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and Negotiable Instruments An Overview
by Stefan Lawrence, Esq.
WRIGHT, FINLAY & ZAK, LLP
Introduction
Negotiable instruments are an essential part of the modern world
of consumerism. The law governing negotiable instruments is concerned
with the effective payment for goods and services. Because of
the risks attached to transactions involving money, such as convenience
and transferability, negotiable instruments are used as a substitute
for money. In addition, the law is also concerned with the mechanism
collecting negotiable instruments through the banking system,
and for converting these instruments to money.
Source of Law
Both state and federal statutory law regulate bank accounts. For
example, the Uniform Commercial Code (UCC) has been adopted, in
one form or another, by each state as the law governing negotiable
instruments. The UCC defines a negotiable instrument as an unconditioned
writing that promises or orders the payment of a fixed amount
of money. Examples of negotiable instruments include checks (drafts
that order a payment to be made) and certificates of deposit (notes
that promise that payment will be made). Article 3 of the UCC
governs the relationship between parties who receive and transfer
checks, and provides for warranties to protect the various parties.
The process by which instruments are collected by banks is the
subject of Article 4. Specifically, Article 4 governs (1) the
actions of the first bank to accept the check (depository bank)
and other banks that handle the check but are not responsible
for its final payment (collecting banks); (2) the actions of the
bank that is responsible for the payment of the check (payor bank);
and (3) the relationship between a payor bank and its customers.
Regulation J of the Federal Reserve Act attempts to expedite the
check collection process by requiring payor banks to give prompt
notice of nonpayment of checks that have been collected through
the Federal Reserve System. Regulation CC governs extensively
the availability of funds in a depositor's account and the process
involving checks dishonored due to non-payment. The Expedited
Funds Availability Act attempts further to expedite the check
collection process, and limits the time that a depository bank
can delay before making the amount of a deposited check available
for withdrawal.
Types of Negotiable Instruments
There are two types of negotiable instruments: drafts and notes.
Drafts are orders to pay, and if drawn on a bank, are called checks.
Notes, on the other hand, are promises to pay. Notes made by a
bank are called certificates of deposit. Drafts A draft is a three-party
instrument. The most common draft is the check, which is defined
as a draft that is drawn on a bank and that is payable on demand.
The party creating the check is the drawer, the bank ordered to
pay is the drawee, and the party to whom the check is payable
is the payee. Other forms of drafts include cashier's checks,
where the bank is both the drawer and the drawee, traveler's checks
and money orders.
Notes and Certificates of Deposit
The most basic form of negotiable instrument is a two-party instrument,
or note, in which the maker promised to make payment to the order
of the payee. Notes can be either payable on demand or at a definite
time, and can be payable either "to order" or "to bearer." A certificate
of deposit is a note that a bank issues when a party deposits
money with the bank. The bank promises to repay the money, with
interest, on a certain date. The bank is the maker of the note,
and the other party is the payee.
Requirements for Negotiability
For an instrument to be negotiable, it must meet the following
requirements: 1. It must be signed by the maker or drawer; 2.
It must be an unconditional promise or order to pay; 3. It must
be for a fixed amount of money, with or without interest; 4. It
must be payable on demand or at a definite time; and 5. It must
be payable to order or to bearer.
Unconditional Promise or Order to Pay
The terms of the promise or order must be included in writing
on the face of a negotiable instrument. A negotiable instrument
cannot contain a promise other than the one to make payment, which
must be unconditional. The promise cannot be conditioned on the
occurrence or nonoccurrence of some other event or agreement over
which the holder has no control.
Fixed Amount of Money
The instrument must include a promise or order to pay a fixed
amount, ascertainable from the face of the instrument. A note
payable with interest meets this requirement, because the amount
due can be readily calculated.
Payable on Demand or At a Definite Time
The negotiability of an instrument requires that the holder be
able to determine, from the instrument, when the maker, drawee,
or acceptor is required to pay. Instruments that fail to state
the time for payment are payable on demand. A typical check is
an example of such an instrument. An instrument is payable at
a definite time if it says that it is payable (1) on a specified
date, (2) within a definite period of time, or (3) on a date readily
ascertainable at the time the draft or note is issued. The maker
or drawee is under no obligation to pay until the time specified
on the instrument.
Payable to Order of Bearer
To be negotiable, an instrument must either be payable to the
order of a specific person or payable to bearer; i.e., bearer
paper. A bearer is a person in possession of an instrument that
is either payable to bearer or indorsed in blank. With such instruments,
the maker or drawer agrees to pay anyone who presents the instrument
for payment.
Miscellaneous Factors of Check Negotiation
1. Negotiability is normally not affected if an instrument is
undated, unless such date is necessary to determine the time for
payment. 2. Postdating or antedating an instrument does not affect
negotiability. 3. Handwritten terms on an instrument outweigh
typewritten and printed terms, and typewritten terms outweigh
printed terms. 4. Words outweigh figures on a negotiable instrument,
unless the words are ambiguous. This is important when the numerical
amount and the written amount on a check differ.
Transfer by Negotiation
Negotiation is the transfer of an instrument in such form that
the transferee becomes a holder. The person to whom an instrument
is transferred may negotiate it to a third party, making that
person a holder of the instrument. A holder normally acquires
only the rights of the previous possessor. A transfer by negotiation,
however, can make it possible for a holder to receive more rights
in the instrument than the prior possessor had. A holder who receives
greater rights is called a holder in due course. In order to be
a holder in due course, one must (1) be a holder of the instrument;
(2) take the instrument for value; (3) take the instrument in
good faith; (4) take the instrument without notice of defense
of the obligor or defects in the instrument; and (5) the instrument
must not bear apparent evidence of forgery, alteration, or other
irregularity calling into question its authenticity.
Types of Indorsement
There are three general types of indorsements of a negotiable
instrument: 1. Blank indorsements: An indorsement that specifies
no particular indorsee, and can consist of a mere signature, is
a blank indorsement. Such instrument becomes bearer paper, and
can be negotiated by anyone holding said instrument. 2. Special
indorsements: An indorsement that identifies the person to whom
the indorser intends to make the instrument payable - the indorsee
- is a special indorsement. That is, it names the indorsee, and
only that person may negotiate the instrument. 3. Restrictive
indorsements: A restrictive indorsement requires indorsees to
comply with certain instructions regarding the funds involved.
A common type of restrictive indorsement is "for deposit only",
which gives the indorser the right to have a depositary or collecting
bank act consistently with the indorsement. Only a bank can acquire
the rights of a holder following this indorsement.
Misspelled Names
In an instrument is made payable under a misspelled or incorrect
name, the payee or indorsee whose name is misspelled can indorse
with the misspelled name, the correct name, or both.
Multiple Payees
An instrument may be made payable to the order or more than one
payee. If the payees are named in conjunction, both must indorse.
If they are named in the alternative, either may indorse. If it
is not clear whether an instrument is alternative or joint, it
is payable alternatively.
Conclusion
A recurring problem faced by banks and other financial institutions
is liability arising where checks or a business or other organization
are handled in such a manner as to allow the diversion of proceeds
for the personal benefit of employees, agents or fiduciaries.
A typical scenario is bookkeeper embezzlement, where the handling
of checks with forged signatures or forged indorsements can create
significant liability for the bank. However, a working knowledge
of negotiable instruments law and its various built-in defenses,
such as Commercial Code preemption, statutes of limitations, limitations
on liability, customer's duty to report unauthorized signatures
within a reasonable time, etc., can greatly reduce the bank's
exposure.
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