• Negotiable Instruments/Commercial Paper

    The topic of Negotiable Instruments, also known as Commercial Paper, is an important one in the law curriculum. It’s derived from Article 3 of the Uniform Commercial Code. The chapter can be viewed as a “journey” towards creating a person known as a “holder in due course” (HDC, for short). This occurs in three steps. First, there must be an “instrument” (normally a piece of paper) that is “negotiable.” Second, this instrument must be properly “negotiated” (a simpler word would be “transferred”). And, third, the person to whom it’s negotiated must pass special tests to qualify as an HDC. This outline will move through this process in an orderly fashion.

    Background. For some background on this area, let’s remind ourselves about the topic of “assignment of rights” from Contracts. Using an example you may be familiar with from class, say Al has a contract to paint Barbara’s house for $2,000. As you may recall, Al can “assign” (give or sell) his right to that payment to Cindy. However, when Cindy comes to collect the money from Barbara, if Barbara complains that Al performed the paint job poorly, Barbara will win: under contract law, Barbara does not have to pay for bad work. Even though Cindy will argue that it was Al who did the bad work, not Cindy, the law states that, as an assignee, Cindy has only the same rights that Al had (she “stands in his shoes”), and since Al would not have been entitled to get paid for bad work, neither is Cindy. In fact, any “defense” (excuse) Barbara could have used to avoid paying Al will work equally well against Cindy.

     Now, let’s change the picture and bring in Negotiable Instruments. Suppose that, in addition to signing the contract with Al, Barbara also issued him a “negotiable instrument” promising to pay Al the $2,000 for the paint job. Suppose also that Al properly “negotiated” the instrument to Cindy, and that Cindy passed the tests to qualify as an HDC (holder in due course). If this is the case, then when Cindy goes to Barbara for payment, she’s not merely the assignee of contract rights but is a “powerful” HDC. The balance of power shifts, and Barbara will have to pay Cindy even if Al’s work on the paint job was bad or if he never did the job! Except for certain special situations (discussed below in the segment on “real defenses”) Barbara’s “defenses” (her arguments against paying Al) are not effective against an HDC.

    So now let’s see how someone becomes an HDC.

    Negotiable Instruments: There are two main types of instruments: notes and drafts.

     1. Notes. A note involves only two parties: one promises to make payment to the other. So there’s a “maker” and a “payee.” Here’s a simple note: “I promise to pay $2,000 to the order of Al, signed Barbara.” Since notes contain a promise, they are also sometimes called promissory notes. Barbara’s the “maker” and Al is the “payee.”

     2. Drafts (and checks). There are three parties involved in a draft. Here, instead of Barbara promising to pay Al, she commands, or orders, Ed to pay Al. A simple draft might read: “Ed: Pay $2,000 to the order of Al, signed Barbara.” Here, Barbara is called a “drawer” and Ed a “drawee” (Barbara is “drawing” funds out of Ed). Al is still called the “payee.”

    A “check” can then be seen as just a special type of draft. In a check the drawee is a bank. When you write a check on your account with Citibank to pay the electric bill, you are the drawer, Citibank is the drawee, and Con Ed is the payee.  (Later on in this discussion, we’ll see that certain special rules apply to checks.)

     3. Demand Instruments vs. Time Instruments. Notes and drafts will either be “demand” or “time” instruments. A time instrument calls for payment only after the passage of time. Suppose on April 8 Barbara writes: “I promise to pay to the order of Al $2,000 on June 17,” signed Barbara. Since payment is only promised in the future it’s a “time instrument.” (The sample draft discussed above could easily similarly be made into a “time” draft.) If the instrument does not mention a payment date at all, or if it specifically says something like “payable on demand,” that means it’s a “demand” instrument. It also means the instant the payee obtains the instrument he can demand payment.

    All checks are demand instruments. That is, you cannot make out a check payable in the future. If you do, you are not making out a “check,” you are turning it into a regular “draft.”  So, we can now say that a check is a special type of draft, and what makes it a check is: (1) the drawee is a bank, and (2) it is payable on demand.

     4. Trade Acceptances and Certificates of Deposit. These are other less common types of instruments. (i) A “trade acceptance” is a type of draft issued by a seller to a buyer. Tom buys 50 TV sets from Alice for $3,000 and will pay over time. Alice signs an instrument commanding Tom to pay her $3,000 over the time period agreed to. Alice is both the drawer and payee. Tom is the drawee. Alice will also ask Tom to sign as “acceptor” (discussed below). (ii) A “certificate of deposit” is a type of note a bank issues to a depositor promising to pay back an amount deposited in the bank. The bank is the “maker” and the depositor is the “payee.”

    The negotiability rules

    For an instrument (note or draft) to be “negotiable” all of the following rules must be met (memorize this list!):

     1In writing. The note or draft must be in writing. There is no such thing as an “oral” negotiable instrument.

     2. Signed. A note must be signed by the maker. A draft must be signed by the drawer. No one else needs to sign a note or draft for it to be negotiable. Any mark made with the intent to serve as “your mark” will count: initials, fingerprint, rubber stamp, typed name, smiley face, etc., though usually it’s a regular signature, of course.

     3Sum certain. From reading the instrument you must be able to tell exactly how much you will be paid. If interest or collection costs are to be added, that’s fine: it still satisfies this rule. But, e.g., if the promise is to pay “all the money I get from selling my car,” it’s not negotiable because you cannot tell from reading the instrument what amount is to be paid.

    4. Cash only. The instrument cannot call for the payment of goods or services or anything other than cash. So, for example, a note containing a promise to pay “$1,000 plus a Ford Mustang” is not negotiable.

    5. Demand or specified due date (deadline). This is an either/or test. The instrument must either be payable on demand or at a specified due date.

    The best way to view the “due date” rule is to look for a “deadline.” You don’t need to find an actual specific payment date: just a “final” date after which payment is late and you can sue for enforcement.  So, e.g., if payment is called for “either on Jan 16 or May 17,” you won’t know on which date payment will actually be made, but this test is met because you know that May 17 is the final allowable date: the deadline.  Or if it says, payment may be made “any time up to April 8,” that’s fine too: you won’t know the exact day it’ll be paid, but April 8 is the deadline.  On the other hand, if it says, “payment is due May 19 or a reasonable time thereafter,” it’s not negotiable.  A payment date linked to an event, does not qualify, e.g., payable on the death of my Aunt Harriet, or payable when I sell my 2012 Toyota, or payable at the end of the 2017 baseball World Series.  

    It’s also fine if the instrument doesn’t deal with a payment time at all. In that case, it’s a demand instrument. “I promise to pay $100 to the order of Harry, signed Bob.” That’s a negotiable note: It’s payable on demand. As soon as Harry gets it, he can demand payment. Checks never mention a payment date: they are all payable on demand.

     Note: An extension clause is fine (pushing the payment off), but only if it’s either (i) extendable to a specified date, or (ii) can only be extended by the party getting paid (the holder). An acceleration clause (making the payment earlier on the occurrence of a specified event) is also fine, because the original deadline satisfies the test and the potential event can only make it earlier.

     Examples: (a) “payment is due April 8, but if it’s raining on that day, May 8.” That’s fine: May 8 is the “deadline” for purposes of meeting this test.

                 (b) “payment is due April 8, or a reasonable time later.”  This is not good — it can be extended to an undeterminable date.

     (c) “payment is due April 8, or later at the option of the holder.” Also fine: the payment date here seems extendable to an unspecified date, but only the party getting paid can extend it.

    (d) “payment is due July 20, 2025, but if Harry dies before that date payment will be due on the date of Harry’s death.” Also fine. There’s a deadline and the event that can change the payment date can only bring it earlier.

    6. Unconditional right to payment. The holder’s right to payment must be “unconditional” for the instrument to be negotiable. There can be no “ifs.” A note that says: “I promise to pay $2000 to the order of Harry if he paints my house,” is not negotiable.

     Under this test, watch out for references to other documents. Some references make it conditional (and nonnegotiable); others don’t. If you see a statement like: “this instrument is subject to (or governed by, or controlled by), some other document,” it’s conditional and not negotiable. This is because only “if” the other document says payment is to be made is the payment required. But if the statement instead is: this instrument is “in accord with” some other document, or payment will be made “as per” some other document, that’s fine. These are harmless references to other documents without giving them control over the payment.

     7. Promise or command. A note must contain an actual promise to pay. Thus, an “IOU” which merely says: “This document is proof that I owe Tom $200” is not negotiable because it does not contain a promise. It must say: I promise, etc.

     A draft, of course, won’t contain a promise (see discussion of drafts, above); instead it will have language of command. Usually, just using the word “pay” meets this test: “Ed: pay $100 to the order of Sally, signed Bob.”

     8“Magic words,” language of negotiability. This is an important rule. Be sure you remember it: The instrument must be payable either to “bearer” or to “the order of” the named payee. If it just says payable “to Joe Jones,” it’s not negotiable. This language of negotiability indicates that the maker or drawer intends for the instrument to be passed from hand to hand. If it says “payable to bearer,” that means: payable to whoever is bearing (holding) it. If it says “payable to the order of Joe,” that means payable to Joe or to whomever Joe orders it to be paid. (Payable to “cash” is the same as payable to bearer. It means whoever is holding it is entitled to the cash.) NOTE: Under the revised rules, a check does not need to have “to the order of” on it. “Pay to Jim” would not make it non-negotiable. But this exception only applies to checks.

    Another important rule:  The “four corners rule” says that not only must all of the above tests be met, they must be met on the face of the instrument itself.  If you need outside information to meet a test, it is not negotiable.  E.g., an instrument that is payable at the death of my aunt Harriet is not negotiable even if it so happens that Harriet is already dead.  That information is not on the instrument itself, so the test is not met.

    Summary: A short instrument may appear on the test to check to see if you can tell whether it’s negotiable or not. You will need to apply all of the above tests: if any one test is not met, it’s not negotiable.

     Example: An instrument states: I, Tommy Smith, promise to pay Joe Jones $1,000, on April 8 or April 15th, 2018, (signed) Tommy Smith.

     You should be able to recognize that this is not negotiable by applying the tests: It’s in writing and signed by the maker. It calls for the payment of a sum certain in cash only. There is a payment deadline. There is no condition. It contains a promise. But it’s payable “to Joe Jones,” not “to the order of Joe Jones.” (Note that the two payment dates do not make it nonnegotiable, as discussed above. One of the wrong choices on the test will claim that they make it nonnegotiable.)

    How is a negotiable instrument “negotiated?”

    The original holder of the instrument, the payee, can transfer (negotiate) it to someone else. How this is done depends on whether the instrument is “bearer paper” or “order paper.” Recall from negotiability Rule 8, above, that it can be made out either to “bearer” or “to the order of” a named payee. Well, if it’s made out to bearer, it’s called “bearer” paper. And if it’s made out “to the order of” someone, it’s called “order” paper.

     Transfer of possession. Bearer paper can be negotiated by transfer of possession alone. Say Lou issues (is the maker of) a note payable to bearer that he gives to Ellen. Ellen can negotiate it to Tom just by handing it to him. Under the revised rules, even if Tom found the bearer note or stole it, it has been negotiated to him (although he cannot be an HDC). And if Tom found (or stole) it he could properly negotiate it to someone else who can be an HDC. That is, if Tom finds it and hands it over to Max, it has been properly negotiated to Max and Max could qualify as an HDC. We’ll discuss below why this feature makes “bearer paper” dangerous.

     Transfer plus endorsement. If the instrument is “order paper,” transfer of possession alone is not enough to negotiate it: it must also be “endorsed.” To endorse an instrument, you turn it over and sign your name on the back. This requirement makes order paper safer.

     Example 1. Dan is holding a note promising to pay $100 to bearer. Dan falls asleep on the subway and Ron takes it out of Dan’s pocket. It has been negotiated to Ron. Ron cannot be an HDC because there is a claim against it (see HDC tests, below). But Ron goes to Tom and says: “Tom, here’s a note: will you pay me $90 for it?” Tom says sure, and Ron transfers it to Tom. Tom can qualify as an HDC. Even if Dan can show it was stolen, Tom is entitled to payment on the note and not Dan. (Dan’s only hope would be to catch Ron the thief.)

     Example 2. Change one fact: make the note payable “to the order of Dan.” Now it’s order paper, which requires Dan’s endorsement for it to be negotiated. As above, Ron steals it. Now, however, since Dan never endorsed it, it cannot be negotiated to anyone else. So Dan just calls up the issuer, tells him of the theft, and gets him to write him a new one. The old one is worthless without Dan’s endorsement.

    Types of endorsements

    You need to be able to recognize whether an endorsement is (a) special or blank, (b) qualified or unqualified, and (c) restrictive or nonrestrictive.

    (a) Special or blank endorsements. An endorsement is special if it names the person to whom you’re negotiating it. An endorsement is blank if it doesn’t.

     Examples. Tom issues a note payable to the order of Gail and gives it to her. Gail wants to endorse it to negotiate it to Ellen. If she just signs her name “Gail” on the back, it’s a blank endorsement. If instead she writes “Pay to Ellen, (signed) Gail” that’s a special endorsement.

     Either type of endorsement is fine: it works to negotiate the instrument. But here’s the key point: a blank endorsement changes the instrument into bearer paper. If the next holder, Ellen in the above example, wants to negotiate it to someone else, she can do so by delivery alone. A special endorsement keeps the instrument order paper. A special endorsement can also be used to change bearer paper into order paper. Say Hal is the holder of bearer paper (either because it was made out to bearer and given to him, or because the last endorsement on it was a blank endorsement). Hal can convert it into order paper by writing “Pay to Sally, signed Hal.” It would then be order paper in Sally’s hands.

     Key point often tested on the CPA exam: an instrument can bounce back and forth from being order and bearer paper with every endorsement! A blank endorsement makes it (or keeps it) bearer paper and a special endorsement makes it (or keeps it) order paper.

     Key note on negotiability: Notice that to make a special endorsement you can write “Pay to Sally,” and you do not have to write “Pay to the order of Sally.” This is because endorsements can have no effect on negotiability. An instrument is either negotiable or nonnegotiable based on the front of the paper: whatever takes place on the back (endorsements) has no impact. So you don’t need to write “to the order of” in an endorsement. Also: if an instrument is nonnegotiable (for example, if it doesn’t say “to the order of” on the front), an endorsement cannot “fix it” and make it negotiable. That is, using “to the order of” in an endorsement will not make a nonnegotiable instrument negotiable.

     SO: endorsements can change the nature of a negotiable instrument from bearer to order or vice versa, but cannot change it from negotiable to nonnegotiable or vice versa.

                (b) Qualified or Unqualified endorsements.  If an endorser adds the words “without recourse” to his endorsement, it becomes a “qualified” endorsement.  This means if the instrument is dishonored (not paid), you cannot sue the endorser for payment.  Many people aren’t aware of the fact that normally when you endorse a check or other negotiable instrument you are taking responsibility for it.  That is, if the check bounces, the person who issued the check can be sued for payment, of course (the drawer), but the endorsers are also liable!  However, by using a qualified endorsement, the endorser avoids liability.  In reality, qualified endorsements are very rare, but they frequently appear on the final exam!

     Any endorsement that does not contain this words (“without recourse”) is unqualified. Thus, most endorsements are unqualified.

     (c) Restrictive or nonrestrictive endorsements. (i) The most common type of restrictive endorsement is when you endorse a check to deposit it into your bank account and you sign your name and also write: “for deposit only.” That endorsement restricts any future transfers of the check to allow only those made for the purpose of getting funds into your account.

    Note — the next three small points will not be on the test (items (ii), (iii), and (iv).)

     (ii) The second type of restrictive endorsement is a trusteeship endorsement. You have a check you want to endorse and transfer to your grandson Eric. But Eric’s only 3 years old. So you endorse it, Pay to Jim, as trustee for Eric (or “for the benefit of Eric”). Whoever cashes the check for Jim is responsible for seeing to it that the funds are used by Jim solely for the benefit of Eric (i.e., that they go into an account for Eric or pay bills for Eric). If Jim cashes the check and uses the funds for himself, the person who cashed the check for Jim is liable to Eric and will have to pay again (Jim’s liable also but has probably run away).

     (iii) An endorsement no longer considered restrictive is the conditional endorsement. For example, an endorsement can say: “Pay to Jim if he paints my house, signed Sally.” A condition (“if” language) cannot be used on the front of the instrument (it would make it nonnegotiable), but it can be used on the back (in an endorsement). However, the condition has no legal effect and can just be ignored.

    (iv) Another endorsement no longer considered restrictive and with no legal effect is an endorsement that tries to prevent further negotiation. If your endorsement says: “Pay to John and only John NO FURTHER ENDORSEMENTS ALLOWED” the extra words have no legal effect. John can just cross them out and endorse it to anyone.

    The HDC tests

    Once you’ve established the instrument is negotiable and that it has been properly negotiated to you, you need to show you passed the HDC tests in order to attain the rights of an HDC (holder in due course).

    1.  Value.  You must have given “value” for the instrument.  That is, if you get it as a gift you are not an HDC.  Value can include goods or services, but it must actually be given and not merely promised.  (Recall in contract law that a promise to paint Tom’s house serves as “consideration,”  but it won’t count as value given for an instrument until the house is actually painted.)

    2.  Good faith.  You must not be part of a plan to use the HDC rules to cheat the maker or drawer of the instrument. 

    3.  The notice rules.  To be an HDC, at the time you acquire the instrument you must not have notice of any of the following:

     (a) Overdue. If you know the instrument is already past due when you acquire it, you are not an HDC. This may be evident just by looking at it. If payment was due June 8 and you buy it on June 10, obviously it’s overdue and you cannot be an HDC. But what about a demand instrument that doesn’t have a specific due date? Well, if it’s a check, it’s presumed to be overdue 90 days after it’s issued. For all other instruments, there’s a “reasonableness” test (that is, if the case winds up in court it will be up to a judge or jury to determine if the demand instrument had been outstanding so long that it should be considered overdue for these purposes).

     (b) Dishonor. If you are aware when you obtain the instrument that it has been presented for payment and payment was refused, then you can’t be an HDC. Sometimes this is clear from the instrument itself. If a check has bounced it will have “payment refused” or “insufficient funds” stamped all over it. If you cash a check like this for someone you won’t be an HDC because you had notice it’s been dishonored.

     There’s a second way an instrument can be dishonored. For this we need to discuss the important concept of acceptance. Acceptance only relates to drafts, not notes. Let’s say that on May 1, the drawer (Sally) issues a draft to the payee (Max) and it orders the drawee (Paul) to make payment, on June 15. Now Max hasn’t dealt with Paul. So he goes to Paul on May 2nd. He says, “Look, Paul, I’m not here for payment, it’s not due yet. But I just want some assurance that when June 15 comes, you will honor the draft and pay me the money.” Now two things can happen. (i) Paul can say: “Sure I’ll pay.” In that case, Max will ask him to sign the front of the instrument. When Paul does this he has accepted it. (ii) Or Paul can say, no, I won’t sign or I won’t pay. If Paul refuses to accept the instrument he has dishonored it. That is, if Max (who now knows the instrument is worthless) turns around and sells it to Kathy, Kathy cannot be an HDC if she has notice that Paul dishonored it (refused to accept it).

     Again, an instrument can be dishonored when payment is refused when due, or when it is presented to a drawee for acceptance and the drawee refuses to accept. In either case, if a person has notice of these events when he obtains the instrument he cannot be an HDC.

     (c) Defense or claim. If a person has notice of a defense or claim being raised against the instrument and he goes ahead and buys it anyway, he cannot be an HDC.

    The shelter rule.  This is a very important rule, also known as the “umbrella” rule.  This rule says that once one person satisfies the HDC tests he earns the special rights of an HDC and can simply transfer those rights to anyone else (i.e., without that person also having to pass the tests).  This means the HDC tests really only apply once to each instrument.

     Example. Max is the payee of a note. He sells it to Eric for value. Eric is acting in good faith and has no notice of it being overdue, dishonored, or subject to any defense or claim. That means Eric has passed the HDC tests and has earned the rights of an HDC. Now Eric can transfer it to Bonnie who does not have to pass the HDC tests to get the rights of an HDC! That is, he can give it to Bonnie as a gift, or when Bonnie has notice it’s overdue or dishonored: she takes “shelter” under Eric’s “umbrella” and will enjoy all of the rights of an HDC. So if you see a line of holders in a question on the CPA exam, and one of them has passed the tests to become an HDC, remember that all holders coming after him also have all the rights of an HDC. (Of course, if fraud is involved the shelter rule won’t apply, but that’s rare.)

    “Real” and “personal” defenses.

    A person who qualifies as an HDC is in the superior position of having the right to get paid regardless of any “personal” defenses raised against payment. However, an HDC is still vulnerable to “real” defenses. Let’s take a look at both types.

    Real defenses: Let’s say we have a note issued by Barbara to Al in connection with her contract with Al for him to paint her house. The note is payable to the order of Al, which Al endorsed and delivered to Cindy, an HDC. Cindy is now presenting it for payment to Barbara and Barbara is raising the following defenses:

    1. Forgery: Barbara says she never signed the note. Her signature on it was forged by someone else. This is a real defense and Barbara will not have to pay even to an HDC.

    (You may you lose your forgery defense if your own carelessness led to the forgery. For example if you learn that your checkbook was stolen and someone was forging checks but you don’t do anything about it for 3 weeks, any additional checks forged within those three weeks are your responsibility.)

    2.  Duress:  Barbara signed but only because a gun was held to her head: she doesn’t have to pay.

    3.  Material alteration:  Barbara made out the note for $100 but someone changed (altered) it to $1,000.  Or altered the name of the payee.  That’s a real defense and Barbara doesn’t have to pay.   (Actually, in the case of the changed amount, she’d have to pay an HDC the original amount ($100).)

    4.  Minority:  Barbara is under 18 years old.  Minors have the right to disaffirm their obligations.  This is a real defense.

    5.  Fraud in the execution:  This is a special type of fraud, relating solely to how the instrument was created.  If Barbara was tricked into signing the note not realizing it was a note, that’s a real defense.  But the fraud has to relate to the creation of the note for it to come under this rule.

    6.  Bankruptcy:  If Barbara has gone through the bankruptcy process and has had her debts erased (including this one), the HDC will not get paid.

    Personal defenses:  The following are “personal defenses.”  An HDC is not bothered by them and will be entitled to full payment on the instrument.

    1.  Basic contract issues. If the note was issued in connection with an underlying contract, any issues that arise with respect to the contract are personal between the contracting parties and will not affect an HDC’s right to get paid. 

     Example: Barbara issued a note to Al in connection with her contract with Al for him to paint her house. Al negotiates the note to Cindy, an HDC. When Cindy comes to get paid, Barbara complains that the paint job was bad, or that it was never done at all (the bum never showed up!), or that Al committed fraud in connection with the contract. All of these defenses are personal, between Barbara and Al. Cindy as an HDC is entitled to get paid by Barbara. (Note the difference between fraud relating to the contract (a personal defense) and fraud relating to the execution of the instrument (discussed above as a real defense).

    2.  Unauthorized completion.  This is the typical “blank check” situation.  Tom tells Jim to pick up some groceries for him and gives him a signed check but leaves out the name of the payee and/or the amount.  He says: use this at the grocery store, but don’t go over $50.  Jim fills in his own name as payee, fills in the amount for $800, cashes it at the ABC Check Cashing Co., and flees the state.  ABC is an HDC: it doesn’t know Jim is cheating Tom.  When Tom discovers what happened he tries to stop payment on the check, claiming the defense of unauthorized completion.  However, this defense is “personal” between Tom and Jim.  ABC is entitled to payment.  Tom created the problem for issuing the blank check in the first place.  (Be careful not to confuse this personal defense of unauthorized completion with the real defense of material alteration: they sound alike but are different.)

    3.  Prior payment.  Ned pays off a negotiable note presented to him by Pete, but Ned neglects to take the note back from Pete to destroy it.  Pete leaves Ned’s house still in possession of the note!  Pete sells it to Sally, an HDC.  When Sally comes to get paid, Ned says:  “I already paid!”  Ned’s defense is personal and can only be used to try to recover from Pete.  Ned has to pay Sally.  Again, it was Ned’s fault that this problem arose because he failed to recover the note from Pete when he paid it off.

    NOTE:  The material from here to the end of this outline will not be on the final exam.  Accounting majors should be aware, however, it may be on the CPA exam.

    Primary and secondary liability.

    When a note or draft is presented for payment and but payment is refused, it has been “dishonored.” So whom can you sue? The most common type of liability is called “contract” liability. And there are two categories: primary and secondary. Note that only individuals who have signed the instrument can have contract liability.

    Primary liability: notes. On a note, the maker has primary liability. There is no time limit. If the note is dishonored you can always sue the maker.

    Secondary liability: notes. On notes, endorsers have secondary liability. Secondary liability only arises after three things have occurred: it has been presented for payment, it has been dishonored, and you have given notice to the endorsers that it has been dishonored (presentment, dishonor, notice). However, secondary liability has a time limit: after a reasonable amount of time passes from the endorsement, if no notice is received, the endorser is not liable. Also, an endorser who used a qualified endorsement (see above, “without recourse”) avoids liability.

    Primary and secondary liability: drafts. On “regular” drafts nobody has primary liability! The drawee has no liability because he has not signed. The drawer’s liability, like the endorsers, is secondary. That is, it only arises after the draft has been presented to the drawee, dishonored, and notice was given. Unlike the endorser’s secondary liability, however, the drawer’s liability lasts forever. However, if the drawee has “accepted” the draft (see the discussion of acceptance, above) then he has signed and then he has primary liability.

    Special rule for endorsers of checks. As noted above, in general, the secondary liability of endorsers of notes and drafts ends after “a reasonable amount of time.” For checks, however, there’s a set time period of 30 days. If presentment, dishonor, and notice do not occur within 30 days of an endorsement, that particular endorser is relieved of liability. Also, an endorser who used a qualified endorsement avoids liability.

    Warranty liability. A second type of liability is warranty liability. This may arise when there’s some defect in the instrument, such as forgery. (Contrast contract liability discussed above, which arises when the instrument is dishonored.) Unlike contract liability, warranty liability can apply to someone who has never signed the instrument. For example, if bearer paper is negotiated to Tom and Tom negotiates it to Susan by transfer alone (i.e., without signing it), Tom can still be held liable for warranty liability.

    Here are the warranties:

    1. Transferor warranties: When a person transfers the instrument he warrants the following: (i) he has good title to it, (ii) all signatures on it are genuine, (iii) the instrument has not been materially altered, (iv) no defense is good against him, and (v) he has no knowledge of insolvency procedures brought against the maker, drawer, or acceptor. Example: if someone negotiates (transfers) to you a note to which he does not have good title (i.e., it had been stolen), and you end up losing money on it, you can recover your losses from the transferor because of the warranty. Even if it was bearer paper and the transferor never signed it (because he didn’t have to endorse it), the warranty liability applies.

    2. Presentment warranties: When a person presents an instrument for payment or acceptance he warrants the following: (i) he has good title, (ii) it has not been materially altered, and (iii) he has no knowledge that the signature of the drawer is forged. An HDC only warrants that he has good title.

  • Item

    final exam practice questions

    The following few questions are typical of what you may face on the final.  We’ll go over them on the last day of class.


    a. True or False:  The following, by itself, would cause an instrument to NOT be negotiable: It’s written out in pencil.

    b. True or False:  The following, by itself, would cause an instrument to NOT be negotiable:  it has a payment due date of “any day in June 2022.”

    c. True or False:  The following, by itself, would cause an instrument to NOT be negotiable: It calls for payment of “all the cash only that I receive from selling my 2017 Toyota.”

    d. True or False:  The following, by itself, would cause an instrument to NOT be negotiable:  It says the promise to pay is “in accordance with” a separate contract.

    e. True or False:  The following, by itself, would cause an instrument to NOT be negotiable:  It calls for payment “of 2000 Canadian dollars on June 18, 2022 to Jim Barnaby.”

    2. Frank is the payee of an instrument and is not a holder in due course. The instrument calls for the payment “of $5,000 to the order of Frank on November 30, 2021.” Frank endorses it and sells it to Gina for $4,900 on December 2, 2021. Does Gina fail any of the HDC tests?

    3. A check has the following 3 endorsements on it:

    (i) Pay to Sally, signed John, without recourse.
    (ii) Sally
    (iii) Donna, for deposit only

    (a)State whether each endorsement is special or blank.
    (b)Which endorsement is qualified and what does that mean?
    (c)Which endorsement is restrictive?                                                                                                                        

    (d)After John’s endorsement, was it order paper or bearer paper?  Was Sally’s endorsement necessary for her to negotiate the instrument?                                                                                                               

    (e)After Sally’s endorsement, was it order paper or bearer paper?  Was Donna’s endorsement necessary for her to negotiate the instrument?

    4. Tom issues an negotiable instrument telling Ellen to pay $100 to the order of Maxine, signed Tom.   (a) Is this a note or a draft?  What are the  “names” for Tom, Ellen, and Maxine (maker, payee, etc.)?

    5. Is it possible for Melinda have the rights of an HDC if, when she received the instrument, she knew the instrument had been dishonored? Explain briefly.

    6.  Which of the following are real defenses and which are personal?

    (a)_________  unauthorized completion

    (b)_________  bankruptcy

    (c)_________  forgery

    (d)_________  material alteration

    7.  Presenting an instrument for ” acceptance” involves  (select one)–

    (a)(a) Asking the maker to pay on the due date.

    (b)(b) Asking an endorser to sign on the back.

    (c)(c) Asking the drawee to sign on the front

    (d) (d) Asking the drawer to sign on the front


    1.  1. a. False, it’s okay if it’s written in pencil

            b.  False, it’s okay.  June 30 would be the deadline.

            c.  True.  This violates the “sum certain” requirement

            d.  False, this is okay.  “in accordance with is a harmless reference.  If it said “subject to” or “governed by” that would make it nonnegotiable for violating the “unconditional” requirement.

            e.  True.  This violates the “magic words” requirement — it does not say “to the order of” Jim.  (Canadian dollars are fine though.)

    2.   2. Gina fails an HDC test. It’s overdue when she gets it. (Due date was Nov. 30 and she gets it Dec. 2.)

    3. (a) Only the first one is “special” — the others are “blank.” What makes an endorsement special is if it names the next person.

    (b) Only the first one is qualified (says “without recourse”).  It means if the instrument is dishonored John is not liable.

    (c) “For deposit only” makes the third one restrictive.

    (d)(d)  Since John’s’s endorsement was a special endorsement (it names the next person), it was order paper after the endorsement.  As order paper, Sally could not have negotiated it without an endorsement.

    (e) Since Sally’s endorsement was a blank endorsement (did not name the next person), it became bearer paper.  As bearer paper, Donna could have negotiated it without an endorsement.

    4. It’s a draft — you can tell because there are three  parties:  Tom, the drawer, Ellen, the drawee, and Maxine, the payee.

    5. Yes, she can! Under the “umbrella” rule, once one holder is an HDC, everyone coming after him or her has the rights of an HDC too! The HDC tests no longer apply in that case, so it doesn’t matter if Melinda has notice it’s been dishonored, received it as a gift, etc.

    6.  (a) is personal and the rest are real.

    7. (c) Acceptance is when you go to a drawee before the payment due date and ask him or her to sign the front of the draft, thus assuring that he or she will make the payment when it becomes due.