Life Cycle

CPA Regulation
Negotiable Instruments and Secured Transactions

Negotiable Instruments and
Secured Transactions
2011 HOCK international 91
What is a note and who are
the parties to a note?
A note is a written promise to pay money. Notes are dif-
ferent from drafts in that notes are a promise to pay.
If there is any doubt whether a document is a note or a
draft, the holder of the document can decide what it is.
There are two parties involved in a note.
1) The Issuer (Maker) is the promisor. This is the party
who is obligated to pay the note.
2) The Payee is the person to whom the note is owed.
The Payee will receive the money paid by the Issuer.
CPA Regulation
What is a draft and who
are the parties to a draft?
A draft is a written order to pay money. In a draft, one
party orders another party to pay money to yet a third
party.
If there is any doubt whether a document is a note or a
draft, the holder of the document can decide what it is.
There are three parties involved in a note:
1) The Drawer The drawer writes and signs the note,
2) The Drawee (usually a bank) The drawee is or-
dered by the drawer to pay the Payee, and
3) The Payee The payee will receive the money from
the drawee.
CPA Regulation
What are the
common types of
notes and drafts?
The main types of notes are:
1) certificate of deposit (a bank promissory note);
2) time note (payable at a specific time in the future);
3) demand note (payable when it is presented to the
issuer); and
4) installment note (the principal is payable over
time).
The main types of drafts are:
1) checks (written on a bank and payable on demand,
requiring the drawee to be a bank);
2) cashiers checks (a check that is drawn by a bank
on itself);
3) trade acceptances (a seller of goods writes a draft
ordering the buyer to pay at a future time);
4) sight drafts (a draft payable when it is delivered);
and
5) time drafts (a draft payable with a certain period of
time).
CPA Regulation
What are the five
elements of negotiability?
In order for an instrument to be negotiable, it must
have the following five elements:
1) It must be in writing and signed by the issuer.
2) There must be a sum certain.
3) There must be an unconditional promise or order
to pay.
4) It must be payable upon demand or at a specific
time.
5) It must be payable either to order or to bearer.
CPA Regulation
What are the
requirements for the
writing and signature?
A negotiable instrument cannot be an oral communication
it must be written. However, there is no requirement
that the writing be on a piece of paper (the writing may
be on other items).
Additionally, the instrument must be signed by the
issuer, or drawer, to be considered negotiable. The use
of any symbol executed or adopted by a party with a
present intention to authenticate a writing is sufficient to
meet the definition of signed. Thus, a signature can be
made manually or by means of a device or a machine,
and it can use any name (including a trade or business
name) so long as the signatory intends to authenticate the
writing. The signature can also be a sign or symbol differ-
ent from the persons name.
CPA Regulation
What are the exceptions
to a sum certain?
Though these items appear to contradict the sum certain
requirement, the following items do not destroy the nego-
tiability of a note:
1) A disparity between the words and numbers on an
instrument (in this case the written words are used,
not the numbers);
2) A provision for collection costs (including attorneys
fees in the event of the debtors default);
3) A reference to an exchange rate; and
4) Variable interest rate provisions.
However, the instrument must be payable only and
completely in money. Thus, a note fails the negotiability
test if the note specifies that it is payable in money
and/or personal services or goods.
CPA Regulation
What does
unconditional mean for
a negotiable instrument?
The instrument must be a simple unconditional prom-
ise (in the case of notes) or a simple unconditional
order (in the case of drafts). Thus, an instrument must
be a courier without luggage. This means that the
promise or order must not be contingent on some other
event happening.
If, for example, an instrument says, I promise to pay,
contingent upon satisfactory completion of the terms of
the contract signed today, then the note is not negoti-
able because it is conditional.
However, if instead the instrument says, As per the con-
tract signed today, I promise to pay, then this instru-
ment is negotiable because it only makes reference to
an underlying contract.
CPA Regulation
What types of conditions
may exist in a
negotiable instrument
without destroying
its negotiability?
There are, certain conditions that may exist in the instrument
without destroying the negotiability of the instrument:
1) A promise or order is not made conditional if it makes
reference to another writing for the statement of rights
with respect to collateral, a prepayment clause, or an
acceleration clause or because payment is limited to a
particular source.
2) Acceleration clauses enable the creditor to collect more
quickly should the debtor not make timely payment.
These are permitted because they minimize the burden
on creditors and courts.
3) If a promise or order requires countersignature by per-
sons whose signature appears on the promise or order,
as condition of payment, this condition does not make
the promise or order conditional. This instrument would
continue to be negotiable.
The key point regarding negotiability for these types of
clauses is whether the amount or certainty of payment is not
changed by this clause. If no change will occur, negotiability is
not impacted.
CPA Regulation
What are the requirements
for the time of payment?
Since the holder of the instrument must be able to
determine when it comes due, the instrument must be
payable on demand or at a definite time. The time
does not need to be a specific date in the future as long as
there is reference in the instrument that enables the time
to be determined.
Despite the fact that there needs to be a date of payment,
there is no requirement that an instrument be dated.
Undated instruments are negotiable and are treated as
payable on demand by the holder.
Instruments may also be antedated (backdated) or
postdated. An instrument payable on demand is not pay-
able before the date that is written on its face.
It is also possible for the time period for payment to be
extended without destroying the negotiability of the
instrument.
CPA Regulation
To whom must a negotiable
instrument be payable?
In order to be negotiable, the instrument must contain the
words of negotiability: payable to bearer or payable to
order.
1) An instrument is payable to bearer if it:
a) states that it is payable to the bearer or to the
order of the bearer;
b) does not state a payee; or
c) is payable to the order of cash or is not payable
to an identified person. An instrument payable to
bearer allows whoever holds the instrument to
exercise the instruments rights without indorse-
ment by the maker of the instrument.
2) An instrument payable to order specifies the person
to whom payment should be made. Because there is a
named payee, until the named person makes a trans-
fer of his rights by indorsing the instrument, the
instrument cannot be redeemed for value and cannot
be readily transferred to a new holder.
CPA Regulation
List and define the
three stages in the life
of a negotiable instrument.
There are three stages in a negotiable instruments life:
1) Issuance: when the instrument is created and trans-
ferred to the first holder, The issuance of the instru-
ment is not a negotiation.
2) Transfer: when the instrument is transferred from
one holder to another
3) Presentment: when the instrument is presented for
payment and after payment is made ceases to exist
as an instrument.
Transfer and presentment of an instrument may constitute
a negotiation. Physical transfer of the instrument gives to
the transferee (recipient) whatever right the transferor
(giver) had in instrument. If the transferee becomes a
holder of the instrument, then the transfer is called
negotiation.
The way that an instrument is transferred depends on
whether the instrument is payable to bearer or to order.
CPA Regulation
How may order and bearer
instruments be transferred?
Transfer of Bearer Paper If an instrument is made
out to bearer, the person who physically possesses the
instrument is the holder. Since the holder is determined by
physical possession alone, a bearer instrument may be
transferred simply by giving the instrument to another
person. The indorsement (signature) of the previous
holder is not required to negotiate bearer paper.
Transfer of Order Paper If the instrument is payable
to the order of someone, then the identified person is the
bearer once he or she has the negotiable instrument in his
possession. However, the negotiation of order paper to
another person requires the indorsement by the named
party.
CPA Regulation
What are blank and
special indorsements?
Blank indorsement is when the payee simply signs his
or her name to the back of the instrument. A blank
indorsement automatically converts an order instru-
ment to a bearer instrument. However, the holder of
an instrument with a blank indorsement can convert the
instrument to order paper by writing a new payee above
the blank indorsement.
With a special indorsement, if the payee wishes to pre-
serve the order character of the instrument, then the
payee may specify a new payee. After this first special
indorsement, the signature of the new payee is required
for further negotiation of the instrument. If a special
indorsement is placed on bearer paper, the special
indorsement makes it order paper.
CPA Regulation
What are restrictive and
qualified indorsements?
Restrictive indorsement: when the payee adds a condi-
tion to the payment of the instrument. Negotiation and
further transfer of the instrument are not impaired.
Examples are a restriction for deposit only, or for pay-
ment after the completion of X. Banks may ignore all
restrictive indorsements except those made by the imme-
diate transferor.
Qualified indorsement: payee signs his name and adds
without recourse. Without this statement added to an
indorsement, the signatory guarantees payment: if the
original parties do not pay, the signatory will. To avoid this
liability, the signatory indorses the check with the words
without recourse. A qualified indorsement does not des-
troy the negotiability of the instrument and does not pre-
vent its transfer. Instead a qualified indorsement makes it
order paper. As a result, it must be indorsed before it can
be negotiated. A qualified indorsement eliminates the
indorsers contract liability (guarantee of payment), but
not his warranty liability.
CPA Regulation
What happens if a
negotiable instrument
presented for payment
is rejected by the payor?
If a payor does not agree to make payment or to accept
an instrument that has been presented to them, then the
payor has dishonored the instrument.
This refusal to make payment gives the instrument holder
the right of recourse against the parties with secondary
liability.
In some cases this process of dishonoring an instrument
can be done orally. In other cases written documentation,
including a notice of dishonor, is necessary in order to
establish legally the secondary liability against other
parties to the instrument such as the indorser.
CPA Regulation
What party has
primary liability for a
negotiable instrument?
Primary liability is the liability of makers and acceptors
(and sometimes accommodation parties, too). Primary
liability means that the maker or acceptor is obligated to
pay the instrument before any other party.
1) Maker. This is the party who is obligated to pay a
promissory note (not a check the person who
writes a check is called the drawer, below) according
to the terms that existed at the time of issuance.
2) Acceptor. The drawee (the bank) has no liability
for payment until he accepts the draft. Once the
drawee accepts the draft (by signing it), he becomes
an acceptor and agrees to pay the draft as present-
ed. Thus, if the acceptor signs an incomplete draft (for
example, the amount is blank), he is liable for any
unauthorized amount later filled in.
CPA Regulation
Who has
secondary liability for a
negotiable instrument?
Secondary liability is the liability that drawers and indorsers
have for the instrument. Drawers and indorsers are required
to pay for the instrument only if the party with primary liabil-
ity fails to pay.
1) A Drawers Liability. The drawer is the person who
wrote the draft and in so doing ordered another party
(usually a bank) to make payment. The drawer does not
expressly promise to pay the instrument himself or her-
self, but implicitly guarantees payment by virtue of using
the drawee as a payment agent. In the event that the
drawee refuses to pay a draft, the drawer is obligated to
pay so long as the drawer is notified of the drawees dis-
honor of the draft.
2) An Indorsers Liability. An indorser is someone other
than the maker, drawer or acceptor who signs the instru-
ment to negotiate it, restrict it or just to incur liability.
The indorsers signature is called an indorsement. An
indorsers liability is created once an instrument has been
dishonored and the indorser has been notified of the dis-
honor.
CPA Regulation
What are the 5 warranties
that a transferor makes
in respect to the
negotiable instrument that
is being transferred?
Warranty liability relates to the warranties (promises, or
guarantees) that are made by a transferor in respect to
the instrument that is being transferred.
The transferor warrants that:
1) Good title to the instrument exists and the instru-
ment is enforceable (it is their instrument to transfer).
2) All signatures are authorized and genuine
(meaning that there are no forgeries).
3) There are no material alterations (for example, the
dollar amount has not been increased).
4) The transferor has no knowledge of any insol-
vency proceedings associated with the instrument.
5) There are no defenses that can be asserted
against the transferor that would prevent payment
of the instrument.
CPA Regulation
To which parties are
warranties made by a
transferor of a negotiable
instrument?
The parties to whom warranty liability is incurred depend
on how the instrument is transferred:
1) Transfer with Indorsement. When the transferor
signs the instrument, he or she incurs warranty liabil-
ity with respect to the immediate transferee and all
subsequent (following) transferees.
2) Transfer without Indorsement. If the transfer is
made without the indorsement of the transferor, the
transferor incurs warranty liability only with respect to
the immediate transferee (recipient). Therefore, it
is better for the transferor to transfer without indorse-
ment if that is possible.
CPA Regulation
What are
accommodation parties
and what type of liability
do they have?
An accommodation party is a party who signs an
instrument as maker, drawer, acceptor or indorser with
the deliberate purpose of backing the obligation of another
party (the accommodated party). Thus, the accom-
modation party incurs liability without being a direct
beneficiary of the instrument (this is true even if the ac-
commodation party acts as a paid surety; the key is that
someone else gets a direct benefit of value given for an
instrument).
Accommodation parties incur no warranty liability, but
they do incur secondary contract liability just like
drawers and indorsers. Additionally, an accommodation
party has primary contract liability if he or she signs on
behalf of a notes maker.
CPA Regulation
How may liability
on an instrument
be terminated?
A person who is liable for an instrument can be discharged of
some or all of the liabilities through:
1) Discharge by Performance (payment of the instrument).
2) Discharge by Mere Tender of Payment. The party who
offers payment to the holder is discharged from any future
liability for collection costs, interest and attorneys fees.
3) Discharge by Cancellation or Renunciation.
4) Discharge by Material Alteration. If the amount of an
instrument is changed fraudulently, this discharges all pre-
vious signatories.
5) Certification of a Check by a Bank. This discharges all
prior parties to the instrument as the bank becomes
primarily liable for the check.
6) Unexcused Delay in Payment. With unreasonable delay
in the presentation of the instrument, previous signatories
may be discharged.
7) Discharge Through Release of the Collateral. When
collateral is released, the original promisor is also released.
CPA Regulation
What are the
four requirements to be a
holder in due course and
what are the benefits?
A holder in due course (HDC) has special status. This
status protects an innocent third party (the HDC) from
losing his or her investment in a negotiable instrument
due to some underlying problem with the instrument.
There are four requirements that must be met for a
holder to be an HDC:
1) Holder. The individual must be a holder of a negoti-
able instrument.
2) Value Given. The holder must have given present
or past value (not future value) for the instrument.
3) Good Faith. The holder must have acted in good
faith in the acquisition of the instrument.
4) No Notice of Defect. The holder must take the
instrument without notice that the instrument is over-
due, has been dishonored, or has been forged.
CPA Regulation
What is a holder under a
holder in due course and
what are the benefits
of this status?
The transfer of a negotiable instrument gives to the recipi-
ent (the transferee) any rights the transferor had to
enforce the instrument. This includes the rights as an
HDC. This means that when an HDC transfers the instru-
ment to someone else, that recipient automatically has all
of the same rights as an HDC. If the recipient meets the
requirements as an HDC, they will be an HDC. If, however,
the recipient does not meet the HDC requirements (per-
haps they received the instrument as a gift), they will be a
Holder Under Holder in Due Course (HUHDC) if the
transferor was an HDC.
This means that it is possible for a person who would not
be an HDC (perhaps because he or she knew about some
defect or the instrument was overdue) to be an HDC
simply because the person from whom they obtained the
instrument was an HDC. This is the case regardless of
whether the transfer is a negotiation or a gift.
CPA Regulation
What are the
real defenses?
When an HDC makes a claim to force payment, the only
defenses that the person can use to prevent having to
make payment to the HDC are real defenses.
Real defenses concern the validity of the instrument itself.
By using a real defense, the defendant (who tries not to
pay) claims that the instrument was never actually an
instrument and they never had a liability to that person.
They include:
1) Infancy.
2) Duress.
3) Incapacity.
4) Illegality.
5) Discharge in Bankruptcy.
6) Fraud in the Execution.
7) Forgery.
8) Alteration.
9) Subsequent Claims and Defenses.
CPA Regulation
What are the
personal defenses?
All other defenses, other than real defenses, are personal
defenses.
Examples of personal defenses are:
1) Fraud in the inducement;
2) Lack of consideration;
3) Breach of contract; and
4) Mistakes.
Personal defenses are ineffective against HDCs. This
means that these defenses will not prevent someone from
having to pay the HDC.

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CPA Regulation

Negotiable Instruments and Secured Transactions

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