Chapter 23. Creation of Negotiable Instruments

Chapter Objectives
Distinguish between a negotiable and a nonnegotiable instrument.
Describe the functions served by negotiable instruments.
Distinguish between orders to pay and promises to pay.
Describe a check and identify the parties to a check.
Describe a promissory note and identify the parties to the note.
Describe a certificate of deposit and identify the parties to a CD.
Describe the requirements of permanence and portability of a negotiable instrument.
Describe how a negotiable instrument must be signed.
Distinguish between instruments payable on demand and payable at a definite time.
Distinguish between instruments payable to order and payable to bearer.
Describe how negotiable instruments are indorsed and transferred.
Distinguish between blank and special indorsements.
Define and apply the imposter rule and the fictitious payee rule.

Difference between a negotiable and a nonnegotiable instrument
Negotiable instruments must meet certain requirements established by Article 3 of the Uniform Commercial Code. An instrument that does not meet these requirements is not a negotiable instrument and is subject to contract law.
According to the UCC 3-104(a), a negotiable instrument must:

• Be in writing
• Be signed by the maker or drawer
• Be an unconditional promise or order to pay
• State a fixed amount of money
• Not require any undertaking in addition to the payment of money
• Be payable on demand or at a definite time
• Be payable to order or bearer

• Drafts
• Checks
• Promissory notes
• Certificates of deposit

• Substitute for money—merchants often do not want to carry cash for fear of loss or theft.
• Credit device—some forms of negotiable instruments extend credit from one party to another.
• Recordkeeping device—these records are used for financial statements, tax returns, and the like.

Orders to pay are drafts or checks.
• A draft is a three party instrument that is an unconditional written order by one party that orders the second party to pay money to a third party.
• A check is a draft that is drawn on a financial institution and is payable on demand. Promises to pay are promissory notes and certificates of deposit.
• A promissory note is a two party instrument that is an unconditional written promise by one party to pay money to another party.
• A certificate of deposit is a special type of note where the maker is the financial institution that issues the certificate and the payee is the party to whom the certificate is made payable.

Checks and parties to a check
Parties to a check are:

• Drawer to the check—the customer who has the checking account and writes (draws) the check
• Drawee of the check—the financial institution where the drawer has his or her account
• Payee of the check—the party to whom the check is written

Promissory notes and parties to a note
Parties to a note are:

• Maker of the note—the party who makes the promise to pay (borrower)
• Payee of the note—the party to whom the promise to pay is made (lender)

• Time note—a note payable at a specific time
• Demand note—a note payable on demand
• Collateral—security against repayment of the note that lenders sometimes require, such as a car, house, etc.

Certificate of deposit and parties to a CD
Parties to a CD:

• Maker of a CD—the bank (borrower)
• Payee of a CD—the depositor (lender)

Requirements of permanence and portability of a negotiable instrument
A negotiable instrument must:

• Be in writing
• Be permanent and portable

Signing a negotiable instrument
A negotiable instrument must:

• Be signed by the maker (note or CD) or drawer (check or draft)

• Be an unconditional promise or order to pay—must be unconditional to be a negotiable instrument
• State a fixed amount of money—must be a value that can be determined with certainty to be a negotiable instrument
• Not require any undertaking in addition to the payment of money—must be payable in money only and cannot require any undertaking in addition to the payment of money

• Be payable on demand or at a definite time
• Be payable to order or bearer
• An order instrument is payable to the order of an identified person.
• A bearer instrument is payable to anyone in physical possession of the instrument who presents it for payment when it is due.

• Order paper is negotiated by indorsement and delivery.
• Bearer paper is negotiated by delivery; indorsement is not necessary.

How order and bearer paper can be converted
Instruments can be converted from order paper to bearer paper, and vice versa, many times until the instrument is paid. The deciding factor is the type of indorsement placed on the instrument at the time of each subsequent transfer. An indorsement is the signature (and other directions) written by or on behalf of the holder somewhere on the instrument.

• A blank indorsement is an indorsement that does not specify a particular indorsee. It creates bearer paper.
• A special indorsement is an indorsement that contains the signature of the indorser and specifies the person (indorsee) to whom the indorser intends the instrument to be payable. It creates order paper.

• A qualified indorsement is an indorsement whereby the indorser promises to pay the holder or any subsequent indorser the amount of the instrument if the maker, drawer, or acceptor defaults on it.
• A qualified indorsement is an indorsement that includes the notation "without recourse" or similar language that disclaims liability of the indorser.

• A restrictive indorsement is an indorsement that contains some sort of instruction from the indorser.
• A nonrestrictive indorsement is an indorsement that has no instructions or conditions attached to the payment of funds.

Imposter rule
The imposter rule says if an imposter forges the indorsement of the named payee, the drawer or maker is liable on the instrument and bears the loss.

Fictitious payee rule
The fictitious payee rule says the drawer or maker is liable on a forged or unauthorized indorsement of a fictitious payee.

• allonge—A separate piece of paper attached to the instrument on which the indorsement is written.
• assignee—The party to whom the right has been transferred.
• assignment—The transfer of contractual rights by the obligee to another party.
• assignor—The party who transfers the right.
• bearer paper—Bearer paper is negotiated by delivery: indorsement is not necessary.
• blank indorsement—An indorsement that does not specify a particular indorsee. It creates bearer paper.
• certificate of deposit (CD)—A two-party negotiable instrument that is a special form of note created when a depositor deposits money at a financial institution in exchange for the institution's promise to pay back the amount of the deposit plus and agreed-upon rate of interest upon the expiration of a set time period agreed upon by the parties.
• check—An order by the drawer to the drawee bank to pay a specified sum of money from the drawer's checking accounting to the named payee (or holder).
• collateral—Security against repayment of the note that lenders sometimes require; can be a car, a house, or other property.
• demand instrument—An instrument payable on demand.
• demand note—A note payable on demand.
• draft—A three-party instrument that is an unconditional written order by one party that orders the second party to pay money to a third party.
• drawee of a check—The financial institution where the drawer has his or her account.
• drawee of a draft—The party who must pay the money stated in the draft. Also called the acceptor of a draft.
• drawer of a check—The checking account holder and writer of the check.
• drawer of a draft—The party who writes the order for a draft.
• drawer's negligence—The drawer is liable if his or her negligence led to his or her forged signature or the alteration of a check. The payor bank is not liable in such circumstances.
• fictitious payee rule—A rule that says a drawer or maker is liable on a forged or unauthorized indorsement of a fictitious payee.
• fixed amount—A requirement of a negotiable instrument that ensures that the value of the instrument can be determined with certainty.
• fixed amount of money—A negotiable instrument must contain a promise or order to pay a fixed amount of money.
• forged indorsement—The forged signature of a payee or holder on a negotiable instrument.
• holder—A person who is in possession of a negotiable instrument that is drawn, issued, or indorsed to him or his order, or to bearer, or in blank.
• imposter—A person who impersonates a payee and induces a maker or drawer to issue an instrument in the payee's name and to give it to the imposter.
• imposter rule—A rule that says if an imposter forges the indorsement of the named payee, the drawer or maker is liable on the instrument and bears the loss.
• indorsee—The person to whom negotiable instrument is indorsed.
• indorsement for deposit or collection—An indorsement that makes the indorsee the indorser's collecting agent (e.g. for deposit only)
• indorsement—The signature (and other directions) written by or on behalf of the holder somewhere on the instrument.
• indorser—The person who indorses a negotiable instrument.
• instrument—Term that means negotiable instrument.
• maker of a CD—The bank (borrower).
• maker of a note—The party who makes the promise to pay (borrower).
• money—A "medium of exchange authorized or adopted by a domestic or foreign government."
• negotiable instrument—A special form of contract that satisfies the requirements established by Article 3 of the UCC. Also called commercial paper.
• negotiation—Transfer of a negotiable instrument by a person other than the issuer to a person who thereby becomes a holder.
• nonnegotiable contract—Fails to meet the requirements of a negotiable instrument and, therefore, is not subject to the provisions of UCC Article 3.
• nonrestrictive indorsement—An indorsement that has no instructions or conditions attached to the payment of the funds.
• order paper—Order paper is negotiated by (1) delivery and (2) indorsement.
• order to pay—A drawer's unconditional order to a drawee to pay a payee.
• payable on demand or at a definite time requirement—A negotiable instrument must be payable either on demand or at a definite time.
• payee of a CD—The depositor (lender).
• payee of a check—The party to whom the check is written.
• payee of a draft—The party who receives the money from a draft.
• payee of a note—The party to whom the promise to pay is made (lender).
• permanency requirement—A requirement of negotiable instruments that says they must be in permanent state, such as written on ordinary paper.
• portability requirement—A requirement of negotiable instruments that says they must be able to be easily transported between areas.
• promise to pay—A maker's (borrower's) unconditional and affirmative undertaking to repay a debt to a payee (lender).
• promissory note—A two-party negotiable instrument that is an unconditional written promise by one party to pay money to another party.
• restrictive indorsement—An indorsement that contains some sort of instruction from the indorser.
• sight draft—A draft payable on sight. Also called a demand draft.
• signature requirement—A negotiable instrument must be signed by the drawer or maker. Any symbol executed or adopted by a party with a present intent to authenticate a writing qualifies as his or her signature.
• special indorsement—An indorsement that contains the signature of the indorser and specifies the person (indorsee) to whom the indorser intends the instrument to be payable. Creates order paper.
• time draft—A draft payable at a designated future date.
• time instrument—An instrument payable (1) at a fixed date, (2) on or before a stated date, (3) at a fixed period after sight, or (4) at a time readily ascertainable when the promise or order is issued.
• time note—A note payable at a specific time.
• trade acceptance—A sight draft that arises when credit is extended (by a seller to a buyer) with the sale of goods. The seller is both the drawer and the payee, and the buyer is the drawee.
• unconditional—Promises to pay and orders to pay must be unconditional in order for them to be negotiable.
• unconditional promise or order to pay requirement—A negotiable instrument must contain either an unconditional promise to pay (note or CD) or an unconditional order to pay (draft or check).
• unqualified indorsement—An indorsement whereby the indorser promises to pay the holder or any subsequent indorser the amount of the instrument if the maker, drawer, or acceptor defaults on it.
• unqualified indorser—An indorser who signs an unqualified indorsement to an instrument.

Internet Links

Legal Information Institute—Overview of Negotiable Instruments Law: http://www.law.cornell.edu/topics/negotiable.html
UCC—Article 3 Negotiable Instruments: http://www.law.cornell.edu/ucc/3/overview.html
How to recognize fraudulent checks: http://www.businessfraudprevention.com/checks.htm