CHAPTER 26

There are two types of liability associated with negotiable instruments:

Signature Liability (signatures on instruments- those who sign are potentially liable for payment of the amount stated)

and

Warranty Liability (whereby the liability extends to both signers and nonsigners)

The main point here is the liability is on the instrument itself OR on warranties connected with the transfer or presentment of the instruments CONTRASTED AGAINST ANY LIABILITY ON ANY UNDERLYING CONTRACT.

SIGNATURE LIABILITY: PRIMARY

A primary key to liability on a negotiable instrument is a signature. The idea of a signature requirement is the need to know whose obligation the instrument represents.

• Primary Liability: A person who is primarily liable on a negotiable instrument is absolutely required, subject to one or more valid defenses, to pay a negotiable instrument upon presentment.

• Only makers and acceptors (drawees that promise to pay when the instrument is presented) are subject to primary liability. The maker of a promissory note promises to pay the note. An acceptor is a drawee that promises to pay an instrument when it is presented later for payment.

• Failure by either a maker or acceptor to pay on presentment constitutes dishonor of the instrument.

• Mere delay in payment does not constitute dishonor, nor does refusal to pay unless the party presenting the instrument provides identification and/or signs the instrument or a receipt for it. For example, presenting at a bank after 2:00 p.m. and the bank won’t pay until tomorrow is not dishonor.

• Likewise, returning an instrument because it lacks a proper indorsement does not constitute dishonor.

· In order to hold a maker or acceptor liable for dishonor, they must receive proper notice of dishonor, which may be given in any reasonable manner, including written, oral, or electronic notice, as well as notice on the instrument itself.

SIGNATURE LIABILITY: SECONDARY

Drawers and indorsers have secondary liability.

• Secondary Liability: A contingent requirement to pay a negotiable instrument upon dishonor or the failure to pay or accept by the party(-ies) primarily liable for the instrument.

• Again, only drawers and indorsers are subject to secondary liability; and then, only if:

(i) the instrument is properly and timely presented;

(ii) the instrument is dishonored or rejected; and

(iii) timely notice of dishonor or rejection is given to the secondarily liable party.

In other words, a drawer or an indorser will only be responsible if the party that is responsible for paying the instrument refuses to do so (dishonors).

Proper Presentment

A holder must present the instrument to the proper person, in the proper manner, and timely.

· This can be via any commercially reasonable method, including oral, written and electronic means.

· Can be via a clearinghouse for banks.

· At the place specified in the instrument for acceptance.

Dishonor

Dishonoring occurs when presentment is properly and timely made and required acceptance or payment is refused.

Recall that postponement of payment or refusal, in certain conditions, will not dishonor the instrument.

Proper Notice

To hold secondary parties responsible, they must be properly notified of the dishonor. There are certain time frames involved, the most rigid being with banks. Notice can be given in any reasonable fashion, and also so noted on the instrument (NSF).

ACCOMMODATION PARTIES AND AGENTS

Accommodation parties can also be held primarily or secondarily responsible on instruments.

• Accommodation Party: A person who signs an instrument for the purpose of lending his or her name as credit to another party on the instrument.

The party could be an accommodation maker (on behalf of the maker) or accommodation indorser (on behalf of the payee), depending on the style of signature. In each case, the party is lending their credit to the transaction.

Agent Signatures: recall an agent agrees to represent or act on behalf of another person generally called the principal.

• Agents’ Signatures: An authorized agent can bind his or her principal on an instrument by signing the instrument in such a way as to clearly show that he or she is signing on behalf of the principal. In such a case, the principal, rather than the agent, will be liable on the instrument.

For example: Aronson, by Sammy, Agent

Aronson is the principal, Sammy the agent – Aronson is bound, assuming Sammy had the authority.

• Agent: A person who agrees to represent or act for a principal (e.g., employee).

• Principal: A person who agrees to have an agent act on his or her behalf (e.g., employer).

• If an agent signs both on behalf of his or her principal and individually, then both the agent and the principal are liable on the instrument.

• If an agent signs on behalf of his or her principal without the authority to do so, the principal will not be liable on the instrument, whereas the agent will be.

· The agent must make it clear they are acting as an agent, else they will be liable individually.

UNAUTHORIZED SIGNATURES

· Unauthorized Drawer/Maker’s Signature: As a general rule, unauthorized signatures are wholly in-operative and will not bind the person whose name is forged.

However, an unauthorized signature will bind the person whose name is forged if that person ratifies, or affirms, the obligation.

A forged signature normally is a defense, unless the person whose name is forged may be denied this defense if their own negligence contributed to the deed. For example, leaving a signature plate/stamp open and available, along with blank checks for anyone to pick up.

In theory, an unauthorized signature acts as the signature of the unauthorized signor for purposes of HDC. Of course, you have to find that person first!

• Unauthorized Indorsement: RULE: The first party to accept an instrument bearing an unauthorized indorsement will bear the burden of loss, unless the unauthorized indorsement is that of the payee, in which case the loss falls on the drawer/maker. Why? You had the opportunity to inspect that person’s credentials and authenticity.

EXCEPTIONS:

• Imposter: One who, by use of the mails, telephone, or personal appearance, induces a maker or drawer to issue an instrument in the name of the imposter. Indorsements by imposters are not treated as being unauthorized. Why? The maker or drawer actually intended the imposter to receive the instrument, although obviously in error.

• Fictitious Payee: A payee whom the maker or drawer does not intend to have an interest in the instrument. For example, where a dishonest employee (i) issues an instrument on his or her employer’s behalf, or (ii) deceives the employer into signing an instrument payable to a party with no right to receive payment. Rule: the payee’s indorsement is not treated as an forgery, and the employee can be held liable on the instrument by an innocent holder. Thus, if the check has been negotiated to a HDC, the company will take the loss, not the banks, and the company has recourse only against the employee

Warranty Liability

Transferors make certain implied warranties regarding the instruments they are negotiating. Liability under these warranties are NOT subject to the conditions of proper presentment, dishonor and notice of dishonor. There are two types: transfer warranty and presentment warranties.

TRANSFER WARRANTIES

Transfer Warranties: Implied warranties, made by any person who transfers an instrument for consideration to subsequent transferees and holders who take the instrument in good faith, that

(1) the transferor is entitled to enforce the instrument;

(2) all signatures are authorized and authentic;

(3) the instrument has not been altered;

(4) the instrument is not subject to a defense or claim of any party that can be asserted against the transferor; and

(5) the transferor has no knowledge of any insolvency proceedings against the maker, the acceptor, or the drawer of the instrument.

• Warranty Liability extends to any subsequent holder who takes in good faith an instrument transferred by indorsement. If, on the other hand, the instrument is transferred for consideration and without indorsement, liability extends only to the immediate transferee.

èRecovery: a transferee or holder who takes an instrument in good faith can sue on the basis of breach of warranty as soon as he has reason to know of the breach. Notice must be given within 30 days.

• Presentment Warranties: Implied warranties, made by any person who presents an instrument for payment or acceptance, that

(1) the person seeking payment or acceptance is entitled to enforce the instrument or is authorized to obtain payment or acceptance on behalf of a person who is entitled to enforce the instrument;

(2) the instrument has not been altered; and

(3) the person seeking payment or acceptance has no knowledge that the signature of the drawer is unauthorized.

These warranties are known as presentment warranties because they protect the party to who the instrument is presented.

HDC: DEFENSES

• Universal (real) Defenses: Absolute defenses to liability on a negotiable instrument that are valid against all holders, including HDCs and other holders with the rights of HDCs.

• Forgery: Forgery of a maker’s or drawer’s signature cannot bind the person whose name is used unless that person ratifies the signature or is precluded from denying it (e.g., because the forgery was made possible by the maker’s negligence).

• Fraud in the Execution: A person whose signature is obtained through fraud or deception is generally not liable unless reasonable inquiry (in light of, among other things, the signer’s age, experience, and intelligence) would have revealed to the signer the nature and terms of the instrument.

• Material Alteration: An alteration that changes the terms of the instrument between any two parties in any way (e.g., adding words or numbers).

• Material alteration is a complete defense against claims of an ordinary holder. Material alteration is a partial defense against an HDC, only to the extent of the alteration.

• Discharge in Bankruptcy: Discharge is an absolute defense against the claims of any holder, including an HDC.

• Minority: Minority is a defense to liability on an instrument to the same extent that it is a defense under the applicable state law to contract liability.

• Illegality: Any illegal act which would render a contract void under state law is an absolute defense against the claims of any holder, including HDCs.

• Mental Incompetence: Any instrument made or issued by a person previously adjudged to be mentally incompetent is void ab initio(from the beginning) and, therefore, unenforceable even by an HDC.

• Extreme Duress: Any Instrument signed and issued under immediate threat of force or violence is void and unenforceable by any holder, including an HDC.

PERSONAL DEFENSES

• Personal Defenses: Defenses that may be used to avoid payment to an ordinary holder, but not an HDC or a holder with the rights of an HDC.

• Breach of Contract or Warranty: When there is a breach of the underlying contract for which the negotiable instrument was issued, the maker of a note can refuse to pay it, or the drawer of a check can order his or her bank to stop payment. Breach of warranty may also be claimed as a defense to liability on an instrument.

• Lack or Failure of Consideration: The absence of consideration may constitute a defense in some cases.

• Fraud in the Inducement: A person who issues a negotiable instrument based on false statements by another party will be able to avoid payment of the instrument unless the holder presenting the instrument for payment is an HDC.

• Illegality: Acts that render a contract voidable create a defense against an ordinary holder, but not against an HDC.

• Mental Incapacity: A person who has not been adjudged mentally incompetent, nonetheless may claim mental incapacity as a defense against an ordinary holder, but not an HDC.

• Other Personal Defenses:

(1) Discharge by payment or cancellation;

(2) Unauthorized completion of an incomplete instrument;

(3) Nondelivery of the instrument; and

(4) Ordinary duress or undue influence rendering the contract voidable.

FEDERAL LIMITATIONS ON HDC RIGHTS

In general, the HDC rule leaves consumers who have purchased defective goods liable to HDCs. To protect consumers, Rule 433 was established which abolishes HDC doctrine in regard to CONSUMER credit transactions.

• FTC Rule 433 limits the rights of an HDC in an instrument evidencing a debt arising out of a consumer credit transaction.

• Rule 433 applies to:

(1) any seller of goods or services who takes or receives a consumer credit contract, as well as

(2) any seller who accepts as full or partial payment for a sale or lease the proceeds of any purchase-money loan made in connection with a consumer credit contract.

• The purpose of the Rule is to protect consumers from being forced to pay a third party for a defective good and then incur the cost of pursuing the seller separately.

• As a consequence of Rule 433, a consumer who does receive a defective product may assert the defect as a defense to any claim for payment by the seller or any subsequent holder.

DISCHARGE FROM LIABILITY

• Discharge from liability on an instrument can occur in several ways:

(1) If the party primarily liable pays the instrument in full, all parties on the instrument are discharged;

(2) If a secondarily liable party pays the instrument, only that party and subsequent parties are discharged -- the primary party (maker or drawer), as well as any indorsers prior to the paying party, remain(s) liable;

(3) Intentional cancellation (e.g., writing “PAID” across the face of the instrument, destroying the instrument) discharges the liability of all parties;

(4) Material alteration may discharge the liability of any party(-ies) affected by the alteration;

(5) A party reacquiring an instrument discharges the liability of all intervening indorsers to subsequent holders who are not holders in due course; and

(6) If a party’s right of recourse (i.e., right to seek reimbursement) has been impaired, that party may be discharged from further liability.