Overview
Cash is often inconvenient as a payment medium in transactions that involve large sums of money or where an ordinary promise to pay is unsuitable. A“negotiable instrument”is a document that guarantees that payment will be made of a certain sum of money. Payment will be made either upon demand or at a specified time by the person (or entity) named on the document. A check, for example, is considered to be a negotiable instrument.
Essentially, a negotiable instrument is a contract that promises the payment of money. That means, therefore, that rights and liabilities attach to a transaction involving a negotiable instrument. The law of negotiable instruments arose, at least in part, to provide a convenient and safe substitute for cash in these types of situations. Presently, Article 3 of the Uniform Commercial Code (UCC) governs negotiable instruments, and Article 4 (concerning bank deposits and collections) specifies the rules regarding bank processing of negotiable instruments.
The rights and liabilities of the parties to a negotiable instrument – that’s the focus of today’s post.
Types of Liability
Once an instrument is determined to be negotiable, it is necessary to determine whether or not a particular person is liable on the instrument and, if so, the nature of that liability. Liability can be based on contract principles involving a person's transfer of property related to the instrument, or on a tort theory relating to a breach of warranty on the instrument that intentionally or negligently causes loss to others.
Contract liability. The contract liability of the maker (also known as the issuer) of a note is based on that person's promise to pay. Article 3 requires the maker of a note, cashier's check or other draft to pay the instrument “according to its terms” either at the time of issue or at the time it first comes into possession of the holder. UCC § 3-413. The maker's promise is unconditional, and the maker owes the obligation “to a person entitled to enforce the instrument.” That includes the holder of the instrument, a non-holder in possession of the instrument who has the rights of a holder, or a person not in possession of the instrument who is entitled to enforce the instrument. UCC § 3-301. Thus, only two parties can be primarily liable – the maker and the acceptor. However, a person can still be entitled to enforce the instrument even though such person does not own the instrument or is in wrongful possession of the instrument.
A party that receives a check in payment of a debt expects the bank on which the check is drawn to pay the specified amount. However, until the bank accepts the check, the bank is not obligated to pay anything on the check. UCC § 3-411(2), Comment 2. Even if the bank arbitrarily dishonors a check, the payee or holder ordinarily has no cause of action against the bank on the instrument. As such, a payee may wish to obtain assurance that the bank will carry out the drawer's order. In particular, the payee or other holder may demand that the bank “accept” the draft and thus become primarily liable on the instrument. When a bank upon which a check is drawn accepts the check (usually by signing vertically across the face of the instrument), the bank is said to have certified the check. Once a bank accepts a check, it becomes primarily liable to all subsequent holders and the drawer of the check is discharged. UCC § 3-411(1).
The drawer of a draft drawn on a bank or other party is only “secondarily” liable on the instrument. Someone other than the drawer is expected to pay. The holder must make an attempt to collect elsewhere before the drawer must pay. While the drawer of a check, like the issuer of a note, signs the instrument in the lower right-hand corner, the drawer's contract is unlike the issuer's in that the drawer orders another to make payment and promises to pay only if the order bears no fruit. The holder of a draft looks first to the bank for payment and if it cannot be had there, to the drawer. If an unaccepted draft is dishonored, the drawer is obliged to pay the draft according to its terms at the time it was issued or if it was not issued, at the time it first came into possession of the holder. UCC § 3-413(2). With the 1990 changes to Article 3, it is no longer necessary that a holder give the drawer notice of the dishonor.
Article 3 frees a drawer from an obligation to pay a check if the check is not presented for payment within 30 days or given to a depository bank for collection within that time. However, this rule applies only where the drawee bank fails and because of the delay, the drawer is deprived of funds. In that event, the drawer is discharged, but only to the extent that the drawer is deprived of funds. On this point, consider the following example:
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Example: Sam bought a rare Arabian quarter horse from Kenny, and wrote Kenny a check for $265,000 drawn against Sam's account at Wea Cheatum State Bank. Kenny misplaced the check and found it four months later under a stack of papers in his office. In the meantime, Wea Cheatum State Bank failed. If the bank was federally insured, Sam would collect $250,000 in federal bank deposit insurance, and his obligation to pay Kenny the remaining $15,000 would be discharged because Sam would otherwise be deprived of funds that he could have withdrawn from the bank before it failed. Sam would assign to Kenny his drawer's rights against the drawee, and it would be up to Kenny to try to collect the $15,000 balance.
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An indorser of a negotiable instrument is also secondarily liable. Indorsement is the formal act that passes title to the indorser's transferee and obligates the indorser on the contract. Indorsement can also serve as a means of protecting against conflicting claims later on by restricting payment of the instrument. For example, the indorsement “for deposit only” not only serves to pass title or incur a guarantor's liability, it also prevents a party that accepts a stolen check from later claiming HDC status.
An indorsement can accomplish three functions: (1) negotiating the instrument; (2) restricting payment of the instrument; or (3) incurring an indorser's liability on the instrument. Thus, every signature that satisfies one or more of the above functions is an indorsement. This is true even if the indorsement is not in its usual place on the back of the instrument, but even in that event indorsers are normally liable in the order in which their names appear on the instrument.
All indorsements fall into three broad categories: special, blank and qualified. A special indorsement is an indorsement that identifies a person to whom the instrument is payable. A negotiable instrument that has been specially indorsed becomes payable to the identified person and may be negotiated only by the indorsement of that person. For example, “pay to the order of John Doe, \s\ Jim Jones” is a special indorsement that converts the negotiable instrument into an “order instrument” if the instrument is not already an order instrument. A blank indorsement converts a negotiable instrument into a “bearer instrument” and the instrument becomes payable to bearer and may be negotiated by transfer of possession alone until it is specially indorsed. For example, a blank indorsement “\s\ John Doe” makes the instrument bearer paper and is payable to anyone, with negotiation occurring solely by delivery (or possession for lost or stolen bearer paper).
A qualified or restrictive indorsement is utilized by individuals that want to limit their liability if the instrument is dishonored. Restrictive indorsements such as “for deposit only,” “pay any bank,” and similar phrases establish the terms for further negotiation of the instrument. Most often, their main purpose is to prevent thieves and embezzlers from cashing checks, but some phrases may constitute offers or terms of underlying agreements between the parties (i.e. “in full satisfaction of all claims”). If an indorser adds the words “without recourse” to its indorsement, the indorsement is qualified and the indorser transfers title to the instrument, but does not promise to pay should the instrument be dishonored upon presentation.
In one prominent Kansas case, a co-op employee forged customer signatures on co-op checks made payable to the customers and absconded with the funds. The co-op sued the bank for not honoring the restrictive indorsement on the checks which specified that the checks were for deposit only. Instead, the bank paid the cash amounts directly to the co-op employee. The bank was held liable for breach of the express contract with its depositor. Cairo Cooperative Exchange v. First National Bank of Cunningham, 620 P.2d 805 (Kan. 1980).
Tort Liability
A tort is a civil wrong for which a court will award recovery. The essence of a tort case is that the defendant owed a duty to the plaintiff that was breached, with the breach constituting the proximate cause of the plaintiff's damage. All of the elements must be present before the plaintiff can recover. As applied in the negotiable instrument context, if a bank wrongfully dishonors a customer’s check, and the wrongful discharge proximately causes the customer’s damages, tort liability may apply. See, e.g., Maryott v. First National Bank of Eden, 624 N.W.2d (S.D. 2001).
Article 3 also imposes tort liability for actions grounded in negligence and conversion. For example, if a check is altered and the alteration should be obvious upon reasonable inspection, a bank making payment on such check may be deemed to have not paid the check in good faith for failing to exercise reasonable care, and may be liable to the drawer to the extent the drawer is damaged by the alteration, unless the drawer's negligence, such as not adequately safeguarding checks and embossing equipment, substantially contributed to the alteration. See, e.g., Commercial Credit Corp. v. First Alabama Bank, 636 F.2d 1051 (5th Cir. 1981).
Conclusion
Banking transactions are often straightforward. However, when a transaction doesn’t turn out as expected, or fraudulent conduct is involved, or a bank fails, it’s helpful to know the applicable rules.