© Cavico & Mujtaba, 2008 Business Law for the Entrepreneur and Manager Frank Cavico and Bahaudin G. Mujtaba Chapter 8 – Commercial Paper and Banking Transactions

© Cavico & Mujtaba, 2008 Business Law for the Entrepreneur and Manager (Frank Cavico & Bahaudin g. Mujtaba, 2008; ILEAD Academy, LLC) Table of Contents – Chapter Titles Chapter 1 – Introduction to Law and the Legal System Chapter 2 – Torts and Business Chapter 3 – Products Liability Chapter 4 – Contract Law Chapter 5 – Sales Law and the Uniform Commercial Code Chapter 6 – Agency and Employment Law Chapter 7 – Business Organizations Chapter 8 – Commercial Paper and Banking Transactions Chapter 9 – Creditors and debtors – Rights and Responsibilities Chapter 10 – Internet Law Chapter 11 – Intellectual Property Law Chapter 12 – Real Property Law Chapter 13 – International Business Law Chapter 14 – Liability of Accountants and Other Professionals Chapter 15 – Wills and Trusts Chapter 16 – Personal Property, Gifts, and Bailment Chapter 17 – Conclusion and Case Problems

© Cavico & Mujtaba, 2008 Chapter Topics Commercial Paper Banking and Transactions Summary Discussion Questions

© Cavico & Mujtaba, 2008 Law and Commercial Paper The law of commercial paper, as well as banking transactions is found predominantly in the Uniform Commercial Code (UCC) specifically in Articles 3 and 4 (as revised in 1990 and 2002). –The term “commercial paper” refers to written obligations, promises, and orders to pay sums of money which arise from the use of negotiable instruments, such as promissory notes, drafts, checks, and trade acceptances. –There are two basic purposes of commercial paper. The first is the credit function; that is, some forms of commercial paper are used primarily to obtain credit now, to be repaid out of future income. The second purpose is the payment function; that is, some types of commercial paper are used primarily as a paying obligations as a substitute for money.

© Cavico & Mujtaba, 2008 Types of Commercial Paper The UCC specifies four types of commercial paper: drafts, checks, notes, and certificates of deposit. –First, a draft (also called a “bill of exchange”) is an instrument where the party creating it (called the drawer) orders another party (called the drawee) to pay money to a third party (called the payee). It is very important to observe initially that one of two conditions must exist for a draft arrangement to work. –The second type of commercial paper is the check, which is also a variant of the draft. This variant of the draft must be drawn on a bank and payable on demand. The check is premised on an order by the drawer ordering the drawee-bank to pay a sum of money to the payee of the check. –The third type of commercial paper is the promissory note. The note consists of a promise by one party (the “maker”) to pay a sum of money to another party (the “payee”). –Finally, the fourth type of commercial paper is a certificate of deposit (CD), which is a variant of the note. The CD is an instrument whereby a bank (the maker) acknowledges the receipt of money and promises to repay the money at a later date or on demand. CDs may be negotiable or non-negotiable.

© Cavico & Mujtaba, 2008 Demand and Time Instruments Commercial paper can be further divided into demand and time instruments. –A demand instrument (also called a sight instrument) is payable whenever the holder of the instrument chooses to present it to the maker (if a note) or the drawee (if a draft); that is, the holder is entitled to demand payment at any time after the instrument is issued. –A time instrument is one payable at a specific future date. Notes, drafts, and CDs can be either demand or time instruments; but a check must be a demand instrument. However, a check can be post-dated and can still be negotiated prior to the date shown, but is not payable until the date stated. Thus, if a demand instrument is post-dated, the holder must wait until the date shown on the instrument arrives before demanding payment.

© Cavico & Mujtaba, 2008 Ambiguities in Instruments The Uniform Commercial Code provides four general rules to guide parties and courts when an instrument is ambiguous as to terms, parties, and/or legal consequences. –The first situation involves language in the instrument which is ambiguous or instruments with omissions. There may be a discrepancy between words and figures in an instrument. –The second ambiguity area concerns additional description of the payee, for example, “pay to the order of KA, Vernon Valley, NJ.” The rule of law is straightforward, and that is that any additional description of the payee has no legal effect. –The third situation deals with the omission of an interest rate in an instrument. The rule of law holds that if a negotiable instrument states that the maker or drawer agrees to pay an amount ‘with interest,” but does not specify the rate, the “judgment rate” is construed as the interest rate. –Finally, joint signers may sign an instrument; that is, two or more parties may sign an instrument as a maker, drawer, acceptor, or indorser as part of the same transaction; and if so they are “jointly and severally” liable, which means the full amount can be collected from any one of them, even though the instrument may say “I promise to pay” or similar words.

© Cavico & Mujtaba, 2008 The Negotiability Requirement The concept of negotiability is a very significant one in UCC commercial paper law. The extensive protection afforded to buyers of commercial paper (for example, attaining HDC status) applies only when an instrument is a “negotiable” one under the UCC. A non-negotiable instrument is “merely” a contract, and thus is only assignable. Recalling contract law, the assignee of a contract merely possesses rights the contract rights of his or her assignor; that is, the buyer of a non-negotiable instrument takes the paper subject to the claims and defenses of prior parties. A negotiable instrument is more freely transferable, and accordingly serves as a much better substitute of money or an extension of credit, which are two of the fundamental purposes of commercial paper.

© Cavico & Mujtaba, 2008 Requirements for Negotiability There are several requirements for negotiability. The term “negotiability” in essence refers to the form of the instrument. “Speaking” generally, in order to be negotiable under the UCC, the instrument must be: –1) in writing; –2) signed by the maker or drawer; –3) contain an unconditional promise or order to pay a sum certain in money, on demand or at a definite time; –4) contain the “words of negotiability”; and –5) be free from other promises as a general rule.

© Cavico & Mujtaba, 2008

Banking Transactions Article 4 of the UCC (“Bank Deposits and Collections) amplifies and alters –Article 3 provisions regarding negotiable instruments when the negotiable instrument (particularly a check) becomes part of the bank collection process. If there is any conflict between the two, –Article 4 generally prevails. Article 4 has two basic parts: 1) rules for governing the relationship between a bank and its customers; and 2) rules governing the check collection among banks (although the latter has been superseded in part by federal statute).

© Cavico & Mujtaba, 2008 The Relationship between Banks and Their Customers The focus of this part of Article 4 is the contractual relationship between the drawee bank (called the “payor” bank) and the drawer (the customer) and the rights and duties that stem from that relationship. The first area to cover is called wrongful dishonor. The bank has a duty to honor checks drawn by its customers when sufficient funds are available in the customers’ accounts to cover the checks. –A “wrongful dishonor” occurs when a check is properly payable from the drawer’s account, but the bank wrongfully refuses to honor it; then the drawer has a cause of action against the bank.

© Cavico & Mujtaba, 2008 Bank Collection Procedures When a bank customer puts cash or a check in his or her account, the bank may or may not permit immediate withdrawal, according to its own rules. However, what is the length of time that a check must be deposited in an account before it must be made available for withdrawals? In the past, the UCC had certain rules, including allowing a bank to wait a “reasonable time” before allowing customers to make withdrawals. However, the U.S. Congress felt that banks were taking advantage of the latitude granted by the UCC and were making their customers wait unreasonably long periods of “reasonable time.”

© Cavico & Mujtaba, 2008 Electronic and Online Banking The application of computer technology to banking, especially in the form of electronic fund transfers, certainly has helped to improve the efficiency and accuracy of the banking system, but technology has also raised a whole host of complex legal and practical problems. In the “old days,” checks had to be physically transported and transferred in order to be cleared by banks. Now, with the new technology, checks can be processed electronically, which means that presentment can occur on the day of deposit.

© Cavico & Mujtaba, 2008

Summary Laws regarding commercial paper and banking transactions are primarily found in the Uniform Commercial Code (UCC); and a foundational knowledge and understanding of this body of law is critical for all managers and entrepreneurs. The chapter defined “commercial paper” as the written obligations, promises, and orders to pay sums of money which arise from the use of negotiable instruments, such as promissory notes, drafts, checks, and trade acceptances.

© Cavico & Mujtaba, 2008 Reference 1.Cavico, F. & Mujtaba, B. G., (2008). Business Law for the Entrepreneur and Manager. ILEAD Academy Publications; Davie, Florida, USA. ISBN: Cavico, F. and Mujtaba, B. G. (2008). Legal Challenges for the Global Manager and Entrepreneur. Kendal Hunt Publishing; United States.