier to buy and sell; there is a lively market for drafts and promissory notes), and easy to transfer (i.e., holder analysis). COMPARE: the article 9 definition of negotiable instrument is broader than article 3. Negotiable Note versus Negotiable Draft 3.104(e) 1) Negotiable instruments come either as notes, if it is a promise to pay, or 2) Drafts, if its an order to pay; and if the instrument falls w/in the definition of both, 3) A person entitled to enforce the instrument may treat it as either. EITHER CAN BE BEARER OR ORDER PAPER: do not be confused by the terminology; both notes and drafts can and must be either bearer paper or order paper to be negotiable, e.g., a note (a promise) can be made payable to order, and therefore order paper. NEGOTIABLE DRAFTS: an order by drawer to drawee to pay the draft to the holder. These look like checks and usually a remitter purchases the check to be payable to an identified person from a bank so that the draft becomes the banks obligation making a secure method of payment. CHECKS: a species of drafts (1) payable on demand and drawn on a bank, (2) or a cashiers check or tellers check. An instrument may be a check even though described on its face by another term, such as money order. HYPO Problem 21.1 (page 412 b/c problem long): is the corporate bond a negotiable instrument? Maybe. First, this is a written promise, but ML its not unconditional b/c the bond says its payable to Mark Henry or registered assigns, i.e., a holder transferred to and registered on the corporate books. The condition on payment does not need to say this is a condition, only the effect thereof. Moving on, this is a condition to pay money, $1000.00, which is a fixed amount, even though interest accrues. Is the bond payable to bearer or order? Possibly order paper b/c it does not indicate that the person in possession is entitled to payment and is payable to an identified person: Mark Henry or registered assigns. But this is not order paper, and therefore not negotiable b/c 3.109(b) requires the note or promise to be payable to the order of an identified person, or payable to [an identified person] or order. Here, order is not included in the payment line. Therefore, the ability for Mark Henry to further make the promise payable to

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the order of a transferee is precluded. But this corporate bond may be order paper b/c older cases provide that if an instrument reads payable to [an identified person] or assigns, it is order paper. This bond though reads registered assigns. The bond would clearly be order paper if it was payable to the order of Mark Henry, or payable to Mark Henry or order. Moving on, it is payable at a definite time b/c installment instruments are payable at a definite time. And, this bond does not require extraneous undertakings. Problem 21.3: Do these provisions prevent the home-mortgage notes from being negotiable? Note there is no right to pre-pay these notes its entitled to be paid on the schedule laid out in the agreement between borrower and lender. So, if want that right, must be provided for by K, or by statute or CL, e.g., in 4 on page 311 there is a pre-pay provision, but must wait 5 years. Prepayment provisions are permitted in notes today, and can trace the history of these back in Texas more than 100 years. Now, all saying on the pre-payment clause in this problem is that if I make a pre-payment I can tell you how to allocate the money I am sending in, e.g., this money goes to principal, not interest and principal. Does this look like this is not negotiable b/c this violates 3.104 as any other undertaking or instruction in addition to paying money? Mann is willing to raise the issue . . .and you can certainly look at it as nothing more than right to pre-pay and right to allocate the payment to interest, principal, or both. But the question can be raised as to whether this is an extraneous undertaking. In a Fannie Mae loan, this would be disaster to say this is such, b/c that would destroy negotiability and ability to put the loan/note into the secondary mortgage market. Therefore, the borrowers right to pre-pay provision in this problem is ML not an extraneous undertaking precluding negotiability. Transfer and Enforcement of Negotiable Instruments Becoming a Holder of a Negotiable Instrument (And therefore entitled to enforce) A person becomes a holder of an instrument either by 1) The instrument being issued to them or 2) through negotiation. Transfer by Negotiation (Holder Analysis) 3.201 1) Negotiation means a transfer of possession, whether voluntary or involuntary, 2) of an instrument by a person other than the issuer to a person who thereby becomes 3) its holder (and therefore entitled to enforce), and if an instrument is a) payable to an identified person, negotiation requires transfer of possession of the instrument and its endorsement by the holder; or b) payable to bearer, it may be negotiated by transfer of possession alone. Transfer of Negotiable InstrumentsSpecial Endorsements 3.205(a) 1) If an endorsement is made by the holder of an instrument, whether payable to an 2) identified person or bearer, and the endorsement identifies a person to whom it makes 3) the instrument payable, it is a special endorsement, and when specially endorsed, 4) an instrument becomes payable to the identified person and may be negotiated, 5) making the transferee a holder (entitled to enforce), only by the endorsement of that person. ORDER LANGUAGE NOT REQUIRED: the negotiability requirement of an instrument being payable to bearer or order, which requires the word order to make it order paper, is not

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required for a special endorsement. All that is required is an identification of whom the instrument is made payable to, e.g., pay to Matt Reed; not require pay to the order of ___. CONVERTING BLANK INTO SPECIAL: 3.205(c) the holder may convert a blank endorsement that consists only of a signature into a special endorsement by writing, above the signature of the endorser, words identifying the person to whom the instrument is made payable. An example, would be writing above the holders blank endorsement Paul Payee, Pay to the order of Matt Reed, and as a holder, I have the authority to do that. But even if there is no endorsement, instead, it was issued to me as bearer paper, e.g., pay to the order of: cash, I can turn the check over and specially endorse it to myself, e.g., pay to the order of Matt Reed, /s/ Matt Reed, converting the bearer paper to order paper. Transfer of Negotiable InstrumentsBlank Endorsements 3.205(b) 1) If an endorsement is made by the holder of an instrument, whether payable to an identified 2) Person or bearer, and the endorsement is not a special endorsement, it is a blank 3) endorsement, and when endorsed in blank, an instrument becomes payable 4) To bearer and may be negotiated by transfer of possession alone, making that person 5) A holder (entitled to enforce), even if a thief, until specially endorsed. CONCEPT: a blank endorsement is usually the signature of the endorser on the back of the instrument w/o other words; this is a blank endorsement b/c though the holder has put his name as the endorser on the check, he has not identified to whom the instrument is now payable to. ADVICE: tell clients to have customers not endorse instruments to them in blank b/c its risky as anyone thereafter becomes a holder through negotiation by mere by possession. For example, if I bring in a check payable to me to cash outlet and endorse w/ just my name on the back, than breaking it down, it was order paper when I brought it in and as order paper, to negotiate it, the actual holder has to endorse it, which me, as the holder (b/c it was issued to me) did, in blank. Because of the negotiation, cash outlet is now the holder of an instrument payable to bearer and if the cash outlet loses the check, than anyone, even a thief, becomes the holder and therefore entitled to enforce. Or, at least tell your clients, after they have received an instrument endorsed in blank to thereafter specially endorse the instrument making it payable to the client, an identified person, converting what was once order paper, that became bearer paper (w/ the blank endorsement), back to order paper, e.g., check payable to Paul, and endorses Paul Payee that is a blank endorsement, but Tom can convert the bearer paper to order paper by a special endorsement w/ a rubber stamp Pay to the order of: _____ and fill in Toms Kash Outlet. Restrictive Endorsement For Deposit Only In General 3.206(a) 1) An endorsement limiting payment to a particular person or otherwise prohibiting transfer 2) Or negotiation of the instrument is not effective to prevent further transfer or negotiation. For Deposit Only 3.206(c) 1) But if an instrument bears an endorsement for deposit or for collection, 2) The following persons convert the instrument unless the amount paid for the instrument is 3) received by the endorser or applied consistently w/ the endorsement: a) A person, other than a bank, who purchases the instrument, or b) A depositary bank that purchases the instrument or takes it for collection, or a c) Payor bank that is also the depositary bank or that takes the instrument for immediate collection over the counter from a person other than a collecting bank.

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EXCEPTIONPAYOR & INTERMEDIARY BANKS: (except for payor banks that are also the depositary bank or that take the instrument for immediate collection OTC) a payor bank or intermediary bank may disregard the endorsement and is not liable if the proceeds of the instrument are not received by the endorser or applied consistently w/ the endorsement. EFFECT: the depositary or payor bank that takes the check for immediate payment OTC must act in accordance with the endorsement, but an intermediary bank or payor bank that takes the check from a collecting bank is not affected by the endorsement. BLANK RESTRICTIVE ENDORSEMENT: the instrument is still bearer paper, so that a finder or thief is negotiated the instrument by mere possession and therefore the holder, but for deposit only makes it so that the thief or finder, or depositary or payor bank that takes it for immediate payment OTC commits conversion unless proceeds given to the endorser. An example of a blank restrictive endorsement is where I, Matt Reed, am the payee, and I endorse For deposit only, /s/ Matt Reed. That is less confusing than Matt Reed, for deposit only. But in advising your clients that receive blank endorsements, e.g., Toms Kash Outlet, have Tom take the check and endorse, after Paul endorsed in blank: Paul Payee; For Deposit Only, Toms Kash Outlet. Signature for Endorsement A signature may be made 1) Manually or by means of a device or machine, and 2) By the use of any name, including a trade or assumed name, or by a word, mark or symbol 3) With the present intention to authenticate a writing. IMPORTANCE: a person is not liable on an instrument unless the person has signed the instrument or is signed by an agent that is binding on the principal. ENDORSEMENTS: sometimes endorsements are made by machine and w/ trade names, but as long as executed w/ the present intention of authenticating a writing its a signature for endorsement, e.g., Toms Kash Outlet, a sole proprietorship DBA of Tom, if stamps back of checks Toms Kash Outlet, that is a signature of Tom and is a blank endorsement. Reacquisition of an Instrument Allows Cancellation of Subsequent Endorsements 3.207 1) Reacquisition of an instrument occurs if it is transferred to a former holder, by negotiation or 2) otherwise, which allows a former holder to cancel all endorsements subsequent to the time 3) the holder became a holder, and if the cancellation causes the instrument to be payable to the 4) re-acquirer (i.e., order paper) or to bearer, the re-acquirer may negotiate the instrument. EFFECT OF CANCELLATION: an endorser whose endorsement is cancelled is discharged, and the discharge is effective against any holder after cancellation. Anomalous Endorsements (Accommodation, i.e., Surety/Guarantor) 3.205(d); 3.419(c) 1) An endorsement made by a person who is not the holder of the instrument, and an anomalous 2) Endorsement does not affect the manner in which the instrument may be negotiated; and 3) there is notice that the instrument was signed for accommodation 4) if the signature is an anomalous endorsement, meaning the accommodation endorser 5) can be held liable for endorser liability. NOT A HOLDER: an anomalous endorser will usually occur when the instrument is order paper, e.g., if issued as order paper, than for an anomalous endorser to be a holder, it must have been specially endorsed to him, or a subsequent holder endorsed it in blank. REIMBURSEMENT: an accommodation party is entitled to reimbursement from accommodated

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party and can enforce the instrument against accommodated party (i.e., subrogation). Special RuleDepositary Bank Holder of Un-Endorsed Item 4.205 1) If a customer delivers an item to a depositary bank for collection, the depositary bank 2) Becomes a holder at the time it receives the item if the customer was a holder, 3) whether or not the customer endorsed the item, and, if the bank satisfies the other 4) requirements of 3.302, the bank is a HDC. NEGOTIATION AFTER BANK BECOMES HOLDERSPECIAL ENDORSEMENT: Reg CC 229.35(c) provides that the only way a person, other than a bank in the collection process, can become a holder subsequent to a depositary bank becoming a holdereven if the bank endorses the check in blankis for the bank to specially endorse the check (e.g., a bank employee than does not become a holder if he steals the check thinking it to be endorsed in blank) or for the bank to return the check to the depositing person (in which case, the depositing customer, on reacquisition can cancel out any endorsements subsequent to his). But a depositary bank can negotiate an item once its a holder to other collecting banks w/o special endorsement. Liability from endorsements and transfers of instruments 1) An endorser can be liable on an instrument for 2) Endorser liability; 3) Conversion; 4) Transfer warranties; and 5) Presentment warranties. THIRD PARTY CHECKS: businesses not take 3rd party checks (i.e., checks endorsed to the customer by the named payee (versus a check endorsed by the payee)) b/c of the identity risk. HYPO: Tom, from Toms Kash Outlet, also want to know the risks if he began accepting thirdparty checks. He says that customers frequently try to cash checks that have been endorsed to them by the named payee. If the check appears to have been specially endorsed by the named payee and is submitted for cashing by the person to whom the named payee endorsed the check, what risk does Tom face in cashing the check? The risk is the check is stolen and someone forged the special endorsement. And, up the line Tom could be liable for breach of transfer warranties, presentment warranties, endorser liability and a converter of the instrument. Tom can go after the thief on breach of transfer warranties and endorser liability but ML not find thief. HYPO Problem 22.2: Doug could not get a taxpayers bank to honor a check written on the back of the taxpayers shirt. Doug wants to know if the IRS can make the taxpayers bank pay the shirt-check, and if not, can the IRS at least sue the taxpayer on the shirt-check? The IRS, as the payee, cannot force the taxpayers bank to pay the check b/c a payor bank is not liable on an instrument to a payee or other holder until, under 3.408 it either accepts the instrument (making it a certified check), or fails to dishonor by the midnight deadline after presentment. The taxpayers bank has no machinery to process a shirt-check. Now, while payor bank may not be liable to the payee for not paying the shirt-check, the bank may be liable to the drawer, its customer, for wrongful dishonor under 4.402 (usually banks put in account agreement no checks other than those on the official forms provided to the customer). The IRS, however, can go after the shirt-check writer if the shirt-check is dishonored because 3.310(b)(1) provides that once a check is issued for an obligation, the obligation is suspended until the check is honored or dishonored, and if dishonored, the obligee may sue on either the underlying obligation, usually

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through breach of K, or on the dishonored check. If sue on the check, IRS comes under 3.414(b) for drawer liability on a dishonored check that drawer obligated to a person entitled to enforce the check to pay the check per its terms. Procedurally, the IRS should sue on the check b/c under 3.308(b) if the signatures on the instrument are admitted or prove, the IRS is entitled to enforce the instrument if a party entitled to enforce, unless shirt-check-writer can prove a defense. Accord and Satisfaction by Use of Instrument 3.311 1) If a person against whom a claim is asserted proves: a) That person in good faith tendered an instrument as full satisfaction of the claim; b) The amount of the claim was un-liquidated or subject to a bona-fide dispute; c) The creditor/claimant/obligee obtained payment of the instrument; and d) The instrument or an accompanying writing contained a conspicuous statement to the effect that the instrument was tendered as full satisfaction of the claim. 2) The claim is discharged, unless 3) The creditor/claimant/obligee, if an organization, proves: a) w/in a reasonable time before the tender, a conspicuous statement was sent to the debtor that communications concerning debts, including an instrument tendered as full satisfaction of debt, are to be sent to a designated person, office, or place; and b) the instrument or accompanying communication was not received in conformance. 4) And, an A&S is cancelled if: a) The creditor, whether or not an organization, proves that w/in 90 days b) After payment of the instrument, returned the payment to the debtor. POLICY: precludes inadvertent A&Ss by tricky debtors. 5) Yet, the claim is nonetheless discharged even if (a) the check was not sent to the person, office, or place required by a notice from the creditor, or (b) the claimant returned the check w/in 90 days, if the debtor can prove that: a) Within a reasonable time before collection of the instrument, the creditor, b) Or an agent thereof having direct responsibility over the disputed obligation, c) Knew (actual knowledge) the instrument was tendered in full satisfaction of the claim. POLICY: creditor cannot deposit the check and sue for the rest w/ such knowledge. BONA-FIDE DISPUTE: these arise one of two ways(a) where there is a dispute that there is an obligation at all, e.g., to a tort action disputes he was negligent in settlement negotiations; (b) where there is a dispute as to the amount owed, e.g., sign a promissory note for 1k due in one year, and if in 6 mos I send in a check for 500 dollars w/ the notation full satisfaction of the claim, and the creditor deposits the check, there is no A&S b/c no bona-fide dispute to the amount owedmerely trying to pay less. CONSPICUOUS: 1.201(b)(10) defines conspicuous as a term so written that a reasonable person ought to have noticed it. Whether a term is conspicuous is a question for the court. HYPO Problem 22.3: Jan has a difficult tenant that has been complaining constantly about problems w/ the space it leases. Jan received from the tenant this morning a check for exactly half of the rent w/ a notation on the check that it constitutes full payment for all past-due rent. In the past, Jan has a practice of drawing a line through such a notation and depositing the check. Jan wants to know what you think of her practice of merely striking through such notations? Importantly, there is ML no A&S b/c no facts show a basis for a bona-fide dispute regarding the amount of rent owed unless more facts are shown on the tenants complaints on habitability, etc.

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Assuming there is a bona-fide dispute, what happens when payee strikes through that language and takes the check? Jan found the language and struck it through, which shows it was conspicuous. Jan is wrong b/c she needs to instead return the check w/in 90 days if not know the check was for an A&S at time of tender, but b/c she has actual knowledge, if she obtains payment on the check, b/c shes the person responsible for disputes, the A&S is ML effective. HYPO Problem 22.4: Tom wants to know if youd be interested in collecting checks for him that payor banks dishonor after he cashes them. Can he sue on the following checks: a. The first check was written by Drawer payable to Payee. Toms employee took the check in accordance w/ Toms procedures. Thus, the check bears an endorsement purporting to be the signature of Payee. But the person that cashed the check actually was Interloper, who mugged Payee and stole his check. Interloper endorsed the check as requested by Toms clerk. Drawer stopped payment on the check. The check was returned to Tom. Can Tom sue Drawer on the check? Paul Ingrid? The first issue is whether Tom can recover on the check as a person entitled to enforce, which begs the question whether Tom is a holder. A holder is a person entitled to enforce. To be a holder, must be in possession, which, after returned, Tom has possession again. Tom gave up possession when he deposited the check, but under 4.201(a) the bank, upon taking the check for collection, acts as an agent of Tom giving him constructive possession of the check. To be a holder, b/c Tom was not the person to whom the check was issued, he must take by negotiation. This was payable to Payee, and therefore order paper. To negotiate order paper, there must be an endorsement by the actual holder, here Payee. Payee did not endorse this check; Interloper forged Payees endorsement. Therefore, Tom cannot be a holder b/c he was never negotiated the check as the chain of holders was broken (Tom would be a holder if this was bearer paper even if Interloper was in unlawful possession b/c bearer paper can be negotiated be mere change in possession). The check is still technically payable to the order of Payee. So, can Tom recover from Drawer under 3.414(b) for drawer liability? This was an unaccepted draft that was dishonored, therefore Drawer is obliged to pay the draft, but only to a person entitled to enforce or an endorser who paid the draft and is liable under 3.415 for endorser liability. Tom is not entitled to enforce b/c not a holder and is not an endorser who was held liable under 3.415 for endorser liability (which would be the case if he had endorsed it to another person for collection that was eventually dishonored triggering endorsement liability down the collection chain back to Tom). Toms bank merely returned the check and charged back the provisional credit to Toms account under 4.214(a). Tom cannot recover against Drawer. Can he recover against Payee for endorser liability? No, b/c under 3.401(a) to be liable on an instrument must have the persons signature and Payees signature was forged. Sadly, Tom cannot recover against Interloper on endorser liability b/c while her forged endorsement of Payees name is effective under 3.403(a) against her in favor of a person who in good faith pays the instrument or takes it for value, endorser liability under 3.415 runs to persons entitled to enforce or persons themselves held liable for endorser liability. Here, Tom is not entitled to enforce and was not hit for endorser liability. But, amidst it all, Tom can hold Interloper liable under 3.416 for breach of transfer warranties, b/c although this was not a negotiation, it was a transfer b/c she delivered it to Tom for consideration by endorsement to give Tom the right to enforce the check, specifically the warranties that she is a person entitled to enforce and that all signatures are authentic and that the instrument is not subject to a defense. Note that Drawer is still liable to Payee on the check (and b/c dishonored Payee can sue on the check or obligation), and Payee can also go to Tom and demand the check or sue for conversion!

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b. The second item is a check written by Drawer as Pay to the order of Bearer. Payee brought the check into one of Toms facilities. B/c Toms clerk could not figure out whose signature to get, the clerk simply paid Payee cash and took the check w/o getting any endorsement from Payee. The bank dishonored the check and returned it to Tom. Can Tom sue Drawer? ML, yes, when the check was returned to Tom, he reacquired the check under 3.207 allowing him to cancel all endorsements subsequent to the time he became a holder. Any subsequent endorsements after Tom were made by his bank, which may have converted the check to order paper. But Toms cancellation of such endorsements converts it back to the status it was at the time he became a holder, which was bearer paper. Therefore, as the holder, Drawer is liable to Tom for the dishonored check b/c drawer liability runs to persons entitled to enforce and that means, inter alia, a holder, and b/c this was bearer paper it was negotiated to Tom by mere possession. Payee is not a drawer, thus no drawer liability, and couldnt be hit for endorser liability b/c facts show he never endorsed it (but if he did, than he would be liable to Tom for endorser liability b/c dishonored and endorser liability would run to Tom as a person entitled to enforce). Tom may be able to nail Payee for the transfer warranty under 3.416(a)(4) of there being no defenses against the instrument. (Paul, to be safe, even though the check was issued to him as bearer paper, endorsed the check to himself on the back pay to the order of Paul Payee. Doing so would have converted the check from bearer paper to order paper.) c. The third check was written by Drawer to Paul. Two signatures appeared on the back of the check. The first (at the top) is by Paul and states Pay to Tom May, /s/ Paul Payee. Below that appears a signature by Martin Chuzzlewit. To si not sure what happened, but when he tried to deposit the check, it was dishonored, apparently b/c Dorothea closed her account and left town. Paul, as the holder of order paper, negotiated this check to Tom May by endorsement making him the holder. Tom can recover against Paul for endorser liability under 3.415, b/c the check was dishonored and Tom is a person entitled to enforce b/c hes a holder. Nothing suggests Martin took the check by transfer, or that he was ever a party to the transfer. ML, this is an anomalous endorsement b/c no facts show Martin was a holder. This was order paper from the beginning b/c issued to Paul Payee, therefore, for Martin to have been a holder, there must have been an endorsement from Payee either identifying Martin for a special endorsement, or Payees blank endorsement, but that is not found. And, under 3.419(c) there is notice that a signature is for accommodation, and here that is an accommodation endorser. Therefore, Martin can be held liable for endorser liability as well. And, if Martin has to pay, remember the defenses a guarantor has against the principal, e.g., Martin can be reimbursed or sue Paul for endorser liability as an endorser subsequent to Paul held liable for endorser liability himself. HYPO Problem 22.5: Chambers wrote a check to Alans for a stereo for $3400.00. But the stereo sucked and Alan went out of business the next day. Chambers called his bank, CountryBank and demanded a stop-payment order be issued. CountryBank said the order could not issue b/c the check was already paid. Chambers examined the check and said the bank wrongfully paid the check to a person, Alans depositary bank, not entitled to enforce b/c the depositary bank was not a holder because Alan did not endorse the check to his depositary bank; the check did have a stamp by the depositary bank. The theory is that under 4.401, CountryBank paid an item not properly payable b/c paid a person not entitled to enforce. First, under 4.303(b) banks can pay items in whatever order (not have to pay items on a first-come basis), and under 4.303(a), a stoppayment order must be received within a time reasonable for the bank to act on the stop-payment order. Otherwise, the stop-payment order is too late b/c automated equipment procedures have

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already processed the item for payment. That is why CountryBank could not issue Chambers stop-payment order. Was the depositary bank nonetheless a holder despite Alans failure to endorse the check when he deposited it w/ his bank? Yes, under 4.205(1) a depositary bank becomes a holder at the time it receives it for collection if the customer was also a holder regardless of whether the customer endorsed the check or not. Alan was ML a holder b/c the facts show he was issued the check. Alan should be smart though and not endorse in blank like he did w/ the stamp, but put a blank restrictive endorsement on items received for deposit. Cashiers Checks 3.104(g); 1) A species of draft, and a species of check, a cashiers check means a draft 2) Where the drawer and drawee are the same bank or branches of the same bank. OBLIGATION OF ISSUER OF CASHIERS CHECK: a bank that issues a cashiers check owes, to a person entitled to enforce or to an endorser held liable for endorser liability, the obligation to pay the instrument per its terms at the time of issue. HYPO Problem 22.6: in the mail, Cliff received an odd-looking check for 12k: it appears to be drawn on the Third State Bank, but also is singed by that bank in the lower-right hand corner. In the lower-left hand corner, it lists Slater as remitter. Cliff wants to know what to do w/ the check? This is ML a cashiers check b/c the drawer and drawee are the same bank. Tellers Check 3.104(h) 1) A draft drawn by a bank on 2) that banks account at another bank or is payable at or through a bank. Remitter 3.104 1) The person who purchases the instrument (e.g., draft) from its issuer that is 2) payable to an identified person other than the purchaser. REMITTER IS NOT A PARTY TO THE CHECK: a remitter is not a party to the instrument and therefore is not liable on the check but is also not entitled to enforce it either. HYPO: want to buy a car, but dealership not take a personal check, and require a cashiers check. When I go to my bank and purchase a cashiers check, I am the remitter and I make it payable to the dealership and the bank will require money right then or from my account to fund it, and my bank will be the drawer and drawee. Discharge of Obligation if Cashiers, Tellers, or Certified Check Taken 3.310(a) 1) Unlike personal checks that merely suspend an underlying obligation, if a 2) Cashiers, tellers or certified (accepted) check is taken, the obligation is 3) Discharged to the extent of the amount of the cashiers, etc., check, 4) Unless the parties agree the obligation will merely be suspended while check pending. EFFECT: great to be a remitter of a cashiers check given for an obligation b/c if check dishonored, the remitter is not a party to the check and cannot be liable thereon and the underlying obligation is discharged! Therefore, as a seller of goods, it may be safer to not accept a cashiers or tellers check, but a personal check b/c then if check fails, can sue on either the obligation or the check (sue on check b/c burden of proof on drawer if signature proven). PAYEE WORRY: the payee then may sue the drawer, the bank, on a cashiers check, for drawer liability, and if win, than need only worry about banks solvency (notwithstanding FDIC). The

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payee, usually a merchant, if worried about the solvency of the bank should not take the check b/c taking a check is a voluntary act. Holders in Due Course [HDC] 3.302 To be a HDC, 1) Foremost, the person must be a holder; 2) the instrument, when issued or negotiated does not bear apparent evidence of forgery or 3) alteration, or is not so irregular or incomplete as to call question to its authenticity; and 4) the holder took the instrument: a) for value; b) in good faith; c) w/o notice that the instrument is overdue or, or an uncured default w/ respect to payment of another instrument issued w/in the same series; d) w/o notice that the instrument contains an unauthorized signature or has been altered; e) w/o notice of any claim to the instrument described in 3.306 (claims of ownership and any other claim of a property or possessory right, including lien holders); f) w/o notice that any party has any of the 4 real defenses in 3.305(a); EFFECTSUPER RIGHTS: 3.305(b) shows that a HDC has greater rights than mere owners or holders, or transferees. A holder in due course takes free from common defenses of the obligor. NUANCE: a HDC is always a holder, but a holder is not always a HDC. The Four Real Defenses to a HDC 3.305(a)(1) A HDC is subject to the following four defenses from the obligor: 1) infancy of the obligor to the extent it is a defense to a simple K (i.e., voidable, not void); 2) duress, lack of legal capacity, or illegality of the transaction that nullifies the transaction; 3) fraud that induced the obligor to sign the instrument with neither knowledge nor reasonable opportunity to learn of its character or its essential terms; or 4) discharge of the obligor in insolvency proceedings. REAL FRAUD: this is not garden variety CL fraud (a HDC cuts off garden variety fraud as a defense); the defense extends to an instrument signed w/ knowledge that it is a negotiable instrument, but w/o knowledge of its essential terms. The party must not only have been in ignorance, but must also have had no reasonable opportunity to obtain knowledge. In determining what is a reasonable opportunity factors include the intelligence, education, business experience, and ability to read or understand English. Also relevant is the nature of the representations made, whether the signer had good reason to rely on the representations, or confidence in the person making representations. DEFENSES CUT OFF: 3.305(a)(2) states other defenses that are cut off by a HDC. These defenses include article 3 defenses and defenses on CL K principles. Article 3 defenses are nonissuance of the instrument, conditional issuance, and issuance for a special purpose; failure or forgery of a countersignature to a travelers check; payment violating a restrictive endorsement; instruments issued without consideration; and breach of presentment warranty (3.417(b)). The most prevalent common law defenses are fraud, misrepresentation or mistake in the issuance. GOOD FAITH: 1.201(b)(20) means honesty in fact and the observance of reasonable commercial standards of fair dealing. EASTS BIG STUDENT HYPO: a former student calls and East and a client hired an independent Ktor and issued a check to this Ktor for 3k and later the Ktor called to say he lost

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the check and asked if they could replace the check; the client did and went to their bank to issue a stop-payment order on the first check. Next, a check cashing store calls and says they cashed the first check already and came back to them dishonored b/c of the stop-payment order and the cash outlet claims it is entitled to payment on the first check and by the way we cashed the second check this morning! The former student wants to tell the client they dont have to pay the first check. The facts show the cash outlet is a person entitled to enforce b/c they were negotiated the check by its holder, the Ktor, by endorsement. Cash outlet may sue for drawer liability under 3.414 and a drawer, if a check is dishonored, owes the amount of the instrument to a person entitled to enforce. But client does have a defense to paying twice on the basis of fraud in the inducement through misrepresentationsCL contract fraud, and ML for want of consideration on the second check. But whats the problem w/ client saying it wont pay the first check? Cash outlet is ML a HDC as they are a holder, and ML gave value, in good faith, w/o notice of forgery, alteration, or other irregularity to call into question authenticity, etc., even if she presents another check a few days later b/c they not know theres any claim or defense of any of these checks. As a HDC, cash outlet takes free from all defenses except the four real defenses in 3.305(a)(1). And, the defenses of want of consideration and CL fraud are ineffective. The sad news is the former student must try to marshal the facts to contest the formation elements of a HDC have not been met, e.g., cash outlet did not take in good faith. Claims in Recoupment Cut-off by HDC 3.305(a)(2) 1) If a holder, when negotiated to him, was w/o notice of a claim in recoupment, a 2) HDC takes free from a claim in recoupment of the obligor against the 3) original payee of the instrument if the claim arose from the transaction 4) that gave rise to the instrument. CLAIM IN RECOUPMENT: the right to have a claim reduced because of a demand by the party owing an obligation arising out of the same transaction. EXCEPTION: if holder had notice of the claim in recoupment, at the time the note was negotiate to the holder, the holder is not a HDC and the obligor may assert the claim against the holder but only as a claim in recoupment, i.e., to reduce the amount owed on the instrument. WANT OF CONSIDERATION VERSUS CLAIM IN RECOUPMENT: buyer issues a note to the order of seller in exchange for a promise to deliver goods. If seller fails to deliver or delivers goods rightfully rejected, buyer has a defense to the note b/c the performance that was the consideration for the note was not rendered. That is not a claim in recoupment but a defense to payment for want of consideration. But suppose seller delivered the equipment and the equipment was accepted, although defective. Buyer has a claim for breach of warranty and may assert against seller as a counterclaim or as a claim in recoupment to reduce the amount owing on the note. The seller is still on the hook and cannot use the HDC doctrine to allow seller to cut off a warranty claim that buyer has against seller. If seller negotiated the note to Holder, and Holder did not have notice of buyers claim, buyer may not assert the claim against Holder if Holder otherwise qualifies as a HDC. Rights Acquired By Transfer of InstrumentShelter Rule for HDC 3.203(b); 3.301(ii) 1) Transfer of an instrument (i.e., delivered for purpose of giving transferee right to enforce), 2) Whether or not the transfer is a negotiation, vests in the transferee any right of the transferor 3) to enforce the instrument, including any right as a HDC, and under 4) 3.301(ii) such transferees become persons entitled to enforce even if not a holder.

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EFFECT: a transferee acquires the rights of the transferor to enforce the instrument even if the transferee did not take by negotiation. And, even if not take by negotiation (e.g., absence of endorsement), and thus not a holder, they are nonetheless entitled to enforce under 3.301(ii). EXCEPTION: the transferee cannot acquire rights of a HDC by a transfer, directly or indirectly, from a HDC if the transferee engaged in fraud or illegality affecting the instrument (transferee cannot launder an instrument through a HDC). HYPO Problem 23.5: WWF calls about a problem. Venn operatess a dyeing business, where he has a purported permanent red dye. Yeobright asked Venn to dye a set of 20 uniforms for a fire department. Y agreed to pay w/ a negotiable promissory note for 3k, payable to the order of V in equal monthly installments over two years. V sold the note to Wessex Bank for 2800, and V specially endorsed: Pay to Wessex Bank, /s/ Venn. Wessex donated the note to WWF w/ a special qualified endorsement: Pay to WWF, without recourse, Wessex Bank, by /s/ Vye, VP. Venn did a terrible job on the dye, and Y refuses to pay on the note. WWF got a call from Ys lawyer saying WWF cannot make Y pay b/c WWF is not a HDC. Is WWF a holder? Yes, b/c the note was negotiated to them by Wessex all in accordance w/ negotiating order paper (i.e., that an actual holder endorsed the instrument). As holder, WWF is entitled to enforce the note. But Y, as obligor, will assert want of consideration as a defense to a suit for breach of contract on the note. This is a defense that is cut off by a HDC b/c its not one of the four real defenses in 3.305(a)(1). At the time Wessex became a holder, it was ML a HDC, and if it was Wessex seeking payment, Ys defense of want of consideration would be ineffective. But its not Wessex seeking payment, but WWF, and while they are a holder, they did not take for value, but as a donee, and to be a HDC, a holder must take for value under 3.302. But under 3.203(b), when an instrument is transferred, whether by negotiation or not, the transferee acquires the rights of the transferor under the shelter ruleto enforce the instrument, including the rights of a HDC. Therefore, WWF can enforce the instrument against Y despite Ys pugnacious lawyer. What if instead when Wessex made the gift of the note to WWF delivered the note but forgot to endorse the check; can WWF still enforce against Y? Yes, b/c the absence of an endorsement means an absence of negotiation, but WWF is the owner of the note and has been transferred the note (delivered for purpose of WWF enforcing) under 3.203(b) for purposes of the shelter rule to take effect. Notice that the Instrument is Overdue for whether HDC 3.304(a)-(c) 1) An instrument payable on demand becomes overdue at the earliest of the following times: a) On the day after the day demand for payment is duly made; b) If the instrument is a check, 90 days after its date; or c) If the instrument is not a check, when the instrument has been outstanding for a period of time unreasonably long under the circumstances in light of the nature of the instrument and usage of the trade. 2) With respect to an instrument payable at a definite time: a) [INSTALLMENTS] If the principal is payable in installments and a due date has not been accelerated, the instrument becomes overdue on default under the instrument for nonpayment, and the instrument remains overdue until the default is cured; b) [NOT PAYABLE IN INSTALLMENTS] If the principal is not payable in installments and the due date has not been accelerated, the instrument becomes overdue the day after the due date; and c) [PRINCIPAL BEEN ACCELERATED] If a due date w/ respect to principal has been

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accelerated, the instrument becomes overdue the day after the accelerated due date. EXCEPTIONINTEREST ACCELERATED: unless the due date of principal has been accelerated, an instrument does not become overdue if there is default in payment of interest but no default in payment of principal (e.g., default in paying an installment where all of the installments are interest w/ a balloon payment at the end composed solely of principal; but if default on an installment that is part interest and part principal, this exception does not apply and the instrument is overdue). NUANCE: Whether an instrument is payable on demand versus payable at a definite time is determined by 3.108, which is noted above for the requirements of negotiability (instrument must be payable on demand or at a definite time for negotiability). The Effect of Notice of Discharge on HDC Status 3.302(b); 3.601(b); 3.602(a) 1) An obligors discharge on an instrument is effective against a person 2) Who became a HDC with notice of the discharge, but discharge is not effective 3) Against a person acquiring rights of a HDC without notice of the discharge. Std for discharge: an obligation on an instrument is discharged only if (1) payment comes from a person obliged to pay (2) to a person entitled to enforce the instrument. DEFENSERESTATEMENT OF MORTGAGES & K LAW: under the restatement of mortgages 5.5, and the CL of contracts, a payment by a borrower to a party that the borrower believes to be the holder is valid to discharge the borrower even if the supposed holder already has transferred the note to a third party. Said another way, the burden is on the assignee to notify the obligor that payments must now be made to the assignee. Remember, article 3 applies only to negotiable instruments. Therefore, counsel for the obligor/borrower should argue that the instrument is not negotiable under the seven factors above. If successful, these defenses come into play so that even if the assignee of the note would otherwise qualify as a HDC, the borrowers payment to a party the borrower believes to be the holder of the note discharges the borrower regardless of whether the assignee took the note with notice of the discharge. (There are also pending revisions to article three that may change the harshness of 3.601(b).) HYPO Problem 23.2: Bill borrowed 2 million from TAB, and TAB sold the note to Bulstrode. But two weeks before TAB sold to Bulstrode Bank, Bill paid the 2 million in full to TAB, and Bulstrode says thats not his problem, Bill has to pay Bulstrode. The question is whether Bill still must pay Bulstrode even though it has paid TAB. ML, Bill has to pay Bulstrode as a HDC but can go after TAB on an unjust enrichment theory for restitution. 3.302(b) provides that discharge is effective against a person who became a holder in due course with notice of the discharge. And, 3.601(b) provides that discharge is not effective against a person acquiring rights of a holder in due course w/o notice of the discharge. Further, 3.602(a) provides that an instrument is paid to the extent payment is made (i) on behalf of a party obliged to pay the instrument, and (ii) to a person entitled to enforce the instrument. Here, Bulstrode was ML w/o notice of the discharge b/c it bought the instrument 4 weeks before Bill paid TAB, and a discharge is not effective against a person acquiring rights of a holder in due course w/o notice of the discharge. And, a discharge is only effective, under 3.602(a), if paid to a person entitled to enforce, and here, TAB, at the time Bill paid was not entitled to enforce the note. Here, Bills payment did not even constitute a discharge for Bulstrode to have notice of b/c TAB not entitled to enforce. HYPO: what if instead, at the time Bill paid TAB, it was still the holder of the note, does that discharge the obligation? Yes, b/c TAB was still the holder of the note and therefore under

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3.602(a) they were a person entitled to enforce. Is it possible however, that even if note paid by Bill to TAB, TAB could thereafter negotiate the note to Bulstrode so that Bulstrode becomes a HDC? Yes, as long as Bulstrode does not take the note w/ notice of the discharge of the obligation between Bill and TAB per 3.302(b), the discharge will not effect Bulstrode. Does that mean Bill has to pay again to Bulstrode? Yes. Now, Bill though can recover against TAB in restitution for unjust enrichment. If TAB is insolvent, when try to get restitution, Bill is in a hurt.

HYPO Problem 23.3: can Tom enforce the cashiers check against Hunt Bank as a HDC of the check even thought the counter-signature was forged? The check was issued by Hunt Bank payable to bearer but required, as a condition to payment, Kingsleys countersignature, which was forged by the customer that cashed the check w/ Toms Kash Outlet. The first issue is whether the requirement of a countersignature constitutes a condition on payment precluding negotiability of the cashiers check. The requirement does not constitute a condition on payment b/c 3.106(c) provides that a requirement, as a condition on payment, of a countersignature whose specimen signature appears on the promise or order, does not make the promise or order conditional. If the person whose specimen signature appears on an instrument fails to countersign the instrument, the failure to countersign is a defense to the obligation of the issuer, but the failure does not prevent a transferee of the instrument from becoming a holder. Comment 2 to 3.106(c) provides that the countersignature is for the purposes of identification of the owner of the instrument. It is not an endorsement. A forged countersignature is a defense to the obligation of the issuer to pay the instrument under 3.305(a)(2), but that defense is not effective against a HDC b/c it is not one of the 4 real defenses in 3.305(a)(1). What is required for becoming a HDC is no notice that any signatures are forged. But that is a fact issue and here, the forgery of the countersignature was well done. Therefore, TKO is ML a HDC. That being so, the issuers defense of a forged countersignature is a defense to payment under 3.305(a)(2) but is not effective against a HDC, therefore Tom can enforce the cashiers check against Hunt Bank. Defense to HDCFTC Legend 1) When an instrument is required to contain a legend prescribed by the FTC stating, e.g., 2) the holder of this consumer credit contract is subject to all claims and defenses that the 3) issuer could assert against the original payee, that legend does not preclude negotiability as 4) a condition to payment, but such a legend, if actually affixed, does preclude HDC status. EFFECT: if the legend is missing, the holder can become a HDC.

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