Negotiable Instruments

• Negotiable instruments are also known as "Commercial Paper."
• Cash is the most preferable form of payment.
• Negotiable instruments enhance enforceability compared to verbal promises or simple written agreements.
• To ensure full payment, demand cash only.

Categories of Negotiable Instruments

• Holder In Due Course (HIDC): Has higher value and legal standing.
• Not HIDC.

Types of Negotiable Instruments

• Draft (e.g., check).
• Note (e.g., Note Payable).

Draft

• Drawn on a "Drawee" (typically a bank).
• Signed by the "Drawer" (the bank customer who writes the check).
• Paid to the order of a "Payee" (the person or entity the Drawer intends to pay).

Note

• Paid to the order of a "Payee" (the person or entity to whom money is owed).
• Signed by the debtor or "Maker" (the person who owes the money).

Criteria for Negotiable Instruments

• Unconditional promise to pay "to Order" or "to Bearer".
• Payable on Demand or at a specific time/time interval.
• Sum Certain (legally recognized tender, like USD).
• In Writing.
• Signed by the Drawer (for a Draft) or the Maker (for a Note).

Payable on Demand

• Payable on demand if no specific time or time interval outlined.
• Examples: Check, Draft, Money Order, Cashier's Check.

Time Interval

• Payable over a time interval.
• Examples: House Note, Car Note (typically paid to a bank or financial institution in installments).

Sum Certain

• Often in USD, but can be in any denomination/currency recognized.

Doesn't Destroy NI

• The following terms do not destroy negotiability:
• Interest rate.
• Collateral.
• Acceleration clauses.
• Attorney fees.

Draft Example

• Jane Adams, President (Drawer) of OurTown Real Estate, signs a draft.
• First National Bank (Drawee) is instructed to pay Eastman Supply Company (Payee).
• The Drawee pays the Payee from the Drawer's account when the Payee cashes or deposits the draft.

Note Example

• Lawrence E. Roberts and Margaret P. Roberts (co-makers/Debtors) sign a note.
• First National Bank (Payee/Creditor) receives payment.
• Each co-maker is 100% liable for the debt.
• Common Notes include: House Notes, Student Loans, Car Notes.

Negotiable Instruments - Basics with Illustration

• By using a check (Draft), a customer makes it a negotiable instrument.
• A negotiable instrument allows for third-party transfers.
• If the plumbing service transfers the Draft/check to a good faith third party who paid value and has no knowledge of any problems, the third party becomes a Holder In Due Course (HDIC).
• A Holder In Due Course (HDIC) can enforce the instrument against you (the customer) regardless of the "defect in plumbing services".

Holder in Due Course (HDIC) Criteria

• Holding/Has possession of the negotiable instrument.
• To reach the status of HIDC one must Paid value for the instrument.
• Acting in good faith, and having no knowledge of problems.

Good Faith and No Knowledge

• Good faith: Is there something suspicious/odd? Does the transaction look strange?
• No knowledge: Is the party aware of a breach of contract claim, etc., between the two parties?

Personal Defenses

• Personal Defenses cannot be used against HIDC
• Examples: Breach of Contract, Failed Consideration, Wrongful Completion, Duplicate Payment, Fraud in the Inducement.

Real Defenses

• Real Defenses can be used against HIDC and are effective against all holders.
• Examples: Bankruptcy, Forgery, Judicial Insanity, Material Alteration, Fraud in the Execution.

Negotiable Instruments - Personal and Real Defenses

• If Payee sells the NI to a third or fourth party, these parties could be HIDC, and if they are, all personal defenses "go away"/cannot be used
• There are 5 other defenses that NEVER go away (they're indelible) - these are the Real Defenses
• Personal Defenses cannot be used against HIDC

Orthodontist Example

• Orthodontist provides service, can create a negotiable instrument for payment.
• Selling a negotiable instrument (NI) can raise its quality and selling price.
• If the instrument is not NI, subsequent purchasers are subject to Real AND Personal Defenses.
• If instrument NI, third-party buyers cannot escape Real Defenses, but they can escape Personal Defenses.

Endorsements

• Signing the NI on the back has different implications based on the type of endorsement.
• There are 5 Endorsements.
• Blank: Signing the NI on the back.
• Restrictive: Signing NI + “for deposit only”.
• Special: Writing "pay to (new Payee)" on the back of NI.
• Qualified: Writing "without recourse" or "no warranties" on the NI, which cheapens its quality.
• Combo: Combined Endorsements (more than one Endorsement on a NI).
• If you're really concerned about getting paid, cash is the way to go
• No endorsements required
• Highly liquid
• NI have some constraints that don't make them as liquid as cash
• NI are still pretty liquid

Transfer Warranties

• Endorsements have warranties that "back up the paper"
• The more Endorsements the better
• When a NI is Endorsed, the transferor (the party Endorsing the NI) is making 5 warranties to the recipient
• If the recipient encounters any defenses, they can sue the Endorser on the warranties.

Transfer Warranties

• No forgeries
• The Drawer/Maker is not a forgery (it's an authentic signature)
• All Endorsements before Drawer/Maker were also authentic
• No material alterations
• No insolvency (at this time)
• At the time, the Drawer/Maker is solvent
• No claims or defenses
• Party is entitled to get paid

Summary of Negotiable Instruments

• Verbal promises are not recommended.
• NI are simple but can have complex terms.
• The goal is to make NI as near to cash as possible.
• Want to make them extremely fluid and liquid
• Want to elevate NI to cash equivalents on the balance sheet

Exhibit 28-3 (The Collection Process)

• Forgery on the BACK of the NE, it's the depository institution responsibility to catch
• Forgery on the FRONT of the NE, the bank should be checking
• Drawee bank is liable for forgeries on the FRONT of the NI
• 30 Day Rule: Notify forgery in 30 days, if not you assume responsibility and liability

Exhibit 27-2 (Personal and Real Defenses)

• Universal (Real) Defenses
• Valid against all holders, including HIDC
• Personal (limited) Defenses
• Valid against ordinary holders, but NOT against HIDC

Hypotheticals

• If note is left with blanks, it's not a NI for no Sum Cetain and specific Time Interval.
• Court found that Breach of Contracts is a Personal Defense
• If bank is NOT a THIC, bank is subject to personal defenses.
• If bank meets all four HIDC requirements, the Personal Defense goes away and bank can recover.

Hypothetical #2

• A gave a Draft/Note to B (made it out to B's order - "pay to order of")
• B then donates the Draft/Note to C
• C is a child.
• Is C a HIDC? NO
• Reason, they didn't pay value
• Normally, a successor only gets what their predecessor had, but if C sells the NI -to- D, D now adds the value piece, D now has all 4 criteria and is a HIDC
• Here, the law creates greater rights for the next party in the chain (very rare)