The rules governing negotiable instruments streamline the flow of monetary obligations between entities and individuals. This chapter will define negotiable instruments and then provide an overview of how those instruments are transferred and the common problems that arise.

The Uniform Commercial Code (UCC) defines a negotiable instrument as an unconditional promise or order to pay a fixed amount of money if …

Article 3 of the UCC contains the detailed and often complex rules that govern negotiable instruments. This area of law is filled with definitions. Stick with this section and you’ll see how the definitions tie together.

There are several types of instruments that qualify as negotiable instruments. Each fills a specific role and can be issued by certain types of institutions or individuals.

Promissory notes are written promises to pay a sum certain to the holder. The holder is the person with possession of an instrument that is 1) payable to that person, 2) indorsed to that person, or 3) bearer paper.

Certificates of Deposit are a bank’s promise to pay a set sum of deposited money back to the customer with interest when the customer surrenders the document.

Drafts are an order by one party to another to pay a sum of money to a third party. In general, if you issue a draft, you instruct somebody to make a payment to a third party on your behalf. You are the drawer, the person making the payment is the drawee, and the person receiving the money is the payee. The drawee only needs to pay when he or she accepts the draft from the payee.

Still confused? Think of a check—you know, the ones you get from your bank. When you fill it out, you essentially order your bank to pay a specific amount to the identified party. A check is a specific subset of drafts.

Then there are teller checks (a draft drawn by one bank on another bank), cashier’s checks (a draft drawn by a bank on itself), traveler’s checks (drafts that are payable to the bearer if countersigned by the person who originally signed the check), and money orders (draft issued by a bank or nonbank).

Each instrument has at least two parties to it. However, those parties change based on the type of instrument. Here’s the summary of the vocabulary you need to know.

If a note is involved there are two parties: the maker signs the note and is responsible for payment while the payee is the named person on the note who receives payment. If it’s a draft, the drawer is the party who writes or creates the draft or check, the drawee is the party who is to pay on the draft or note, and the payee is the one named on a check to receive payment.

There are two additional terms that could come up in this context. The drawee becomes an acceptor when the drawee indicates a willingness to pay the draft. And an accommodation party is someone who has no original duty under the note but signs to guarantee payment. The addition of the accommodation party strengthens the collect-ability of the note.

Just because a document has been drafted that says someone should be paid does not make the paper a negotiable instrument. For that to occur, the note must meet several requirements. If an instrument is negotiable, the rules in Article 3 of the Uniform Commercial Code govern and provide stronger protection than contract law. To achieve those extra protections, the note must be 1) evidenced by a record, 2) signed 3) by the maker or drawer, 4) pay a sum certain, 5) payable in money, 6) payable on demand or at a specific time, and 7) payable to order or bearer.

To receive the protections of Article 3 of the UCC, all seven requirements must be met in the instrument from the time it is written. If it fails to meet all seven requirements, then the note or draft can be enforced under contract law.

A record essentially means the instrument needs to be in writing. There has to be a physical piece of paper or electronic record that can be taken to court if a dispute arises. Under Article 3 the record can be handwritten, typed, printed, or electronic. The UCC does not dictate that specific forms be used, merely that a record exists and that it contain the other six elements.

The record must be signed by the person making the promise or order to pay. In this increasingly electronic world, the UCC now requires that the document be signed or authenticated. This can occur by old-fashioned signature, a seal, symbol, electronic mark, or any other device allowed by law. A company or individual may authorize an agent to sign on its behalf, and the agent can use language in their signature that clarifies the relationship. An agent should sign in a way that avoids personal liability. This can be achieved by signing the company name, then “by Don Marks, Director.” Without making it clear that the person signing is doing so as a representative or agent, that person becomes personally liable on the instrument.

On the face of the document, the promissory note must contain a promise to pay. A draft or check must have an order to pay. For it to qualify the promise or order to pay must not have any conditions. Instead, it must be payable when presented. For example, the payment can come from a specific fund, but the fund must exist at the time the note is written. Otherwise, the payment is conditional on the fund’s creation.

Money includes any currency used by a government or intergovernmental agency. While the parties can agree to use foreign currency, they cannot agree to a non-monetary source like stocks or bonds. If they do, the UCC no longer applies.

The requirement for a sum certain means that the amount owed must be specific. It must be an exact amount of money that leaves no doubt about what is owed. The note or draft can have a floating or variable interest rate without violating this requirement.

The due date must be specific to a definite time or the paper must be payable on demand. An instrument is payable on demand if it states that it is payable on demand or at sight, or indicates it is payable at the will of the holder. A definite time is either spelled out on the document or is readily ascertainable from the document. If there is no date, it is taken to be dated when it is issued to the payee. A paper is not due before the date on its face.

The words of negotiability are “payable to order” or “payable to bearer.” Usually, you will see phrases like “Pay to the order of Andrew Smith,” “pay to Andrew Smith or order,” “pay to bearer,” or “Pay to Andrew Smith or bearer.” Pay to order language indicates that there is no restriction that the payment be made to Andrew Smith alone. He can sign it over to somebody else. Bearer language indicates that anyone holding the paper can be paid if he or she presents it for payment.

The following table shows whether the language used makes the note order or bearer paper.

Negotiation is the transfer of possession of paper. The holder of the paper is different from the possessor of the paper. To be a holder, the person must not only have possession of the paper, but it must also be payable to her, indorsed to her, or bearer paper.

Bearer paper (remember the magic words: pay to bearer?) is negotiated by delivery. Possession of the instrument is all it takes to acquire the money promised.

Courts have held that even when the note or instrument is transferred by mistake or inadvertently, if the paper is bearer paper, then the holder gets to keep it. Even fraud and embezzlement don’t change this general rule as long as the bearer took the paper in good faith without knowledge of the fraud.

If the paper is order paper (contains the magic words “pay to order”), then the paper can be negotiated only by indorsement and transfer of possession of the paper. Possession alone is insufficient.

If order paper is transferred to another with an indorsement alone, that is called a blank indorsement. In that case, the order paper is transferred to bearer paper. Think of a check. When you sign the back of the check, it is a blank indorsement. You are not transferring it to the order of another person. If you lose the check, whoever finds it can take it to a bank and cash it. It has become bearer paper.

Special indorsements are those that contain language detailing who the indorser is making the instrument payable to. Take a check. If instead of merely signing your name you wrote “Pay to John Smith” over your signature, the check now has a special indorsement and continues to be order paper. You have left specific instructions about who the money should be paid to. Then if John Smith signs only his name on the back, he has now transferred the order paper to bearer paper.

A qualified indorsement places some limit or disclaimer on the liability of the indorser to the maker or drawee. The usual language you will see in this situation is “without recourse.” By adding those two words to the signature, the indorser has now told the drawee and maker that he is not accepting responsibility for all of the secondary liabilities for payment of the instrument. Qualified indorsements are used to show an intent to limit liability.

Restrictive indorsements are used to limit or restrict the way the instrument is transferred. This can be used to indicate the funds are in trust or that the funds are “for deposit only.” To ensure that the check can only be deposited in your account, you must add your account number to the signature block. Otherwise, the paper is turned into bearer paper and can be deposited into anybody’s account. These restrictive indorsements are designed to reduce the risk of theft.

Banks also endorse notes, but may use any agreed method including listing its Federal Reserve System number. A bank may also indorse for a customer who forgot to indorse the instrument. A customer may stamp the instrument rather than sign it—think of the stacks of checks restaurants take to the bank that are stamped with the relevant information rather than signed by the restaurant’s agent.

An instrument can be made out to more than one person or entity. If it is made out to “Adam Smith and Tom Banks,” then both parties must indorse the check. If it is made out to “Adam Smith or Tom Banks,” then either can indorse it. If there is any doubt, the court will default to the preference that the instrument is made out to alternate payees.

The terminology of indorsements is complicated. So what happens when someone forges a signature on a check? Or embezzles funds? Or other misconduct occurs with negotiated instruments?

A forged indorsement is not authorized or a valid indorsement. If a forged indorsement exists on an instrument, the person with the instrument is not a holder with the added protections. If the payer makes payment on a forged indorsement, the payer is still liable to the original payee, unless that payee’s negligence contributed to the forgery.

The imposter rule provides exceptions to the general forgery rule that allow the instrument to continue to be effectively negotiated. This is important because if the rule applies, the signature is treated as a genuine endorsement even though it is not. For the imposter rule to apply, the payee or its agent is impersonated. The imposter rule also applies if a dummy payee is used. A dummy payee may be used to hide why money was taken from a personal account. Or a dummy payee may be used when an agent or employee supplied the name for the payee line intending to take the money for himself. In that situation the employee intends to forge the indorsement of the dummy payee and keep the money. The imposter rule does not apply when there is a valid check but someone forged a signature.

The dummy payee exception as applied to employees is designed to give employers a reason to keep their internal controls in place to prevent employees from committing fraud.

A minor or other incapacitated person can negotiate an instrument unlike contract law. Fraud, mistake, and duress do not make negotiation ineffective. Neither does the fact that the negotiation was illegal or a breach of duty.

If a lost instrument is order paper, the finder does not become the holder because the paper is not made to the order of the finder. If a lost instrument is bearer paper, the finder is the holder and entitled to enforce the instrument.

The UCC creates a host of warranties that the parties to a negotiated instrument make to each other.

The unqualified indorser makes six warranties. First, he is entitled to enforce the instrument. Second, all signatures are authentic and authorized. Third, the instrument has not been altered. Fourth, the instrument is not subject to a defense or claim that can be asserted against the warrantor. Fifth, in regards to consumer accounts, that if it does not have a handwritten signature, the drawer has authorized the instrument. And sixth, the warrantor does not know the maker is insolvent.

The party submitting the paper for payment makes three warranties. First, the warrantor is entitled to enforce the draft or authorized to obtain payment. Second, the draft has not been altered. And third, the warrantor has no knowledge that the drawer’s signature is unauthorized.

What happens if the document becomes forged at some point? The last person who qualified as a holder can go to the transferor she received the paper from to recover under the warranties. It doesn’t matter that neither was a party involved with the original instrument.

You may have noticed that the implied warranties do not guarantee payment. Nor is there a guarantee of sufficient funds in an account. The warranties focus on the character of the instrument (that it’s not forged, altered, etc.) rather than on payment. All of the warranties pass to the transferee and any subsequent transferees. Warranties may be disclaimed on all instruments except checks. The disclaimer may be made with signing by using language like “without warranties.” If someone wants to enforce a warranty, notice must be given to the breaching party within 30 days of learning of the breach.

If an instrument is transferred with a qualified indorsement, the indorser does not assume liability for the payment of the instrument as written. All other warranties remain in place. Finally, if the instrument is transferred by delivery rather than indorsement, the warranty liability from the transferor only flows to the immediate transferee.

A holder in due course (HDC) has more protections than a regular holder. These extra protections exist because the HDC takes the instrument and meets additional requirements at the time the note is negotiated to the holder and the holder gives value. The extra requirements to take the note as an HDC fall into three general areas: taking the note for value, in good faith, and without notice.

Value can include performance of consideration, acquisition of the instrument, taking the instrument for payment of a preexisting debt, giving a negotiable instrument for the instrument, or giving the instrument in exchange for an irrevocable obligation. The value does not need to match the face amount of the instrument. The time the value is given determines whether the holder took the instrument in good faith and without notice.

Good faith means that the holder acted honestly in acquiring the instrument. The holder must have also observed standards of fair dealing. Bad faith can come from something as simple as giving too little value for the instrument. The standard for honesty is subjective, while fair dealing is objective—uses the reasonable person standard.

To be an HDC, the holder must obtain the instrument without notice under one of these conditions:

The notice must occur in a way that gives the holder a reasonable opportunity to act on that notice. As it often does, the law has decided to balance the scales if there is a problem with who had the best opportunity to prevent the problem from occurring. If a person is an HDC, then that individual or entity did nothing to perpetuate the problem. He or she cannot have knowledge that anything was wrong. Thus, he or she receives extra protections.

Transferees after the HDC are sheltered by the rights of the HDC. In a sense, the transferee steps into the shoes of the HDC who transferred the instrument to them and acquires all of the rights and protections of the HDC.

An HDC can often obtain payment because of the added protection that status affords despite any underlying problems between the original parties to the instrument. That is why that status is so valuable. The defenses break into two categories: those available against HDCs and those available to everybody else. All of the defenses can be used against a general holder.

One benefit of attaining HDC status is that several defenses cannot be raised against a claim from an HDC. Those include ordinary contract defenses, incapacity of the maker or drawer, and fraud in the inducement. Instead, the defending party has very limited defenses.

However, there are certain defenses that can be used when defending a claim made by an HDC. These defenses are called universal defenses because public policy dictates the defense should apply to everybody. For example, the fact that one party had the inability to contract due to minority or another capacity issue is a universal defense. If the contract was illegal, that is a defense to HDC status, as are forgery, alteration, fraud in the execution or terms of the paper, and duress.