Chapter 14 Negotiable Instruments and Digital Banking PowerPoint Slides to Accompany ESSENTIALS OF BUSINESS AND ONLINE COMMERCE LAW 1st Edition by Henry R. Cheeseman Chapter 14 Negotiable Instruments and Digital Banking Slides developed by Les Wiletzky

Negotiable Instruments (1 of 2) To qualify as a negotiable instrument (commercial paper), the document must meet certain requirements established by Revised Article 3 (Negotiable Instruments) of the Uniform Commercial Code (UCC) Article of the UCC that establishes rules for the creation of, transfer of, enforcement of, and liability on negotiable instruments

Negotiable Instruments (2 of 2) If the requirements of Article 3 are met, a transferee who qualifies as a holder in due course takes the instrument free of many defenses that can be asserted against the original payee In addition, the document is considered an ordinary contract that is subject to contract law

Functions of Negotiable Instruments Negotiable instruments serve the following functions: Substitute for money Credit device Record-keeping device Most purchases by businesses and many individuals are made by negotiable instruments instead of cash

Types of Negotiable Instruments Term that means negotiable instrument [UCC 3-104(b)] Revised Article 3 recognizes four kinds of instruments: 1. Drafts 2. Checks 3. Promissory Notes 4. Certificates of Deposit

Drafts A draft is a three-party instrument that is an unconditional written order by one party that orders the second party to pay money to a third party Drawer of a draft Drawee of a draft Payee of a draft

Checks A distinct form of draft drawn on a financial institution and payable on demand Drawer of a check Drawee of a check Payee of a check Article 4 of the UCC establishes the rules and principles that regulate bank deposit and collection procedures

Special Types of Checks Bank Checks – Checks for which the bank is solely or primarily liable: Certified Check Cashier’s Check Traveler’s Check

Promissory Notes A two-party negotiable instrument that is an unconditional written promise by one party to pay money to another party Maker of a note – the party who makes the promise to pay (borrower) Payee of a note – the party to whom the promise to pay is made (lender)

Certificates of Deposit (CD) A two-party negotiable instrument that is a special form of note created when a depositor deposits money at a financial institution in exchange for the institution’s promise to pay back the amount of the deposit plus an agreed-upon rate of interest upon the expiration of a set time period agreed upon by the parties Maker of the CD – the bank (borrower) Payer of the CD – the depositor (lender)

Summary: Types of Negotiable Instruments (1 of 2) Orders to Pay Party Description of Party Draft Drawer Drawee Payee Person who issues the draft Person who owes money to the drawer; person who is ordered to pay the draft and accepts the draft Person to whom the draft is made payable Check Owner of a checking account at a financial institution; person who issues the check Financial institution where drawer’s checking account is located; party who is ordered to pay the check Person to whom the check is made payable

Summary: Types of Negotiable Instruments (2 of 2) Promises to Pay Party Description of Party Promissory Note Maker Payee Party who issues the promissory note; usually the borrower Party to whom the promissory note is made payable; usually the lender Certificate of Deposit (CD) Financial institution that issues the certificate of deposit Party to whom the certificate of deposit is made payable; usually the depositor

According to UCC 3-104(a), a negotiable instrument must: Be in writing Be signed by the maker or drawer Be an unconditional promise or order to pay State a fixed amount of money Not require any undertaking in addition to the payment of money Be payable on demand or at a definite time Be payable to order or to bearer

Summary: Formal Requirements for a Negotiable Instrument (1 of 4) Description Writing Writing must be permanent and portable. Oral or implied instruments are nonnegotiable [UCC 3-104(d)]. Signed by maker or drawer Signature must appear on the face of the instrument. It may be any mark intended by the signer to be his or her signature. Signature may be by an authorized representative [UCC 3-104(a)]. Unconditional promise or order to pay Instrument must be an unconditional promise or order to pay [UCC 3-104(a)]. Permissible notations listed in UCC 3-106(a) do not affect instrument’s negotiability. If payment is conditional on the performance of another agreement, the instrument is nonnegotiable.

Summary: Formal Requirements for a Negotiable Instrument (2 of 4) Description Fixed amount of money Fixed amount: Amount required to discharge the instrument must be on the face of the instrument [UCC 3-104(a)]. Amount may include payment of interest, discount, and costs of collection. Revised Article 3 provides that variable interest rate notes are negotiable instruments. In money: Amount must be payable in U.S. or foreign country’s currency. If payment is to made in goods, services, or non-monetary items, the instrument is nonnegotiable [UCC 3-104(a)].

Summary: Formal Requirements for a Negotiable Instrument (3 of 4) Description Cannot require any undertaking in addition to the payment of money A promise or order to pay cannot state any other undertaking to do an act in addition to the payment of money [UCC 3-104(a)(3)]. A promise or order to may include authorization or power to protect collateral, dispose of collateral, waive any law intended to protect the obligee, and the like.

Summary: Formal Requirements for a Negotiable Instrument (4 of 4) Description Payable on demand or at a definite time Payable on demand: Payable at sight, upon presentation, or when no time for payment is stated [UCC 3-108(a)]. Payable at a definite time: Payable at a definite date, or before a stated date, a fixed period after a stated date, or at a fixed period after sight [UCC 3-108(b)(c)]. Instrument payable only upon the occurrence of an uncertain act or event is nonnegotiable.

Nonnegotiable Contract A promise or order to pay that does not meet the requirements of a negotiable instrument It is not subject to the provisions of UCC Article 3 A nonnegotiable contract can be enforced under normal contract law

Transfer by Assignment or Negotiation The transfer of rights under a contract It transfers the rights of the transferor (assignor) to the transferee (assignee) Transfer by Negotiation The transfer of a negotiable instrument by a person other than the issuer The person to whom the instrument is transferred becomes the holder Negotiating order paper Negotiating bearer paper

Indorsement The signature (and other directions) written by or on behalf of the holder somewhere on the instrument The signature may: Appear alone Name an individual to whom the instrument is to be paid, or Be accompanied by other words

Holder Versus Holder In Due Course A person who is in possession of a negotiable instrument that is drawn, issued, or indorsed to him or his order, or to bearer, or in blank Holder in Due Course (HDC) A person who takes a negotiable instrument for value, in good faith, and without notice that it is defective or is overdue

Requirements for HDC Status To qualify as an HDC, the transferee must meet the requirements established by the UCC The person must be the holder of a negotiable instrument that was taken: For value In good faith Without notice that it is overdue, dishonored, or encumbered in any way, and Bearing no apparent evidence of forgery, alterations, or irregularity [UCC 3-302]

Holder in Due Course (HDC) Negotiable Instrument Negotiable Instrument Holder in Due Course (HDC) Maker or Drawer Payee or Bearer Holder Takes a negotiable instrument For value In good faith Without notice of defect The instrument bears no apparent evidence of forgery, alterations, or irregularity

Real Defenses Real Defenses Effect Minority Extreme duress Mental incapacity Illegality Discharge in bankruptcy Fraud in the inception Forgery Material alteration Real defenses can be raised against both holders and holders in due course

Personal Defenses Personal Defenses Effect Breach of contract Fraud in the inducement Mental illness that makes a contract voidable instead of void Illegality of a contract that makes the contract voidable instead of void Ordinary duress or undue influence Discharge of an instrument by payment or cancellation Personal defenses cannot be raised against a holder in due course

HDC Status Eliminated with Respect to Consumer Credit Transactions The Federal Trade Commission (FTC) has adopted a rule that eliminates HDC status with regard to negotiable instruments that arise out of certain consumer credit transactions Sellers of goods and services are prevented from separating the consumer’s duty to pay the credit and the seller’s duty to perform Thus, both personal and real defenses can be raised against an HDC

The Bank – Customer Relationship Creditor – Debtor Relationship Created when a customer deposits money into the bank The customer is the creditor and the bank is the debtor Principal – Agent Relationship Created if the: deposit is a check that the bank must collect for the customer or the customer writes a check against his or her account The customer is the principal and the bank is the agent

The Collection Process A bank is under duty to accept deposits into a customer’s account This includes collecting checks that are drawn on other banks and made payable or indorsed to the depositor UCC Article 4 regulates the collection process

The Check Collection Process Metro Bank sends the check to City Bank for collection Drawer issues a check to Payee drawn on Country Bank Payee deposits the check in her account at Metro Bank METRO BANK CITY BANK DRAWER PAYEE Drawer has a checking account at Country Bank (Depository and collecting bank) (Intermediary and collecting bank) COUNTRY BANK City Bank sends the check to Country Bank for collection (Drawee and payor bank)

Electronic Fund Transfer Systems Electronic fund transfer systems (EFTS) are supported by contracts among and between customers, banks, private clearinghouses, and other third parties The most common forms of EFTS are: 1. Automated Teller Machines (ATM) 2. Point-of-Sale (POS) Terminals 3. Direct Deposits and Withdrawals 4. Paid-by-Internet

Wire Transfers (1 of 2) UCC Article 4A – Fund Transfers governs wholesale wire transfers: Applies only to commercial electronic fund transfers Consumer fund transfers subject to the Electronic Fund Transfer Act are not subject to Article 4A

Wire Transfers (2 of 2) UCC Article 4A (continued) Governs the rights and obligations between parties to a fund transfer unless they have entered into a contrary agreement If a receiving bank mistakenly pays a greater amount to the beneficiary than ordered, the originator is liable for only the amount he or she instructed to be paid