S's obligation: deliver conforming goods (UCC 2-301)
B's obligation: take conforming goods and pay for them
S's Remedies for B's breach: See Concept Summary, p. 304
Key Questions affecting remedies
Who has the goods? S, Carrier, B? Is B insolvent?
B's remedies for S's breach (see Concept Summary, p. 307)
Key issues: do the goods conform? Does B want them?
"Warranty": a promise about quality that is part of a contract, often implied even if not expressly stated
Note special Federal rules for consumer products: Magnuson-Moss Act: full warranty disclosure. Also state consumer protection laws. Warranties are the contract counterpart of tort law product liability.
Significance of warranties: can sue on the basis of a contractual breach of express or implied warranty. Unlike tort cases, with warranty there's no need to show negligence or "defective design", and one can recover economic loss when there's no physical injury. Loss = value as warranted less value actually received.
Warranties may be expressly disclaimed
Procedural requirements: "conspicuously" indicate what's being disclaimed
Can't disclaim if disclaimer is "unconscionable"
Procedural and substantive tests. It is a difficult question as to when a form contract disclaimer of an implied warranty is valid. Under what conditions should people be allowed to waive rules that were made to protect those like them? Why not let knowledgeable B's take on the risk of using untried products, or those that are cheap for good reason?
UCC Article 3 covers "Negotiable Instruments", meaning promises to pay money, or orders directing someone else to pay money, that may be freely transferred ("negotiated"). It's an extension of the concept of assigning contract rights to third parties. Just as contracts are "private law", this is "private money". In this area, rights and obligations are largely standardized by law, rather than being left to the agreement of the original parties, such that "money doesn't care who has it", and "all money is pretty much alike." Pecunia non Olet!
UCC Article 4 covers an important subset of orders directing payment, namely checks drawn on bank deposits. Note tho that there are many other laws and regulatory bodies affecting banking.
The key concepts are:
- What makes something a "negotiable instrument"?
- How is such an instrument "negotiated"?
- What are the rights of a subsequent holder, especially a Holder in Due Course?
- What special rules apply to bank checks?
Types of negotiable instruments:
A promise to pay money at a stated time or on demand. A CD (certificate of deposit) is a promissory note from a bank to a depositor
A "draft" is a three party instrument payable at a stated time, or on demand (a "sight" draft). The "Drawer" tells the "Drawee" to pay money to the "Payee". There is an underlying debt the "Drawee" owes the "Drawer", and a draft functions like an assignment of the right to payment.
The "Drawee" must "accept" to become liable on the draft -- like being notified that a contract right has been assigned.
A "trade acceptance" is a draft where the seller of the goods is both the drawer and the initial payee. ("I assign to myself the right to have buyer pay me for the goods.") Purpose is to make B's promise to pay negotiable
A check is a demand draft drawn on a bank
Formal requirements for Negotiability
An instrument must be:
In Writing. UCC 3-103(a)
Signed by the maker/drawer.
Sec. 1-201(38): "'Signed' includes any symbol executed or adopted by a party with present intention to authenticate a writing."
Can be rubber stamp, machine, or signed by an agent
And meet the definition in UCC Sec. 3-104(a):
"3104. (a) Except as provided in subdivisions (c) and (d), "negotiable instrument" means an unconditional promise or order to pay a fixed amount of money, with or without interest or other charges described in the promise or order, if it is all of the following:
(1) Is payable to bearer or to order at the time it is issued or first comes into possession of a holder.
(2) Is payable on demand or at a definite time.
(3) 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 ...
Reason for definition: allow promises to circulate in commerce.
To be "private money", a promise to pay must be transferable and as free of conditions as possible -- detached from the circumstances of its creation. A later holder of the instrument looks only to the credit of the maker, nothing more. ("All money is pretty much alike.")
"Pay to the order of X", or "pay to bearer" are magic words of negotiability
The instrument itself must fix the amount. No need to look at other agreements (tho can refer to general indices -- eg. for variable interest rates.)
Time of payment similarly fixed (tho can refer to other writings that define the collateral, acceleration and prepayment rights)
Non negotiable instruments are assigned/enforced under normal contract rules
Negotiation and "endorsement"
In general: Payee can freely transfer note or draft. No need to re-notify maker/drawee. ("Money doesn't care who has it.")
Order paper and bearer paper
"Order" = Payable to named person. "Bearer" = Payable to whoever has it.
Can convert from one to the other: named person indorses "pay to bearer", or bearer indorses "pay to the order of X". Key question: does the last indorsement say to whom the instrument is now payable?
How paper is "negotiated"
UCC 3-201(b) "... if an instrument is payable to an identified person, negotiation requires transfer of possession of the instrument and its indorsement by the holder. If an instrument is payable to bearer, it may be negotiated by transfer of possession alone."
What is an indorsement?
UCC 3-204(a): a signature for the purpose of negotiating the instrument. An indorser normally guarantees subsequent holders that the instrument will be paid according to its terms.
Types of indorsements
Is a particular indorsee named?
- If not, it's bearer paper: example: just sign name on back of check
- if "special" -- pay Mr X -- it's now order paper
Is it "Qualified" -- stated restrictions on liability of indorser
Normally unqualified, making indorser liable to later holders. Qualified indorsements, such as "without recourse" limit liability
Are indorsee's rights restricted?
Normally it's non restrictive - no conditions on payment
Restrictive indorsements may be conditional, may be "for deposit" or "for collection", may be "in trust". Effect is to create liability on part of indorsee who does not comply with instructions -- [except for intermediate banks in check collection]
"Or" and "/" means in the alternative, "and" means both required
Depository bank may supply indorsement for customer
Holder in due course
Significance: a HDC takes paper free from most defenses the maker/drawee may have against initial payee. A reason to be careful when creating negotiable instruments
"... 'holder in due course' means the holder of an instrument if both of the following apply:
(1) The instrument when issued or negotiated to the holder does not bear such apparent evidence of forgery or alteration or is not otherwise so irregular or incomplete as to call into question its authenticity.
(2) The holder took the instrument (A) for value, (B) in good faith, (C) without notice that the instrument is overdue or has been dishonored or that there is an uncured default with respect to payment of another instrument issued as part of the same series, (D) without notice that the instrument contains an unauthorized signature or has been altered, (E) without notice of any claim to the instrument described in Section 3306, and (F) without notice that any party has a defense or claim in recoupment described in subdivision (a) of Section 3305." UCC 3-302(a)
"Holder" = the person who possesses and is named in order paper, or possesses bearer paper
"for value" = for payment, or for past performance, or a security interest, an existing claim, etc. Acquisition at a discount is usually considered "for value", but very large discounts may raise notice of defect. Involuntary HDC's: banks during collection process
"Good faith" means honesty in fact, a subjective test
"without notice" No reason to know it's overdue, dishonored, or subject to defenses, or the claims of others
A time instrument specifies time for payment, so no HDC after due date. 90 days now is reasonable for a check; look to business practice for other demand instruments
"Notice" of dishonor means knowing that it was not paid when presented e.g. "NSF" on face of check
Notice of claims or defenses:
The "Red Light" principle
An obvious irregularity on face of item means holder is not HDC
If knowledge of fraud in inducement etc., no HDC
"Notice of discharge" - is reason to mark notes as "paid"
The "Shelter" principle
Someone acquiring from a HDC is a HDC, even if they otherwise would not be a HDC. E.g. a holder not an HDC who sells to a HDC and later acquires for value, becomes an HDC. [p. 352 of the 6th edition leaves out a critical "not".]
Limit: this does not apply to persons party to fraud or prior holders who had actual notice of defenses. Concern is of "laundering" notes. And is a reason the Federal Trade Commission has cited the HDC rule as a potential unfair trade practice in consumer transactions
Signature liability of parties
Maker is primarily liable on note or draft, and each indorser (and drawer of draft) is secondarily liable, to each other in the order of indorsement
Endorser liability is triggered by presentment, dishonor and notice of dishonor
Banks must give notice of dishonor before midnight of 2nd following banking day. Others have til midnight of 3rd business day
Unauthorized endorsements (i.e. forgery)
Usually, person paying the forger is liable. The party who first takes the forged instrument after the forgery is liable to subsequent holders. Know your indorser!
Two exceptions: where drawer or maker bears the loss. These involve embezzlement of outgoing payments, as for accounts payable and payroll. Consider in the context of accounting control systems.
Impostor induces maker to create instrument in payee's name, and forges payee's indorsement. Maker is liable under a "know your payee" principle
Fictitious payee rule
person signing for maker intends named payee to have no interest. e.g. "Pay to the order of Mickey Mouse"
Warranty liability of transferors
- Transferor has good title
- Signatures are genuine
- No material alterations
- No defenses against indorser liability (unless "without recourse")
- No knowledge of insolvency of maker or drawee
Implied warrantees when presented to maker for payment
- A HDC warrants good title
- Non-HDC warrants no knowledge of unauthorized signatures
HDC and Defenses of the Maker
These go to the validity of the instrument itself and are defenses even against a HDC: "the note is not a debt of mine"
- adjudicated incapacity
- extreme duress - force
- Illegality -- if void by law (e.g. gambling debts)
- fraud in the inception (deceived as to what the note was)
- discharge in bankruptcy
"Personal" defenses -- not good against a HDC
Breach of contract: "the note is a debt of mine, but I have offsetting claims against the payee"
Fraud in the inducement (lies to create the debt, vs lies that it is a debt).
Discharge of notes and drafts
- Payment (tho if restrictive indorsement, must follow restriction)
- Reacquisition by maker/prior indorser discharges intermediate parties
- Discharge of secondary parties if holder releases obligor or impairs collateral
Key point to remember: a check is a demand draft drawn on a bank
Electronic checking is altering the rules.
See National Consumer Law Center Explanation. Also be aware that legal theory here must confront the "paper ocean".
Special types of checks
Certified: bank has "accepted" it and agreed to pay: funds are set aside for payment
Cashiers: issuing bank is drawer and drawee
Travellers: drawn by bank on itself: 2 signatures of holder required for it to become negotiable
bank will normally honor (pay and debit customer account). If wrongful dishonor (enuf $ in account), bank is liable to the customer, tho customer is still liable to payee
IF NSF, bank can bounce it back, or extend overdraft protection
Checks go stale after 6 months
Stop payment order: by drawer
Oral 14 days, written 6 months
Forged and altered checks: who bears the loss?
Significance for accountants: affects the design and implementation of control systems to prevent/detect embezzlement of incoming or outgoing payments. The Fraud Tree
Who embezzles? How do they do it? See the ACFE's Report to the Nation : 2008 and today's discussion cases
Bank is responsible for knowing customer signature. Bank is primarily liable
i.e. decimal point moved. Bank may charge customer in accord w/ original terms. Each party in chain of collection can recover from prior party, which in effect puts loss on party who first paid after the alteration
But: customer bears loss caused by customer's negligence
If series of forgeries: rule re examination of statements. Customer is liable starting 14 days after statements available. Reporting forgery shifts liability back to bank.
Real payee not liable: never really indorsed. Transfer warranty shifts the loss down the chain to the person who first paid the forger
Bank Clearing houses and Fedwire transfers
Provisional credit to depositor/payee: pending clearing on the drawee bank
obligation of each bank in the settlement chain to act by its "midnight deadline"
Notices that prevent payment of a presented check while being posted, before midnight deadline
- Notice of death, bankruptcy, etc
- Court order freezing account/ garnishment
- Receipt of stop payment order from depositor/drawer
- Bank's right of set-off
format and notes (c) 2001-08 Robert H. Daniels