CHAPTER 20 Negotiable Instruments

20.01 Introduction to Article 3 of the Uniform Commercial Code

[1] Recent Developments in the Law of Negotiable Instruments
[2] Scope of Article 3
[3] Nature of a Negotiable Instrument
[4] Use of a Negotiable Instrument in an Accord and Satisfaction
[5] Relevance of Article 3 to Writings Not Meeting Requisites of Negotiability
[6] Caveats With Respect to the Organization of This Chapter
20.02 The Requirements of a Negotiable Instrument
[1] The Types of Writings That May Constitute Negotiable Instruments
[2] A Negotiable Instrument Must Be Signed by the Maker or DrawerWhat Constitutes a
Signature?
[3] A Negotiable Instrument Must Contain a Promise or Order to PayWhat Constitutes a
Promise or Order to Pay?
[a] Promise to Pay
[b] Order to Pay
[i] An Order Is a Direction and Must Be More Than an Authorization or Request
[ii] An Order Must Identify the Person to Pay
[c] Instruments Payable at a Bank
[4] The Promise or Order to Pay Must Be Unconditional
[a] In General
[b] Implied and Constructive Conditions Do Not Destroy Negotiability
[c] Statement of Consideration or Reference to Underlying Transaction or Agreement Does
Not Destroy Negotiability
[d] Reference to Fund From Which Payment Is to Be Made Will No Longer Destroy
Negotiability
[5] A Negotiable Instrument Must Be Payable for a Sum Certain or for a Fixed Amount
[a] In General
[b] Effect of Interest Rates
[c] Other Clauses Affecting Amount Payable
[6] A Negotiable Instrument Must Be Payable in Money
[a] In General
[b] Foreign Currency
[7] A Negotiable Instrument Must Be Payable on Demand or at a Definite Time
[a] In General
[b] On Demand Defined
[c] Definite Time Defined
[8] A Negotiable Instrument Must Be Payable to Order or to Bearer
[a] In General
[b] Order Paper Defined
[i] What Constitutes Payable to Order?
[ii] To Whom May an Order Instrument Be Made Payable?
[c] Bearer Paper Defined
[9] A Negotiable Instrument Must Contain No Other Promise, Order, Obligation or Power
[a] In General
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[b] Omissions Not Affecting Negotiability

[c] Terms Not Affecting Negotiability
[i] References in an Instrument to Collateral Do Not Affect Negotiability
[ii] A Promise or Power to Maintain or Protect Collateral or to Give Additional Collateral
Does Not Affect Negotiability
[iii] Confession of Judgment Clauses Do Not Affect Negotiability Provided They Are
Legal Under Non-Code State or Federal Law
[iv] Inclusion in an Instrument of a Term Purporting to Waive the Benefit of Any Law
Does Not Destroy Negotiability
[v] Negotiability Is Not Affected by a Provision in Draft That Cashing or Indorsing of
Same Is an Acknowledgement of Full Satisfaction of the Obligation Represented by the
Draft
[vi] Clauses Providing for Choice of Law, Venue, Jury Waivers, and Arbitration Are
Enforceable and Do Not Affect or Destroy Negotiability
[vii] Information in the Memo Portion of an Instrument Does Not Affect Negotiability
[10] Rules of Construction for Ambiguous Instruments
20.03 The Holder of an Instrument
[1] Distinctions Among Possessors of Instruments
[2] Becoming a Holder
[a] What Constitutes Possession of the Instrument?
[b] Transfer and Negotiation of Bearer and Order Instruments
[3] Rights of a Holder
[a] The Right to Negotiate the Instrument
[b] The Right to Secure a Discharge of the Instrument
[c] The Right to Enforce Payment of the Instrument
[i] A Holder Has Important Procedural Advantages Over an Ordinary Transferee or a
Claimant Suing on the Underlying Claim
[A] A Holder Need Only Bring Action on the Instrument Itself
[B] Production of the Instrument Containing the Signature of the Obligor Gives
the Plaintiff-Holder a Prima Facie Right to Recovery
[ii] A Comparison Between the Procedures in an Action on an Instrument and in an
Action on the Underlying Obligation
[4] Rights of a Non-Holder
[a] Lost or Stolen Instruments
[b] The Shelter Principle
[i] Scope of the Principle
[ii] Limitations on the Shelter Principle
20.04 The Holder in Due Course.
[1] In General
[2] A Holder in Due Course Must Be a Holder.
20.05 A Holder in Due Course Must Take an Instrument for Value
[1] A Holder Takes an Instrument for Value Only to the Extent That the Agreed Consideration
Has Been Performed
[2] A Holder Takes an Instrument for Value if the Holder Acquires a Security Interest in or Lien
on the Instrument
[3] A Holder Who Takes an Instrument in Payment of or as Security for an Antecedent Claim
Takes for Value.
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[4] A Holder Takes for Value When Negotiable Instruments Are Exchanged
[5] A Holder Who Makes an Irrevocable Commitment to a Third Person Takes for Value.
20.06 A Holder in Due Course Must Take an Instrument in Good Faith
20.07 Notice as an Element of Holder in Due Course Status
[1] The Importance and Definition of Notice
[2] Notice Within An Organization
[3] When Is An Instrument Overdue?
[4] Purchasers Who Take With Notice That the Instrument Has Been Dishonored Cannot Be
Holders in Due Course
[5] Purchasers Who Take With Notice of a Defense or Claim to the Instrument Cannot Be Holders
in Due Course
[a] Defense or Claim Defined
[b] Voidability or Discharge of Obligation on Instrument
[c] Breach of Duty by Fiduciary
[d] Knowledge That Does Not Constitute Notice of a Defense or Claim
[e] Notice in New York and the Doctrine of Forgotten Notice
[6] Purchasers Who Take Instruments Bearing Irregularity Cannot Be Holders in Due Course
20.08 Additional Issues Affecting Holder in Due Course Status
[1] Transfers Not in the Ordinary Course of Business That Prevent a Purchaser From Being a
Holder in Due Course
[2] The Payee as a Holder in Due Course
20.09 Causes of Action and Statutes of Limitation
[1] Pre-Revision Provisions
[2] Current Provisions
20.10 Rights of a Holder in Due Course
[1] Assertion of Claims and Defenses Against a Holder in Due Course
[a] In General
[b] A Holder in Due Course Takes Free of All Claims
[c] A Holder in Due Course Takes Free of Most Defenses Asserted Against Parties Other
Than the Holder
[d] Real Defenses That Can Be Asserted Against a Holder in Due Course
[i] Infancy of the Obligor
[ii] Incapacity, Duress, and Illegality as a Defense
[iii] Usury as a Defense
[iv] Fraud in the Factum as a Defense Against a Holder in Due Course
[A] Defense of Fraud in the Factum as a Vehicle for Consumer Protection
[v] Discharge as a Defense Against a Holder in Due Course
[2] Assertion of Claims and Defenses Against One Not a Holder in Due Course
[a] One Who Is Not a Holder in Due Course Takes an Instrument Subject to the Defense of
Want or Failure of Consideration
[i] What Constitutes Want of Consideration or Failure of Consideration?
[ii] Pleading and Proof Required in Assertion of Defense
[iii] No Consideration Is Necessary Where the Instrument Is Taken in Satisfaction of an
Antecedent Debt
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[b] One Who Is Not a Holder in Due Course Takes an Instrument Subject to the Defense of
Nonperformance of Conditions Precedent
[i] Conditions Precedent to the Obligation on the Instrument
[ii] Conditions Precedent to the Underlying Obligation
[A] Express Conditions Precedent
[B] Implied or Constructive Conditions Precedent
[iii] Admissibility of Parol Evidence in Proof of Conditions Precedent
[c] One Who Is Not a Holder in Due Course Takes an Instrument Subject to the Defense of
Breach of a Condition as to Delivery
[i] Nondelivery
[ii] Delivery for a Special Purpose
[iii] Conditional Delivery
[iv] Admissibility of Parol Evidence
[d] One Who Is Not a Holder in Due Course Takes an Instrument Subject to the Defense That
It Was Acquired by or Through Theft
[e] One Who Is Not a Holder in Due Course Takes an Instrument Subject to Restrictive
Indorsements
[f] One Who Is Not a Holder in Due Course Takes an Instrument Subject to the Defense That
It Has Been Altered
[i] Alteration in General
[A] Effect of Alteration
[B] Pleading and Proof
[ii] The Nature of the Alteration
[iii] The Alteration Must Be Fraudulent
[iv] When the Defense Is Barred
[A] Assent to an Alteration Will Bar Assertion of It as a Defense
[g] Jus Tertii
[i] Denial of Claims Based on Rights of Others
[ii] Interpretative Difficulties in Section 3-305(c)
[A] Claims vs. Defenses
[B] Section 3-305(c) Is Not Confined to the Claims and Defenses of Third Parties
to the Instrument
[iii] Jus Tertii Arguments May Be Used to Attack the Plaintiffs Status
20.11 Signatures and Forgeries
[1] Necessity of Signature for Liability to Attach
[2] What Constitutes a Signature?
[3] Whose Signature Is It?
[a] Liability for Unauthorized Signatures
[i] Ratification of Unauthorized Signatures
[ii] Preclusion to Deny Authorization
[b] Liability for Signature by an Authorized Representative
[i] A Signature May Be Made by an Authorized Representative
[ii] Failure Both to Indicate Representative Capacity and Name Principal
[A] Personal Liability of Principal and Representative
[B] The Use of Parol Evidence to Disestablish Signers Personal Liability
[iii] Liability of Representative Where Principal Is Named
[iv] Signature on Behalf of an Organization
[4] Burden of Proof Regarding Signatures
[a] Specific Denial Required to Place Authenticity of Signature in Issue
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[i] Effect of Failure to Deny Specifically

[b] Burden of Establishing Genuineness Is on the Party Claiming Under the Signature
[i] Presumption of Genuineness
[ii] Plaintiffs Burden of Establishing Defined
[5] Capacity in Which Signature Is Made
[a] A Signature Is Presumed to Be an Indorsement
[b] Parol Evidence Is Inadmissible to Explain the Intended Liability of the Signer
[6] Liability for Unauthorized Signature Caused by Negligence
[a] Effect of Negligence
[b] Substantial Contribution and Proximate Cause
[c] Comparative Negligence Standard and Burden of Proof
[d] Availability of Defense to Depositary Bank
[e] Imposter Rule and Fictitious Payee RuleIntroduction
[i] Scope of Imposter Rule
[ii] The Fictitious Payee Doctrine
[iii] The Consequences of Negligence
20.12 Liability of the Maker or Issuer
[1] The Maker or Issuers Obligation
[a] The Maker or Issuer Promises to Pay According to the Terms of the Instrument as Issued
[b] The Maker of Issuers Liability Is Primary
[c] A Note is a Contract; Makers Obligation Is Subject to Contract Law
20.13 Liability of the Acceptor or Payor (Drawee)
[1] Drawee as Acceptor
[a] The Nature of a Draft
[b] The Acceptors Obligation
[2] Acceptance
[a] What Constitutes Acceptance?
[b] Personal Money Orders
[c] Certified Checks; Certification as Acceptance
[d] Refusal to Pay Instruments on Which Bank Is Obligated
[e] When Acceptance Becomes Effective
[3] Acceptance at Variance With Terms of Draft
[a] Disclaiming the Obligation
[b] Modifying the Obligation
[c] Acceptance Varying Place of Payment
[4] Finality of Payment or Acceptance Rule
[a] Mistaken Payment and Restitution
[b] What Constitutes Payment Under the Final Payment Rule?
[c] Change of Position in Reliance on Payment or Acceptance
[d] Negligence of the Holder Does Not Preclude Application of the Finality of Payment Rule
20.14 Liability of the Drawer
[1] The Drawers Obligation
[a] Conditions Precedent to the Drawers Obligation
[b] Disclaiming Liability
20.15 Liability of the Indorser
[1] Definition of an Indorsement
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[a] Elements Necessary to Constitute an Indorsement

[b] Types of Indorsement
[i] Special Indorsement
[ii] Blank Indorsement
[iii] Anomalous Indorsement
[iv] Restrictive Indorsement
[2] The Indorsers Obligation
[a] The Indorsers Contract
[b] Conditions Precedent to the Indorsers Obligation
[c] Varying the Indorsers Contractual Obligation
[i] Disclaiming the Indorsers Contractual Obligation
[ii] Modifying the Indorsers Contractual Obligation
[iii] Admissibility of Parol Evidence to Establish Indorsers Contract
[d] To Whom Does the Indorsers Obligation Run?
[e] In What Order Are Indorsers Liable?
20.16 Liability of the Surety
[1] The Nature of a Suretyship Relationship
[a] In General
[b] Suretyship and Negotiable Instruments
[2] Accommodation Parties
[a] Definition of Accommodation Party
[b] Establishing Accommodation Status
[i] Admissibility of Parol Evidence
[ii] Receipt of Benefit
[c] To Whom Does the Accommodation Partys Obligation Run?
[d] The Accommodation Partys Obligation Under the New York State Variation
[e] Defenses Available to Accommodation Parties
[i] Failure of Consideration Not a Defense
[ii] Discharge or Release of Accommodated Party
[iii] Extension of Time of Payment
[iv] Modification of Accommodated Partys Agreement
[v] Impairment of Collateral
[f] Consent to, and Waiver of Discharge
[g] The Accommodation Partys Right of Subrogation
[3] Guarantors
[a] In General
[b] To Whom Does a Guarantors Obligation Run?
[c] A Guaranty Is Not Rendered Unenforceable Because It Violates a Statute of Frauds
[d] Guarantees in Consumer Transactions
20.17 Warranty Liability
[1] In General
[a] Contractual and Warranty Liability Distinguished
[b] The Nature of Warranty Liability
[i] Varying Warranty LiabilityModifications and Disclaimers
[c] Accrual of Cause of Action
[i] A Cause of Action for Breach of Warranty Accrues When the Instrument Is
Transferred or Presented
[ii] Statute of Limitations
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[d] Damages for Breach of Warranty

[2] Transfer Warranties
[a] Against Whom Are the Warranties Imposed?
[i] There Must Be a Transfer of the Instrument
[ii] The Transfer Must Be for Consideration
[b] To Whom Do the Warranties Run?
[i] Transfers With and Without Indorsements
[c] The Specific Transfer Warranties
[i] Person Entitled to Enforce
[ii] All Signatures Are Authentic and Authorized
[iii] No Alteration
[iv] No Defense Good Against Transferor
[v] No Knowledge of Any Insolvency Proceeding
[vi] Warranty as to Remotely-Created Consumer Item under 2002 Revision
[3] Presentment Warranties
[a] Against Whom Are the Warranties Imposed?
[b] To Whom Do the Warranties Run?
[c] The Specific Presentment Warranties
[i] The Presentment Warranties Operate in Conjunction With the Finality of Payment
Rule of Section 3-418
[ii] Person Entitled to Enforce
[A] In General
[B] Title to Bearer Instruments and Order Instruments
[iii] Authorized Signatures
[A] The Basic Warranty
[B] Exceptions to the Basic Warranty
[iv] No Alterations
[A] The Basic Warranty
[B] Exceptions to the Basic Warranty
[v] Right to Assert Drawees Defenses
[d] Third Party Actions and Vouching-In
20.18 Conversion Liability and Forged Indorsements
[1] In General
[2] Incorporation of Common Law
[3] Conversion by Payment on a Forged Indorsement
[a] Introduction
[i] Payee vs. Drawer
[ii] Drawer vs. Drawee Bank
[iii] Drawee Bank vs. Collecting Banks
[iv] Payee vs. Drawee Bank
[v] Drawer vs. Depositary Bank
[vi] Payee vs. Collecting Bank
[A] The Scope of Pre-Revision Section 3-419(3)
[B] Reasonable Commercial Standards
[C] Representative
[D] Proceeds

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20.01 Introduction to Article 3 of the Uniform Commercial Code*

[1]

Recent Developments in the Law of Negotiable Instruments

Article 3 of the Uniform Commercial Code (herein referred to as the Code) concerns the payment mechanisms
through which commercial transactions are most commonly financednegotiable instruments. Negotiable
instruments or commercial paper, specifically drafts and checks, have long played an important role in commerce as
representing one of several payment systems. Checks and drafts are used as a means for one person to make
payment of funds to another person.1 Certain principles with respect to application of the Code must be
recognized. The Code is a codification of the principles of the law merchant; it sets forth liabilities that are different
than existed at common law.2 Where the Code provides for the situation in which the Code codifies the law on a
subject, a common law claim cannot be asserted, as it is supplanted by the Code.3 Notwithstanding recent
inroads made possible by technological advances in electronic payment systems, commercial suppliers of goods
and services typically perform their obligations in return for the drafts, such as checks, and notes governed by
Article 3. The provisions of this Article constitute a comprehensive codification of the rights and duties of the
parties to negotiable instruments.4
Nevertheless, the law of negotiable instruments has recently been the subject of substantial changes on two fronts.
Developments in the use of credit cards, electronic funds transfers, and check collection led to substantial debate
about the need for a more comprehensive codification of the law of payment systems, including credit cards and
electronic funds transfers. Early attempts to create a Payments Code, however, met substantial opposition.5 In
response, the American Law Institute and the National Conference of Commissioners on Uniform State Laws
adopted a comprehensive Revision to Article 3 and amendments to Article 4, which governs the check collection
process.6 The current version of Article 3 retains the basic concepts and structure of prior law, but takes account
of certain technological developments and purports to clarify ambiguous terminology and resolve interpretive
conflicts among the courts.7 Other revisions, however, are substantive, and dramatically alter the law of
negotiable instruments. (Indeed, Article 3 itself has been renamed Negotiable Instruments.). This 1990 revision
and amendments effected by N.C.C.U.S.L have been recognized by the courts as having resulted in significant
substantive revisions.8 At the same time, one also must not lose sight of the fact that many provisions from the
Pre-Revision version are carried forward in the current version without any substantive changes. To the extent a
particular provision remains the same under the successor or parallel section in the revised Code, case law
interpretations based upon the Code provision will continue to provide precedent for construing the revised Code
section.9
Further amendments to Uniform Commercial Code Articles 3 and 4 were drafted by N.C.C.U.S.L. as approved and
recommended for enactment by the states at the N.C.C.U.S.L. annual conference meeting on July 26-August 2,
2002. Unlike the 1990 Official Text, the 2002 Amendments (referred to in this chapter as the 2002 Revision)
affect significantly more modest revisions to Articles 3 and 4, and changes to the law. Topics that are addressed in
the 2002 Revision cover transferring lost instruments; payment and discharge; tele-phonically generated checks;
suretyship; electronic communications; consumer notes and United Nations Convention on International Bills of
Exchange and International Promissory Notes.10 The more significant and substantial revisions effected by the
2002 Revision are, as to suretyship rights, to wit: the respective rights and liabilities of the parties to an instrument
when certain parties are released by the person entitled to enforce an instrument or such person agrees to a change
in the obligations of the principal obligor on the instrument (the entire current version of Code 3-605, Discharge
of Indorsers and Accommodation Parties, has been deleted, and in substitution therefore, a new section has been
added). Also, in connection with the revisions in the 2002 Revision, certain definitions were added.11 Two
notable changes are that the definition of Good Faith has been deleted from Article 3 (in that an exact definition
was added to the 2001 revisions to Article 1) and that a new definition of a term used in several sections in the 2002
Revision, Record, has been added to Article 1, in 1-201(33a). This chapter, therefore, discusses both the law of
the pre-Revision version of Article 3, the modifications and clarifications of that law under the Revision, and the
2002 Revision. Citations to the Revision will be designated by section number alone. Citations to pre-Revision
sections will be designated as pre-Revision Section 3-xxx in text and Pre-Revision UCC 3-xxx in footnotes.
Reference to the 2002 Revisions will be designated as UCC 3-xxx (2002 Revision) in text and footnotes.
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In addition, substantial portions of payments law are now governed by federal, rather than state law. The Expedited
Funds Availability Act12 and Regulation CC of the Federal Reserve Board13 may pre-empt state law that
governs the check collection process. Although most of the effects of these federal enactments limit the range of
Article 4 of the Code, they also have implications for Article 3 provisions, such as the scope of the warranty made
by a bank that transfers or presents a check for payment. Section 3-102(c) recognizes the increasing influence of
federal law by providing: Regulations of the Board of Governors of the Federal Reserve System and operating
circulars of the Federal Reserve Banks supersede any inconsistent provision of this Article to the extent of the
inconsistency.
Adoption of the 1990 Amendments, the Revision, by the various states occurred over a period of several years. As a
result, courts continue to hear disputes concerning transactions that occurredwhen the prior version of Article 3 was
in effect. Courts in this position must decide what effect to give to the revised version where it varies from the prior
version. This raises the question as to the prospective effect of the current version. Some courts have considered
that substantive changes in the current version of Article 3 reflect a desire to clarify prior ambiguities or to make
commercial law consistent with commercial practice. These courts have used the language of revised Article 3 to
interpret provisions of the version in effect when the transaction in dispute arose. In Amberboy v. Societe de
Banque PriveeAmberboy v. Societe de Banque Privee,14 for instance, the Texas Supreme Court determined that
a note bearing a variable interest rate could satisfy the conditions of negotiability, notwithstanding explicit rejection
of that position in a comment to the pre-Revision Code. The Court noted that the revised version of the Code
(which had not been adopted in Texas) made such notes negotiable. The Court concluded that its interpretation was
consistent with the Codes objective of reflecting modern commercial practices. Similarly, a New Jersey court
concluded that an amendment to that states version of the Code adding the current version Article 3 was curative
in nature and thus could be given retroactive effect with respect to notes bearing variable interest rates.15
Numerous appeals courts have recognized the general proposition that unless it is otherwise manifestly intended by
the legislature, or expressly provided in the statute, a new law does not have retroactive effect.16
In an Illinois case that addressed the same issue, however, an appellate court determined that revised provisions that
made such instruments negotiable were substantive in nature and thus could only apply prospectively. In Johnson v.
Johnson,17 the court concluded:
While we believe that the 1992 amendment has no retroactivity, at least one State (New Jersey) has adopted a
contrary view. Where the note was executed in 1989, the trial held in 1990, and the New Jersey U.C.C. amended in
1992, the New Jersey court determined that the amendment was curative, embracing the expectations of the parties.
With remarkable casuistry, the New Jersey court suggests that as an exception to the non-retroactivity rule the
amendment attempts to improve a statutory scheme and bring the law into harmony with the expectations of the
parties and the law in the commercial marketplace. Applying such retroactivity does just the opposite. It is generally
unfair and makes the parties unsure of the bargain they have struck. The New Jersey court has contorted the rules of
statutory construction to meet the exigencies of current leading practices. In Illinois, we do not so bend.
Had our General Assembly desired, it could have designated that the amendment be given retroactive application.
Had the American Law Institute which promulgated the uniform act had such a desire, retroactivity could have been
included in the comment.
The Minnesota Supreme Court has adopted a view more similar to that of the Illinois appellate court. In deciding
which parties were properly the subject of a conversion suit for a check bearing a forged indorsement, the court
presumed that the legislature intended an amendment to effect a statutory change. Thus, in considering whether a
depositary bank could be liable for conversion in a Pre-Revision transaction, the existence of the amendment
imposing liability indicated that such institutions were previously exempt from liability. The current version of
Article 3 was not be given any retroactive effect.18 A federal bankruptcy court similarly refused to give
retroactive effect to a provision that was interpreted as expanding the conditions under which a forged indorsement
by a faithless employee would be effective.19

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The Pre-Revision will continue to apply to any case where the events or transactions upon which a claim or suit is
based occurred prior to adoption of the revised Code in that state, notwithstanding that the current version may be
in effect at the time a lawsuit is commenced or a decision rendered by a court.20 The revised Code is prospective
and will apply where the transactions occurred after its adoption.21 However, a Minnesota appellate case22
recognized that if an amendment to a statute seeks only to clarify the intent of the old statute, then the new
statute may be applied retroactively [citations omitted]. We rely upon the amended UCC to the extent that it
serves merely to clarify usages and practices previously recognized. Finally, as recognized in a Washington
appellate case,23 [S]tatutes are presumed to apply prospectively only [citations omitted]. An exception is
recognized if the statute is remedial in nature, and retroactive application would further its remedial purpose [a law]
is deemed remedial and applied retroactively when it relates to practice, procedure or remedies, and does not affect
a substantive or vested right.24
Another important concept concerns whether the provisions of the Code displace other rules of law (statutory and
case law). In Travelers Cas. & Sur. Co. of Am. v. Manufacturers Life Ins. Co.,25 the court stated the general rule
of interpretation that there will be a displacement under circumstances where the Code articulates a loss
distribution scheme that applies to fact patterns that are involved in the case. In other words, if a loss distributive
scheme is available under the [Code] for a particular fact pattern, then related common law claims must be
dismissed. (citations omitted)
Finally, 42 states and the District of Columbia have also adopted the Uniform Electronic Transactions Act, or
UETA. This Act is designed to facilitate the use of electronic commerce by making electronic records and
signatures legally equivalent to writings and written, or manually-signed, signatures. The UETA interacts with
Article 3 insofar as instruments may be created and executed electronically. For instance, the Proposed 2002
Revision substitutes the term record for writing.26 A record is defined in corresponding revisions to
Article 1 of the Uniform Commercial Code as information that is inscribed on a tangible medium or that is stored
in an electronic or other medium and is retrievable in perceivable form.27 Other provisions in the Proposed
2002 Revision adopt from UETA the definition of an electronic signature as an electronic sound, symbol, or
process attached to or logically associated with a record and executed or adopted by a person with the intent to sign
the record.28 The federal Electronic Signatures in Global and National Commerce Act,29 however, does not
apply to instruments governed by Article 3. Section 7003(a)(3) specifically exempts records governed by Article 3
from coverage of the federal provisions.
[2]

Scope of Article 3

Generally, Article 3 is concerned only with negotiable instruments. Most importantly, Article 3 does not apply to
money,30 although much of the law of negotiable instruments has the purpose and effect of transforming
instruments into money substitutes. It also does not apply to electronic funds transfers governed by Article 4A or
to securities, which are governed by Article 8.31 Nor does it apply to consumer electronic fund transfers such as
credit card, debit card, or ATM card transactions. In addition, if there is any conflict between the provisions of
Article 3 and those of Article 4, which deals with Bank Deposits and Collections, or Article 9, which deals with
Secured Transactions, the provisions of Article 3 are subordinate.32
The Code establishes several requirements that must be satisfied for a writing to qualify as a negotiable instrument.
These requirements will be discussed in detail later in this chapter.33 If an instrument is negotiable, the holder
may qualify as a holder in due course, a status that provides rights far more substantial than those available to an
obligee or assignee under a simple contract. For instance, a party with holder in due course status may take the
instrument free from defenses to payment that could be asserted against a mere assignee of a common law contract
right.34 It is in part for this reason that negotiable instruments are considered money substitutes. As in the case
of a negotiable instrument, a transferor of money can give a good faith transferee better title than the transferor
had.35 If the requirements of negotiability under the Code are not satisfied, however, the obligee under the
instrument has only the rights of an obligee or assignee under a contract. As noted above, to the extent that Article 3
involves transactions governed by the Federal Reserve System, such as the collection and return of checks, the
Code is superseded by federal law and regulations. This may be true even if no Federal Reserve Bank participates
in the transaction. For instance, the Expedited Funds Availability Act36 confers broad authority on the Federal
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Reserve System to regulate check collection nationwide, even if the instrument at issue never passes through a
Federal Reserve Bank.
[3]

Nature of a Negotiable Instrument

A negotiable instrument usually has a dual nature. It is foremost an independent and unqualified promise to pay a
fixed amount of money on demand or at some definite time in the future to either the bearer of the instrument or to
the order of some person named in the instrument.37 In addition, the instrument will often serve as written
evidence of some underlying obligation for which the instrument was given. This is not always the case, however,
as where the instrument is given as a gift. Where the instrument is issued to satisfy an underlying obligation, that
obligation is integrated or merged into the instrument. The legal effect of this merger is that the requirements to
pay the instrument and to make payment on the underlying obligation rise or fall in concert. While the instrument is
outstanding, for instance, the underlying obligation is suspended and the obligee cannot bring an action to enforce it
unless the instrument is subsequently dishonored.38 Thus, an obligee who accepted a draft from an obligor
within the statutory period for receiving compensation from the obligor could not claim that the period had been
exceeded, even though the proceeds of the draft were not available to the obligee until after the end of the period.39
Additionally, payment of the instrument constitutes a discharge on the underlying obligation.40 (It is important to
note, however, that payment is a specialized term that requires payment on behalf of the obligor on the instrument
and payment to a person entitled to enforce the instrument.)41 This suggests both the value of negotiable
instruments as payment devices and their ready acceptance in the commercial world as substitutes for cash
transactions.
[4]

Use of a Negotiable Instrument in an Accord and Satisfaction

Prior to the current version of Article 3, courts divided over the issue of whether a negotiable instrument could
effect an accord and satisfaction when tendered and taken in an amount less than an alleged debt. First, one must
define an accord and satisfaction. It is a contractual method by which a debt or claim can be discharged. The
accord is the agreement between the parties, while the satisfaction is the execution or performance of the
agreement.42 A federal district court43 observed that an accord and satisfaction must contain the elements of a
normal contract; these are an offer, acceptance, and consideration. A Texas appellate court44 recognized that no
separate consideration is necessary for the accord and satisfaction; specifically, for the satisfaction. The
consideration supporting the accord and satisfaction is the good faith dispute as to liability on either a liquidated or
unliquidated claim [which is what] furnishes sufficient consideration for an accord and satisfaction. Some courts
resolved the issue through Section 1-207 of the Code, which permits a party to take a check, but explicitly to
reserve rights when depositing the check, thereby avoidingany claim of accord and satisfaction. The current version
of Article 3 addresses the issue directly. Section 1-207(2) provides that the authorization for a reservation of rights
does not apply to an accord and satisfaction.45 Section 3-311 now governs checks that purport to be in full
satisfaction of a debt.
Section 3-311 relieves a person who offers an instrument in payment of an obligation of further liability when four
conditions are met. First, the party offering the instrument must have a good-faith belief that the instrument fully
satisfies the claim. Second, the amount of the claim must be unliquidated or subject to a good-faith dispute. Third,
the claimant must obtain payment of the instrument. If these conditions are satisfied, the underlying claim will be
discharged if, fourth, the instrument or an accompanying writing contained a conspicuous statement that it was
tendered in full satisfaction of the debt.46
Each of these four elements are explained and discussed in numerous cases. As indicated in an Illinois case,47
when the criteria of the section are satisfied there is an accord and satisfaction if there is a bona fide dispute and the
creditor cashes the check, notwithstanding that the creditor protests that he does not accept the amount in full
satisfaction. The creditor must either accept the payment with the condition or refuse. An Indiana court48
described 3-311 as providing a bright-line rule that the cashing of a check that is clearly marked full
satisfaction check (and where the other conditions of 3-311 are met) operates as an accord and satisfaction. An
endorsement of a full satisfaction check that purports to reserve the payee/creditors rights against the
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drawer/debtor is not effective to prevent the accord and satisfaction and discharge of the debtor on the underlying
obligation.
The tender of the accord and satisfaction check must be made in good faith.49 Addressing the conspicuous
requirement, a Virginia appellate case50 provides a useful explanation of the definition of conspicuous as
provided in Section 1-201(10). It means a term that a reasonable person should notice. It is a physical attribute that
is involved; the focus of the inquiry is the manner in which the statement is displayed, as no specific language is
required. It is the province of the court to decide if a statement meets the requirement and is conspicuous. The
debtor sent the creditor a letter that described the deficiencies of the creditors work. The final paragraph of the
letter stated JSI stands by its final amounts as stated on the latest correspondence dated December 8, 2000.
Enclosed, please find a check in the amount of $13,580.00 representing final payment on the contract. This
statement, the court held, satisfied the conspicuous statementthat the check is tendered in full satisfaction.
Practical Hint:
Although it is not necessary to use any particular word or phrase, in that UCC Section 3-311(b) provides what is
required is a conspicuous statement to the effect that the instrument is tendered as a full satisfaction (emphasis
added), use of the phrase in full and final payment or payment in full satisfaction is preferable and
recommended so that there will be no fact question for a court to determine as to the drawers intention. A drawerobligor who wants to more specifically describe the transaction can certainly do so but should accomplish that goal
by adding additional language to one of the recognized phrases, in lieu of substituting other language. It is also
recommended that the accord and satisfaction language be placed on the instrument and that the obligor not rely
only on language in an accompanying letter, although the statute permits the language to be in a written
communication that accompanies the instrument. It is a much clearer expression of intent if the language is on the
instrument, and there can be no question as to whether the letter was received or not. The obligor can place the
requisite language in both the letter and the instrument, if the obligor desires to send an accompanying letter.
Finally, an obligor is encouraged to emphasize the language that tenders the check in full settlement, in a manner
that satisfies the conspicuous definition, and not rely upon the determination of the court whether the language
was or was not, as a fact determination, conspicuous.
Exceptions to this discharge rule are made in two cases. No discharge results if the claimant is an organization
(defined in Section 1-201(28) to include corporations, governments, or other legal or commercial entities) that sent
a conspicuous statement to the person against whom the claim is asserted, indicating that communications
concerning disputes, including an accord and satisfaction, are to be sent to a particular person, office or place and
that the instrument or communication was not received by that person, office, or place.51 Note that this rule
requires receipt by the person, office or place, not simply the sending of the instrument to the designated person or
location. In addition, no discharge results if the claimant tenders repayment of the amount of the instrument within
90 days of receiving payment as long as the claimant is not an organization that provided a statement about the
proper person or location for receipt of communications concerning disputes.52 Finally, discharge results,
notwithstanding the exceptions that would otherwise apply, if the claimant knew, within a reasonable time before
collection of the instrument was initiated, that the instrument was tendered in full satisfaction of the claim. Thus, if
a clerk in the organization who is not authorized to receive notices concerning disputes receives a check with a
notation in full payment, the clerks failure to notice the notation and deposit of the check will not result in a
discharge. Instead, the statement and 90-day provisions would be triggered. If, however, an agent of the
organization who has been communicating with the alleged debtor receives such a check, notices the notation, and
deposits the check, the claim is discharged.53
[5]

Relevance of Article 3 to Writings Not Meeting Requisites of Negotiability

For the most part, writings that fail to satisfy the requirements of Section 3-104 cannot be negotiable instruments
within the meaning of Article 3, which does not apply.54 Such a writing, though valid, will merely have the
effect of a common-law contract.55 Nevertheless, some writings that do not meet the formal requisites of
negotiability are statutorily deemed negotiable instruments.56 It is common, for instance, for legislation
authorizing the issuance of bonds by the state or its political subdivisions to declare such bonds to be negotiable
instruments. Other writings may bear elements of negotiability by judicial decision, contract or custom.57
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Another important principle recognized by the courts is that negotiability of an instrument is dependent upon the
form of the instrument and is to be determined by what appears on the face of the instrument. The determination of
whether a note is negotiable is based upon the relevant law, not upon the intention of the parties (whether they
intended it to be negotiable) or whether the instrument contains a statement that it is negotiable.58
Although Section 8-105(1) provides that certificated securities59 governed by Article 8 of the Uniform
Commercial Code are negotiable instruments, they are governed by the provisions of Article 8, rather than of
Article 3.60 Nevertheless, Article 8 largely incorporates Article 3 rules that define the rights and powers of
parties to a negotiable instrument. Perhaps the most important distinction is the lack of necessity for an Article 8
security to satisfy the requirements concerning the form of an instrument that are found in Section 3-104.
Prior to its current version, Article 3 provided that a writing that was nonnegotiable by virtue of not being payable
to order or bearer could still be subject to Article 3 if, by its own terms, the writing did not preclude transfer.61
Nevertheless, there could be no holder in due course of such an instrument. Thus, a writing that purported to be a
check in every way other than that it was payable to X rather than to the order of X would be governed by
those provisions of Article 3 other than those that grant special rights or powers to a holder in due course. Currently,
Article 3 excludes nonnegotiable instruments from its coverage altogether, but includes some writings that
previously did not satisfy the requirements of negotiability. The scope provision, Section 3-102, restricts the
applicability of Article 3 to negotiable instruments, a phrase that excludes writings in the form Pay to X.62
Nevertheless, the definition of a negotiable instrument, includes a document that otherwise qualifies as a check
but that is payable to X rather than to the order of X.63 Thus, a person in possession of such a check may be
a holder and, if he or she otherwise satisfies the requirements, may be a holder in due course. The exception is
justified because transferees of instruments that otherwise qualify as checks are unlikely to examine the document
to ensure that it includes the usual to the order of language, and would be surprised to discover that a document
otherwise in the form of a check failed the test of negotiability.64
Pre-Code cases permitted parties to some documents to obtain the benefits of negotiability, even with respect to
documents that did not satisfy the formal requisites of negotiable instruments.65 Some cases decided under the
Code have followed this line. For instance, a party to a writing that did not qualify as a negotiable instrument could
be estopped by its conduct from asserting a defense against a bona fide purchaser. In First State Bank at Gallup v.
Clark,66 the court found that a note that failed to satisfy the Codes requirements of negotiability could, under
contract law, retain the elements of negotiability as between the parties involved in the transaction. Thus, where the
maker of a nonnegotiable note expressly permitted pledge of the note by the payee as collateral for a loan, the court
found the maker estopped from asserting defenses to payment against the pledgee. The doctrine of negotiability by
estoppel was adopted very early in New York and accepted fairly generally under the Negotiable Instruments
Law.67 While these cases suggest that an obligor will be estopped from denying negotiability against third
parties only where the obligor has, by negligence or fraud, induced such parties to believe they had purchased
negotiable instruments, other cases suggest that a contractual waiver of defenses against third-party purchasers
estops the obligor from future assertion of such defenses.68 Comment 2 to Section 3-104 continues this policy by
providing that a court could confer the benefits of negotiability through principles of estoppel or contract, even
though the law of negotiable instruments did not apply.
Although parties may not contractually transform a nonnegotiable instrument into a negotiable one, substantial case
law supports the conclusion that parties can contractually agree that a writing will have the same legal effect as a
negotiable instrument. Early case law in New York recognized, at least in dicta, the creation of negotiable
instruments by contract outside of the Negotiable Instruments Law.69 These cases suggested that as long as such
contractual negotiability would not directly contravene provisions of the Negotiable Instruments Law, as for
example where the statute merely enumerated requirements for negotiability without explicitly denying
negotiability in their absence, an instrument might be made negotiable by contract without having satisfied all of
the statutory requirements. In Cho v. Kacy Chi,70 the court makes it clear that although an instrument is not
negotiable for failure to satisfy the elements of UCC 3-104(a), and is therefore not subject to the provisions of the
Code (not subject to the law on negotiable instruments), that does not render the instrument unenforceable. The
court enforced the instrument to the extent of the legal consideration given for the document.
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Practical Hint:
This is an important point. An instrument does not have to be negotiable to be enforceable against the maker, in
accordance with general contract principles, since an instrument is a contract.71 A non-negotiable instrument is
still enforceable, although lacking negotiability, as certain rights are not obtained by a holder, such as the ability to
quality as a holder in due course.
The current version clarifies the effect of legends on instruments. An instrument which is nonnegotiable due to a
failure to comply with the requirements of negotiability cannot be made negotiable by placing appropriate legends
or statements in the instrument.72 However, the placement of legends or statements such as not negotiable on
an otherwise fully negotiable instrument will be given effect and the instrument will not be negotiable for any
purpose.73
Some scope for contractual negotiability appears to remain under the Code. In the words of the New York State
Law Revision Commission: It would appear that negotiability by contract is still limited although not forbidden,
by Bank of Manhattan v. Morgan, 243 N.Y. 28 (1926) and Enoch v. Brandon, 249 N.Y. 263, 164 N.E. 45 (1928).74
The form of contractual provision necessary to create negotiability by agreement, however, remains unclear. In
Manhattan Co. v. Morgan, Judge Cardozo indicated that it was insufficient for a contract to provide, without more,
that the maker may treat the bearer as the absolute owner for all purposes and shall not be affected by any notice
to the contrary.75 While such a provision serves to protect a maker who, with notice of an adverse claim, pays
the holder, it does not, according to Cardozo, adequately protect future holderspresumably because the maker is
not required by such language to treat the bearer as absolute owner for all purposes.
One early commentator opined that to create negotiability by stipulation the parties must show their clear
intention not to conform to the act, but to make the instrument involved negotiable in spite of the clear prohibition
of these sections.76 Professor Beutel thus recommended insertion of a rather detailedcontractual provision to
make it clear that the parties had, in fact, contracted to create the rights available to the holder of a negotiable
instrument.
The limited case law in this area seems to support Beutels recommendation of a detailed contractual provision to
reflect the parties intent to confer the benefits of negotiability. In Morgan Brothers v. Dayton Coal & Iron Co.,77
an elaborate provision waiving rights between the issuer and the original or any intermediate holder, inserted in
what would otherwise have been nonnegotiable corporate debentures, was deemed sufficient to permit recovery by
a subsequent innocent holder of the bonds.78 In one case, however, a Pennsylvania court suggested that an
otherwise nonnegotiable instrument could be rendered negotiable by the mere inclusion of the words This note
shall be negotiable printed in the body of the note.79
The limits of any attempt to create negotiability by contract are evident in Becker v. National Bank and Trust Co.80
In Becker, the payee of notes transferred those documents to a third party to secure performance of certain
obligations. The transfer was accompanied by an assignment, but there was no negotiation sufficient to make the
transferee a holder. The transferee subsequently retransferred the notes to the Bank. Each note bore a legend
permitting the payee or its assignees to assign or negotiate this Note. The bank claimed that this legend
transformed it into a holder in due course, not subject to the defense of fraud in the underlying transaction because
the parties had contracted for assignment to take place without losing the benefits of negotiability. The Virginia
Supreme Court disagreed. The Court held that any attempt to change the effects of assignment into those of
negotiation was an alteration of the legal concepts or definitions of negotiation and holder in due course, an
attempt barred by the Official Comment to Section 1-102. Thus, the bank was entitled solely to its status and rights
as an assignee.
Comment 2 to pre-Revision Section 3-104 indicated that new types of commercial paper which commercial
practice may develop in the future may create a custom of negotiability notwithstanding failure to satisfy the
formal requisites of Article 3 instruments. Like negotiability by estoppel, the doctrine of customary negotiability
received early judicial recognition by Judge Cardozo in Manhattan Co. v. Morgan.81 Nevertheless, the doctrine
appears to assume the existence of a substantial tradition within the trade of treating a writing as negotiable.
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Cardozo was therefore unwilling to consider a note to be negotiable by custom where its form had only come into
general use in the same year as the transaction that gave rise to the controversy at issue. Other cases, however,
refused to recognize any possibility of creating negotiability through custom.82
Comment 2 to Section 3-104 contains an oblique appeal to the development of negotiability by custom. It indicates
that it may be appropriate, consistent with the principles stated in Section 1-102(2), for a court to apply one or
more provisions of Article 3 to the writing by analogy, taking into account the expectations of the parties and the
differences between the writing and an instrument governed by Article 3. That Section indicates that Code
provisions are to be interpreted, (b) to permit the continued expansion of commercial practices through custom,
usage and agreement of the parties.83 Hence, development of a customary use of negotiable-like instruments
could be enforced by a court notwithstanding the failure of the writings at issue to satisfy the technical requirements
of negotiability. In addition to a court applying an Article 3 provision by analogy, notably, as also stated in
Comment 2, parties to a contract may choose to include provisions from Article 3 in an instrument to determine
their respective rights and obligations.
Conversely, instruments that satisfy the requirements of negotiability may lose the benefits of that characterization
by virtue of other principles of law. Thus, the Federal Trade Commission has, by regulation, required that language
be inserted in notes arising out of certain consumer transactions in order to preclude holders of those notes from
asserting the rights of holders in due course.84 In addition to the Federal Trade Commission Rules, there are
other federal statutes that in specific types of loans contain provisions providing certain consumer protection and
limiting holder in due course status.85 Further, state statutes outside of the Code contain provisions limiting
holder in due course status and rights in consumer transactions.86
[6]

Caveats With Respect to the Organization of This Chapter

It is important to recognize that the Code is a highly integrated statute, and Article 3 in particular has many of the
features of a jigsaw puzzle. The importance of a specific provision becomes clear only when one considers its
relationship to complementary provisions. This is particularly true with respect to the law of negotiable instruments.
The common situation of fraudulent checks, for instance, may involve all of the various theories of liability
discussed in this chapter. The defrauded bank may seek to impose liability on the drawer of the check under a
contract theory. Failing that, the bank may seek to shift the loss to a prior transferee through a warranty theory. The
payee of a stolen check, on the other hand, may seek recovery on a conversion theory. To ensure that all possible
actions have been considered in any given fact situation, the reader should make liberal use of the cross-references
found in this chapter. These statements are recognized in Merrill Lynch Pierce Fenner & Smith, Inc. v. Fakih.87
The court acknowledged that the Code is a highly integrated body of statutes and then remarked that its provisions
must be carefully read as such. Fair and just application of the UCC rarely involves reference to only one or a few
of its provisions in isolation.

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Rene Tierney

20.02 The Requirements of a Negotiable Instrument*

The current version of Article 3 of the Uniform Commercial Code applies exclusively to negotiable instruments.1
Section 3-104(b) defines instrument, as used in Article 3, to mean negotiable instrument. The requirements of
negotiability have evolved over a substantial period of time and are currently codified in Section 3-104(a). These
requirements bear substantial study since they are highly technical, and courts, mindful of the power that
accompanies holder in due course status, are often persuaded to deny a claimant those powers by finding that the
instrument in question was nonnegotiable.
One might infer that bright lines separate negotiable from nonnegotiable instruments. After all, if the requirements
of negotiability were intended to permit transferees of such paper to recognize immediately whether they had
substantial rights against makers or drawers, regardless of defenses those parties might have against the payee, then
clear distinctions would seem necessary. While the history and justification for negotiable instruments law certainly
suggests that parties to them be able to discern readily the nature of the document in front of them, the fact is that
the Code requirements leave substantial room for ambiguity. We will concentrate on the potential for ambiguity and
its resolution throughout the following discussion.
The requirements for an instrument to be negotiable are set forth in Section 3-104:
(a) Except as provided in subsections (c) and (d), negotiable instrument means an unconditional promise or order
to pay a fixed amount of money, with or without interest or other charges described in the promise or order, if it:
(1) is payable to bearer or to order at the time it is issued or first comes into possession of a holder;
(2) is payable on demand or at a definite time; and
(3) does not state any other undertaking or instruction by the person promising or ordering payment to do any act in
addition to the payment of money, but the promise or order may contain (i) an undertaking or power to give,
maintain, or protect collateral to secure payment, (ii) an authorization or power to the holder to confess judgment or
realize on or dispose of collateral, or (iii) a waiver of the benefit of any law intended for the advantage or protection
of an obligor.2
Notably, money does not qualify as a negotiable instrument.3 Nor do securities that are governed by Article 8 of the
Code.4 In determining whether there has been compliance with the requisites of negotiability, it is important to
recognize that the original drafters of the Code argued for strict compliance with the requirements of negotiability.
Thus, doubtful cases should be resolved against negotiability.5 While this principle has not been explicitly endorsed
or rejected in the current version of Article 3, it is sensible if one is concerned that a party who qualifies as a holder
in due course, a status that can only be attained by holding a negotiable instrument, can cut off defenses of innocent
parties who would otherwise be able to avoid liability on the instrument.6
In Qui Ngo v. Park,7 the court observed that courts require strict compliance with the requisites for negotiability
provided in the Code section that defines a negotiable instrument. Courts, the court held, are encouragedto
strictly interpret the definitional requirements to the extent that in doubtful cases the [courts] decision should be
against negotiability. (citation omitted)
Article 3 also permits the issuer of a writing that otherwise qualifies as an instrument to remove it from coverage of
the UCC by including a conspicuous statement that the promise or order is not negotiable. This right, however, does
not apply to a check.8
[1]

The Types of Writings That May Constitute Negotiable Instruments

Although Section 3-104 no longer specifically refers to the need for a writing and that it be signed, 9 a promise
and order that falls within that provision is defined as a written instruction or written undertaking.10
Additionally, the Official Comment to Section 3-104 provides that a promise within the section is a written
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undertaking and an order is a written instruction. Section 1-201(46) defines written or writing to include
printing, typewriting or any other intentional reduction to tangible form.11 There is no requirement that the
writing be permanent or indelible and an instrument written in lead pencil or other erasable form is sufficient.12
The writing need not be on paper and one court has heldthat an oral contract was reduced to tangible form and
qualified as a writing when the contract was tape recorded.13 In Bank Leumi Trust Co. v. Bank of Mid-Jersey,14
the court noted that UCC 3-104 does not require that a check be written on a customary bank form or on paper.
There is also no question that a writing includes duplicated instruments of any sort.15 The advent of electronic
funds transfer promises to generate questions of the scope of a writing.
Some writings take particular forms, several of which have been specified in Article 3. In Transcontinental Holding
Ltd. v. First Banks, Inc.,16 the court set forth the substance of Section 3-104(a) ( 400.3-104 R.S.Mo. (2009)) and
then observed that The UCC recognizes four basic types of negotiable instruments: notes, drafts, checks, and
certificates of deposit. To be a negotiable instrument, the writing must meet certain statutorily-defined
requirements, at the heart of which is an unconditional promise or order to pay a fixed amount of money.
An instrument is a note if it is a promise.17 A check, for instance, is a draft that is payable on demand and is
drawn on a bank.18 A check may be a negotiable instrument even if it is not payable to bearer or order, as long as it
meets all the other requirements of negotiability.19 This exception to the general rule that an instrument must be
payable to order or bearer was created to address the concern that someone in possession of a pre-printed check
forms that lacked language of order (as was the case with numerous drafts drawn by credit unions) could otherwise
be misled into believing he or she was in possession of an instrument, and would be surprised to discover that he or
she did not have a holders rights due to the technical omission of words of negotiability. Thus, a check that is
drawn payable to X will retain its status as a negotiable instrument, although a note with the same language will
fail the test of negotiability. In McMullen Oil Co. v. Crysen Ref., Inc.,20 the court appropriately observed that a
check involves three parties: (1) drawer who writes the check, (2) the payee, to whose order the check is made
out, and (3) the drawee or payor bank, the bank which has the drawers checking account from which the check
is to be paid. It is also important to recognize that while a check is an order to pay money, the check does not
constitute an assignment of funds in the hands of the drawee.21 In Lenares v. Miano,22 the court explained the
differences between a check and note, which are, although fairly obvious, nevertheless worthy to quote. The court
observed that while checks and notes have many similarities and perform substantially like functions in many
commercial transactions [however] the basic difference between the two classes of paper is that a draft or check
is an order to pay money, whereas a note is a promise or undertaking to pay money.
A tellers check is a draft drawn by a bank either on another bank or payable through or at a bank.23 Tellers
checks are typically used by a savings bank or savings and loan association that maintains an account with and
draws checks on a commercial bank. A teller check may also be referred to as an official check. A cashiers
check is a draft on which the same bank serves as drawer and drawee.24 Typically, a bank will issue such an
instrument after it has received funds in return for which the cashiers check is issued. The bank will typically not
allow a withdrawal against the deposited funds, as they are held to secure the cashiers check. A travelers check
is an instrument that is payable on demand, is drawn on or payable at or through a bank, is designated by the phrase
travelers check or its equivalent, and requires, as a condition to payment, a countersignature by a person whose
specimen signature appears on the instrument.25 Note that in order to be a negotiable instrument, a promise or
order must be unconditional. The fact that a countersignature is required as a condition to payment of a travelers
check, however, does not render the writing conditional for purposes of defining a negotiable instrument.26 A
share draft is drawn on the drawers account at a credit union. A share draft may not contain the word order, but
has been interpreted by courts to fall within the category of negotiable instruments. For purposes of Articles 3 and
4, such a document functions exactly like a check.27 A certificate of deposit is an instrument that contains an
acknowledgement by a bank that a sum of money has been received by the bank and a promise to repay the sum of
money. A certificate of deposit is a note of the bank that issues it.28 A money order is effectively a check and may
be sold by banks and nonbanks.29
Two common situations have developed where a party may issue what has come to be recognized as preauthorized drafts or telechecks In the first variation, a consumer, to whom a vendor is providing goods or
services, agrees with the vendor that the vendor can prepare drafts drawn on the consumers account. The consumer
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provides the vendor with his or her account number, and the vendor prepares drafts on the consumers account and
deposits them at the vendors bank for collection. The second variation involves the preparation of checks by
telemarketers who have purportedly sold goods through a telephone order in the name of the purchaser as a means
of obtaining payment for the goods sold. The draft may have a stamp on it in the place where the signature usually
is found, stating authorization on file, verbally authorized by your depositor, or such similar notation. The
liability of the parties under these instruments, as for instance where the consumer claims not to have given an
authorization, is not provided for directly in the Code.
Several states, including Wisconsin, California, Colorado, Hawaii, Idaho, New Hampshire, North Dakota, Oregon,
Texas, Utah, West Virginia, and Nebraska, have addressed this situation by amending 3-104, defining a
negotiable instrument, to incorporate a new definition of a Demand draft30 and providing in the warranty
sections under Articles 3 and 4 that the person creating the demand draft warrants that it was created with the
authority of the person who is identified as the drawer.31 Similarly N.C.C.U.S.L. also addressed the situation by
amending section 3-104 to incorporate a new definition of Remotely-created consumer item (which is,
essentially, the same as a demand draft under the above identified states) in the 2002 Revision to Articles 3 and 4.
Numerous documents or writings may appear to be similar to an instrument but are not negotiable instruments.32 A
withdrawal slip is not an instrument when it contains a statement that it is nonnegotiable.33
[2]

A Negotiable Instrument Must Be Signed by the Maker or DrawerWhat Constitutes a Signature?

The current version of Article 3 (section 3104) omits the requirement, contained in earlier versions, that
instruments be signed by a maker or drawer. Thus, one might initially argue that a promise or order that had been
completed, except for the signature of a drawer or maker, still qualified as an instrument. As noted previously (see
above 20.02[1]) the requirements that an instrument be written and signed are contained in the definitions of
Order and Promise. Nevertheless, Article 3 retains the rule that no one is obligated on an instrument unless he
or she signed it, or a representative signed it in a manner that binds the principal.34 As a result, even if a writing
that contained a signature did constitute an instrument, no party could have a maker or drawers liability.
Presumably, however, if some party subsequently signed the instrument as an indorser, that party would have an
indorsers liability to subsequent transferees.
A signature may be made either manually or by means of a device or machine, such as a check writing machine that
imprints the maker or drawers name. The drawer or maker may use any name,35 including a trade or assumed
name, or a word, mark, or symbol executed or adopted by a person. The key requirementis that whatever name is
used and however the signature is affixed to the instrument, the signer have a present intention to authenticate the
writing.36
Thus, a signature may be typed, even if the rest of the instrument is hand written; or the signature may take the
form of a symbol rather than the signers proper name. Virtually any form of printing, stamping or writing, on any
part of the instrument, may constitute a signature. Moreover, objective intent governs, and where the issue is
whether the instrument is negotiable, only the intent evidenced by the instrument itself is relevant.37 In the proper
context, however, even a preprinted letterhead may constitute a signature, such as where the paper that contains the
letterhead contains words of negotiability that appear to have been written with the intent to bind the party whose
name appears on the document.38 Alternatively, a preprinted signature may render an instrument negotiable when
combined with another indicium of intent to authenticate, as where a preprinted check is completed with an
inscription written by a check writer.39 Courts have recognized the validity of facsimile signatures when they are
authorized in account documentation (account rules and regulations governing an account).40
A signature need not be subscribed but may appear in the body of the instrument.41 For example, a note may read,
I, X, promise to pay without any further signature by X. The instrument must be viewed as a whole to
determine whether the inclusion of the name constitutes a signature. Thus, if the instrument was typewritten,
contained no signature line, but the name was handwritten, a court might conclude that the handwriting evidenced
an intention to authenticate the writing. Such a finding would justify the courts interpreting the document as a
signed negotiable instrument. If, on the other hand, both the text of the instrument and the purported makers name
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were typewritten, and there was a signature line left blank, the court might conclude that there was no intention to
authenticate the writing.42
While there may be a variety of signatures on an instrument, the vital signature is that of the drawer of a draft or
maker of a note. An instrument signed only by parties other than drawers or makers has been held not to satisfy the
requirements of negotiability.43
[3]
A Negotiable Instrument Must Contain a Promise or Order to PayWhat Constitutes a Promise or
Order to Pay?
A negotiable instrument must contain a promise or order to pay.44 An instrument that simply acknowledges an
obligation or is an authorization or request is not negotiable.45
[a]
Promise to Pay
A promise is an undertaking to pay and must be more than an acknowledgment of an obligation.46 In a Delaware
appellate case,47 a document provided I Robert Harrison owe Peter Jacob $ 25,000. This document, the court
held, is an acknowledgment of a debt; although one could imply that it is a promise to pay, it does not satisfy
revised section 3-103(a)(9) that requires the promise to be an undertaking to pay. The court further stated that
[S]uch an undertaking to pay does not exist on the face of the documenttherefore [the UCC] does not apply.
Thus, an I.O.U. would not be a negotiable instrument.48 Similarly, a statement that I borrowed from H. Jones the
sum of five hundred dollars with four percent interest; the borrowed money ought to be paid within four months
from the above date would not constitute a promise to pay within the meaning of Article 3. Nevertheless, the
breadth of the definition leaves unclear the effect of such language as I agree to pay, I am obligated to pay and
I intend to pay. In an Alabama appellate case,49 wire transfer instructions and cash withdrawal slips were held
not to be instruments (UCC 3-104(b)) because they were not undertakings or instructions to pay money. The
policy of requiring strict compliance with the formal requisites of negotiability would seem to dictate that in
questionable cases the courts should lean toward holding such instruments nonnegotiable.
Further, such cases as In re Nellis50 would be rejected under the Code. There the court held that a statement that a
person had borrowed $2,000 which is subject to and payable on demand indicated a promise to pay. The court
looked to the whole writing to discern its true nature. Under Article 3, the result would be different since the
promise must stand on its own as an obligation to pay. The mere implication of a promise derived from a reading of
the instrument as a whole should not be enough to confer negotiability.
[b]
Order to Pay
[i]
An Order Is a Direction and Must Be More Than an Authorization or Request
An order to pay is defined by the Code as a written instruction to pay.51 It must be more than an authorization or
request to make payment.52 Occasionally, the distinction between a direction to pay and an authorization or
request may not be clear. The drafters of the Code have suggested how the niceties of language may generate
disparate legal results. The Official Comments to the prior version of Article 3 suggested that words of courtesy
appearing before the direction, such as please pay, do not render the direction a request;53 but precatory language
such as I wish you would pay will not qualify as an order.54 The instruction to pay may be to the person giving
the order, as is the case with a cashiers check.55
[ii]
An Order Must Identify the Person to Pay
The prior version of the Code stated that the person who is ordered to pay must be identified with reasonable
certainty.56 The current version adds rules which concern identifying the payee of an instrument, and so modifies
the prior Code requirement that the payee be identified with reasonable certainty. Under the current version, intent
of the issuer57 controls as to the identity of the payee.58
Where the payee designation is one of a common name, such as John Smith, the drawers intention as to which
John Smith is the payee will determine the person to whom the check is payable.59 This rule also applies where
there is an inaccurate description60 or a fictitious payee.61 In the case of a forgery of the drawers signature, the
intent of the person making the unauthorized signature, not the purported drawer, controls since the person making
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the forged signature is the drawer and the person whose signature is forged is not liable on the instrument.62 Where
a signature is made by automated means such as a check-writing machine or computer, the payee is determined
by the intent of the person who supplied the name or identification of the payee, whether or not authorized to do
so.63 The person whose intent controls will usually be an employee of the drawer but may be a stranger
committing a fraud through improper use of the automated system.64
Editors Note:
These principles are also discussed below; see 20.02[8]b][i].
An order may be addressed to two or more persons jointly or in the alternative.65 This recognizes the corporate
practice of providing for a number of drawees across the country when issuing dividend checks.66 Drawees in
succession are not permitted, however, because that would require a holder of the instrument to make presentment
to each drawee before having recourse against the drawer and indorsers.67
[c]
Instruments Payable at a Bank
In one instance, the Code provides that an instrument which promises the payment of money may operate as an
order instrument. Under Alternative A of Section 4-106, a note or acceptance payable at a bank that is identified
in the item is treated as the equivalent of a draft (order instrument) drawn on the bank. Thus, the bank must make
payment out of the account of the maker or acceptor when the instrument falls due and the Article 4 timing
deadlines apply.68 In those states that have adopted Alternative B of Section 4-106, the fact than an instrument is
made payable at a bank operates only to designate the bank as a collecting bank and requires the bank to present
the item for payment. The banks only function is to notify the maker or acceptor that the instrument has been
presented and to ask for instructions.69
[4]

The Promise or Order to Pay Must Be Unconditional

[a]
In General
In order for an instrument to be negotiable, the promise or order to pay must be unconditional.70 A negotiable
instrument is designed to circulate in a manner that permits the holder to determine all the terms of payment from
the face of the writing. It is this feature that has provided the analogy that instruments are like a courier without
luggage. The assumption is that avoiding the need to examine obligations and terms outside the writing will
facilitate commercial use of the instrument.71 For this reason, the conditional or unconditional character of a
promise or order must be determined by what is expressed in the instrument.72 Thus, a mere allegation that a
promise or order was intended to be conditional will not be permitted to change the obligors legally unconditional
promise to pay.73 Nor will a memorandum on the instrument, intended to facilitate the drawers own purposes,
constitute a condition that destroys negotiability.74
To some extent, all instruments are subject to conditional promises. For instance, payment is to be made only when
the maturity date arrives, and only upon production and surrender of the instrument properly indorsed.
Unconditional, as used in Section 3-104, has a more narrow meaning. Unconditional is intended to exclude
instruments not commercially acceptable because they do not state an absolute obligation, but an obligation
contingent upon the occurrence of an event foreign to the instrument and the law applicable to it. Negotiable
instruments law attempts to permit ready determination of cases that fall within and without this category. Section
3-106 purports to simplify the test of unconditionality by omitting many of the specific tests included in the
priorversion of Article 3. Instead, that provision presumes that a promise or order is unconditional unless it states (i)
an express condition to payment, (ii) that the promise or order is subject to or governed by another writing, or (iii)
that rights or obligations of the maker or drawer are stated in another writing. The intent is to ensure that a
transferee of the writing is able to determine the conditions of payment from the instrument itself. Mere reference to
another writing alone will not render the promise or order unconditional.75
[b]
Implied and Constructive Conditions Do Not Destroy Negotiability
The Official Comment to Section 3-106 indicates that the omission of specific examples of implied conditions
contained in Section Pre-Revision 3-105(1) is not intended to change the law.76 Rather, the intent is to continue the
understanding that the presumption of unconditionality is not rebutted by an implied condition.77 A condition
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may be defined as operative fact, one on which the existence of some particular legal relation depends.78 An
implied condition is a condition which is supplied by the court in order to give effect to the presumed intent of
the parties.79 A constructive condition, on the other hand, operates by reason of law apart from any expressed or
implied intention of the parties.80 Thus, a recital on an instrument that it was given in return for an executory
promise could give rise to an implied condition that the instrument is not to be paid if the promise is not
performed.81 The presumption of Section 3-106 ensures that such a condition does not impair the negotiability of
the instrument.82
A bankruptcy court83 addressed the issue of whether a note was conditional. The notes provided that The entire
unpaid principal balance shall be due and payable in full upon completion of the project being financed by the
funds secured by this note; or at any time either evidenced in writing by both parties, or within three (3) years of the
execution of this note. The court found that the notes were unconditional promises to pay. The court reasoned that
while completion of the project is a conditional event, and is beyond the control of the holder, the amount due is not
contingent upon only that event. There is another event; if the project is never completed, the amount of the notes
are still due at any time either evidenced in writing or within three years of the execution of this note. This
latter language makes the notes unconditional on their face. In other words, there are two independent events that
trigger payment: the notes are due within three years regardless of whether or not the project is completed, the
statement that the notes are due upon completion of the project only provides one possible time when the balance
may be demanded.
An example of an express condition to payment (conditional language) that will render a note non-negotiable can
be found in a federal district case.84 The note, in which CDL is the maker, stated that The 10/1/08 payment will be
made unless there are business or regulatory changesincluding code editswhich causes CDL to become
insolvent. The court denominated this provision as the conditional clause.
The words upon acceptance on a draft generally do not indicate a conditional promise to pay because it is only a
restatement of an implied or constructive condition of any draft which must be accepted to charge the drawee.85 In
certain cases, the words upon acceptance may refer to an agreement by the payee to specific conditions precedent
rather than to the liability of the drawee. Even in these cases, however, if the term is merely intended to indicate
that the payee accepts the instrument in full satisfaction of the underlying obligation, the negotiability of the
instrument is not impaired.86
[c]
Statement of Consideration or Reference to Underlying Transaction or Agreement Does Not Destroy
Negotiability
A statement of the consideration for which the instrument was given will not destroy the negotiability of an
instrument.87 It does not matter whether the consideration stated has been performed or is merely promised.88 The
negotiability of an instrument is also not affected by the omission of the statement of any consideration.89
A negotiable instrument may refer to the transaction that gave rise to the issuance of the instrument.90 Similarly, it
may refer to another writing for a statement of rights with respect to issues governing collateral, prepayment, or
accelerated payment.91 If the reference provides that either the promise or order or rights or obligations with
respect to the promise or order are subject to that other writing, however, payment is conditional and the instrument
is nonnegotiable.92 So, too, negotiability will be destroyed if the separate agreement provides terms for or governs
the fulfillment of the promise or order in the negotiable instrument.93
An instructive case explaining these principles is Jackson v. Luellen Farms, Inc.94 The court acknowledged the rule
that a note that is secured by a security interest in collateral (a mortgage) is negotiable where the note states that
rights and obligations with respect to the collateral are either stated in or governed by the security agreement; a
reference to the security does not strip the note of its negotiability. Such a note is non-negotiable, however,
where, as in this case, the note provides that all agreements and covenants in the mortgage securing the note apply
to the note. The court explained, There is a significant difference in a note stating that it is secured by a
mortgage from one which provides, the terms of said mortgage are by this reference made a part hereof. A
reference in a note to an extrinsic agreement does not destroy negotiability unless the reference actually makes the
note subject to the terms of that agreement. (citations omitted)
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Some instruments, such as travelers checks, may require, as a condition to payment, the countersignature of a
person whose signature already appears on the instrument. Such a requirement, however, does not destroy the
negotiability of a writing that otherwise satisfies the requirements of Section 3-104. In addition, certain statements
that may govern the transaction between the original parties to the instrument do not affect its negotiability. For
instance, an undertaking to give, maintain, or protect collateral will not destroy negotiability.95 Similarly, an
authorization to the holder to confess judgment or realize on or dispose of collateral will not destroy the
unconditional nature of the instrument.96 Finally, an instrument may remain unconditional even though it contains
a waiver of the benefit of any law intended to protect an obligor.97
Although the rules of conditionality purport to clarify when an instrument is negotiable, some ambiguities remain.
Assume, for instance, that Jones signs a note that reads, I, Jones, promise to pay to the order of Smith, $100 in
accordance with the contract we have executed this date. If the in accordance clause is intended to refer solely to
the origin of the note, the promise is unconditional and the note is negotiable. If, however, the clause implies that
the promise will only be fulfilled in accordance with the terms of the underlying contract, then the clause states a
condition and the note is nonnegotiable. Nevertheless, there is no easy way to determine the intent of the parties
merely by looking at the instrument.
The current version addresses instruments which contain statements required by statute or administrative law. Such
statements typically provide that a holder or transferee is subject to the issuers claims or defenses against the payee
(see, e.g., the Holder Rule under 16 C.F.R. 433.2(a), discussed above 20.01[6]). Under the current version, these
conditions do not render the promise or order conditional, and it is otherwise governed by the provisions of Article
3 except that a cannot become a holder in due course of the instrument.98
Practical Hint:
The 2002 Revision adds a definition of Record, meaning information that is inscribed on a tangible medium or
that is stored in an electronic or other medium and is retrievable in perceivable form.99 Adding a definition of
Record was done in order to facilitate electronic communications.100 The current version was further amended
in the 2002 Revision to substitute this defined term, Record, for the word writing in several sections, including
Code Section 3-106. Accordingly, under the current version, Section 3-106, as amended in the 2002 Revision, a
promise or order is unconditional unless it is subject to or governed by another record (instead of another writing)
and is not made conditional by reference to another record (instead of another writing).101
[d]
Reference to Fund From Which Payment Is to Be Made Will No Longer Destroy Negotiability
Prior versions of Article 3 adhered to the rule that a promise or order was not unconditional if the instrument stated
that it was to be paid only out of a particular fund or from a particular source.102 The rationale for the restriction
was that the instrument will not move smoothly through the stream of commerce if satisfaction of the obligation is
contingent on the existence and sufficiency of the particular fund. Negotiability was considered to be contingent on
the obligors full credit standing behind the promise to pay. Nevertheless, the determination of whether an
instrument was, in fact, payable from a limited fund could be difficult. The prior version of Article 3 added to the
confusion by also permitting an instrument to state that a particular account or fund was to be debited, if that
statement was merely one of expectation, not of limitation.103 Assume, for instance, a note that recites, I, Jones,
promise to pay on June 1, 1989, to the order of Smith, $100, payable from my bank account #123-456 at First
National Bank. While a holder seeking negotiability might have argued that this language constitutes only a
statement of a particular account to be debited under Article 3, Jones was equally likely to prevail on an argument
that the language constituted a limitation on the source of payment under Pre-Revision Section 3-105(2)(b). Thus,
the certainty assumed to flow from the requirements of negotiability was not always borne out in fact.
The current version of Article 3 reverses the limitation of fund rule and leaves the desirability of taking such an
instrument to market forces. This result seems appropriate. Should a holder be willing to accept the risk that a
limited fund will be depleted prior to payment, leaving the holder with no recourse against other resources of the
drawer or maker, there seems no good commercial reason to interfere with that judgment. After all, the holder
presumably will have purchased the note for a price that reflects the increased risk. Thus, currently Section 3106(b) specifically provides that a promise or order is not made conditional by the fact that payment is limited to
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resorting to a particular fund or source.104 This change, however, does throw some doubt on the vitality of the
traditional explanation for rigid requirements of negotiability. If market forces are capable of pricing and either
accepting or rejecting instruments that a payable from a limited fund, then why are they not similarly capable of
pricing instruments that are similarly risky because, for instance, they bear express statements of conditionality of
payment or that are payable at times that are relatively indefinite?
Even prior to the change in legal doctrine, there were additional permissible limitations on the source of payment.
One exception occurred where the instrument is limited to payment out of a particular fund or the proceeds of a
particular source, if the instrument is issued by a government or governmental agency or unit.105 The purpose of
this provision was to permit governments and governmental agencies to draw checks or to issue other short-term
commercial paper in which payment is limited to a particular fund or source of revenue.106 Governments
frequently pay for capital projects by issuing debt in the form of bonds that are payable solely from a specific
revenue source, such as an electric utility or a water system. The government unit exception to the limited fund rule
permitted such bonds to retain their negotiability.
The third exception to the rule that a promise or order was conditional if the instrument stated that it is to be paid
only out of a particular fund or source applied where the instrument is limited to payment out of the entire assets
of a partnership, unincorporated association, trust or estate by or on behalf of the entity.107 Thus, an instrument
that contained a clause limiting payment to the assets of the partnership was negotiable under the pre-Revision
Code, although non-Code law continues to control the effect of such a clause on the liability of the individual
members of the partnership.108
[5]

A Negotiable Instrument Must Be Payable for a Sum Certain or for a Fixed Amount

[a]
In General
Article 3 provides that an instrument must be payable for a fixed amount of money, with or without interest or
other charges.109 This is a significant change from prior law, which required that an instrument be made payable
for a sum certain. The exhaustive description in the Pre-Revision of a sum certain as it is affected by interest,
discounts, or exchanges110 is replaced by the simple definition in Section 3-104(a) and an added section on interest
in Section 3-112. The major substantive difference lies in the treatment of variable interest rates. Article 3
recognizes recent developments in the use of notes with variable interest rates and thereby expands the scope of
negotiable instruments beyond the scope of prior law.
The concern underlying the requirement appears to be that instruments of questionable or ambiguous111 value
cannot be exchanged freely and confidently through the marketplace.112 The Official Comment to Section 3-106
prior to the Revision established the standard for determining whether the sum certain requirement was satisfied:
It is sufficient that at any time of payment the holder is able to determine the amount then payable from the
instrument itself with any necessary computation.113
That language would have excluded variable interest rate notes from the category of negotiable instruments, since
the interest rate at any given time could not have been determined from the instrument itself. In replacing the sum
certain language with language of fixed amountwith or without interest, Article 3 has rejected the position that
the sum to be paid is uncertain if it cannot be determined at the time of issue. Rather, the key is whether the holder
can determine from the face of the instrument at any particular time the principal amount that will be payable at the
time payment is due. The fixed amount language, however, would not necessarily alter those cases that have held
nonnegotiable instruments that provided for the payment of uncertain costs of taxes, assessments, and insurance
premiums, or that limited the makers liability to the fluctuating value of collateral.114 Similarly, courts denied
negotiability to instruments that guaranteed payment of adjustable amounts or that included promises to pay any
and all liabilities.115
Notes that provide for interest at the prime rate of a bank specified in the note have given the parties to such notes
and the courts interpreting such provisions great difficulty. The prime rate is understood to be a rate as
determined by the bank, in its sole discretion, that it uses as the basis of determining the interest rate to be charged
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to commercial customers or for a consumer note. The prime rate is set by the bank, from time to time, based upon
market conditions in the financial world, including the bank discount rates set by the Board of Governors of the
Federal Reserve System. The interest rate is generally set as the prime rate plus a specified percentage in that,
practically, few borrowers are able to borrow at the banks prime rate. For example, the interest rate may be stated
in the note as prime plus 1%. Banks use different terms for prime rate, such as a base rate, benchmark, or
index rate, that are intended to have the same meaning as a prime rate. Prior to 1989, the courts uniformly held
such notes did not meet the sum certain requirement and were nonnegotiable.116 Several commentators suggested
that the Code should permit negotiable instruments to have interest run at the prime rate when and where
paid.117 In 1989 and 1990, a reversal in position took hold and courts began to recognize the commercial practice
and utility of such provisions and held prime rate notes to be negotiable.118 Some states also amended the Code
(current version) to specifically authorize notes where the interest rate was based upon a bank prime rate or other
recognized index.119
[b]
Effect of Interest Rates
An instrument does not necessarily bear interest. Indeed, unless the instrument provides for interest, the holder is
entitled only to the principal amount stated in the instrument.120 If interest is provided for, however, it is payable
from the date of the instrument.121 Traditionally, the sum certain requirement denied negotiability to any
instrument that required reference to some source other than the instrument itself in order to determine the
applicable interest rate. It was quite clear that any provision in an instrument for interest at the current rate, or at
prime defeated the sum certain requirement.122 The only exception was that a note that provided for interest to
be paid at the judgment rate retained negotiability, even though reference to an outside source to determine that
rate might be necessary.123
Article 3 now permits reference to outside sources in all cases where necessary to determine the applicable interest
rate.124 Section 3-112(b) validates instruments which have a variable rate of interest such as prime rate notes or
instruments where the interest rate is determined by an index such as a treasury bill rate, federal funds or discount
rate, London interbank rate, and so forth125 and instruments that describe the interest rate in a manner that may
require reference to information not contained in the instrument to determine the interest rate.126 While interest is
still payable at the judgment rate in cases where the instrument provides for interest but the rate cannot be
ascertained from the instrument itself,127 the more important application of the new rule occurs in the case of
variable interest rates. Presumably, the concern of the original drafters was not simply with the need for the holder
to proceed through the physical act of examining some extrinsic source. More important was the fact that such
sources tend to fluctuate. A holder who took an instrument before its maturity date would be unable to calculate its
value at any future time of payment if the interest to be paid depends on some fluctuating rate. As variable rate
notes became more popular, however, judicial and legislative responses, as discussed above, tended to reject the
rationale for denying negotiability under these circumstances.
Section 3-112(b) explicitly permits interest to be stated in an instrument as a fixed or variable amount of money
or at a fixed or variable rate or rates. Rates may also be determined by reference to some source outside the
instrument. The requirement in Section 3-104(a) of a fixed amount applies only to principal.128 Here again,
market principles appear to prevail over commercial paper tradition. If a transferee wishes to gamble that
subsequent interest rates will make the purchase of an instrument profitable, there appears to be no commercial
reason to inhibit that decision by denying negotiability to the instrument. The commercial interests related to
negotiability are satisfied by the statement of the variable rates on the instrument itself, notwithstanding the
possible need to refer to outside sources, e.g., prime rates, to make a final calculation of money owed. While the
rationale of current law is compelling, this additional move away from the traditionally strict requirements adds
doubt to any claim that negotiability is contingent on the holder having certainty as to terms of payment. While
Section 3-104(a) applies only to principle, the rules respecting interest are stated in Section 3-112(b).129
[c]
Other Clauses Affecting Amount Payable
Prior versions of Article 3 augmented the sum certain requirement with a litany of examples of clauses that would
or would not defeat the requirement. For instance, pre-Revision Section 3-106(1)(a) confirmed that an instrument
payable in stated installments did not render the sum uncertain. Section 3-106(1)(c) similarly provided that a sum
payable would be certain even though it was to be paid with a discount if the instrument were paid before the date
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fixed for payment or for an addition if the instrument were paid after such date.130 Section 3-106(1)(d) provided
that exchange rates could be added to or deducted from the face amount of an instrument without destroying its
negotiability. The rate of exchange could be either at a fixed rate or at the current rate. Finally, an instrument could
be negotiable even though it provided for the payment of the costs of collection, attorneys fees, or both on
default,131 whether the default consisted of the failure to pay in full at maturity or of a default in payment of
interest or installments.132 There is no reason to believe that the omission of similar provisions from the current
version of Article 3 implies any intent to change the law on these issues. Similarly, the absence in current Article 3
of any analogue to prior Section 3-106(2), which stated that [n]othing in this section shall validate any term which
is otherwise illegal, should obviously not be read to imply validation of illegal terms. Although failure to comply
with other statutes will not destroy the negotiability of the instrument, it may give rise to a defense to payment.133
Therefore, state law provisions regulating interest rates, discounts, attorneys fees or costs of collection are not
affected by the Code.134 Similarly, the Code does not affect statutes, such as the Federal Truth in Lending Act or
the Uniform Consumer Credit Code, requiring disclosure of interest rates.
[6]

A Negotiable Instrument Must Be Payable in Money

[a]
In General
Section 3-104(a) provides that a negotiable instrument must contain an unconditional promise or order to pay a
fixed amount in money. Money is defined in Section 1-201(24) as a medium of exchange either authorized or
adopted by a government as part of its currency. Money includes a monetary unit of account established by an
intergovernmental organization or by an intergovernmental agreement.135 The Official Comment to Section 1-201
rejects both the narrow view that money is restricted to legal tender136 and the broad view that it includes any
medium of exchange currently recognized within a community. An instrument payable in currency or current
funds is payable in money.137 A note payable in monthly installments of $125 to be paid incabinets figured at the
prevailing builders price for Jefferson City, however, was not payable in money and thus was not a negotiable
instrument.138
In order to pass freely in commerce, an instrument must represent payment of a widely accepted, relatively stable
medium. The appropriate test of whether the instrument in payable in money, therefore, is whether the medium of
payment has the sanction of a government which recognizes it as part of its official currency. Without this approval,
the medium is likely to be of such uncertain and fluctuating value that its movement through commerce will be
impeded.139
[b]
Foreign Currency
Money is defined in the Code to include foreign currency. It is not limited to United States currency.140 Where
an instrument states the sum payable in a foreign currency, the presumption, rebuttable by a statement in the
instrument, is that the obligation may be satisfied by payment in an equal value of dollars determined by the
exchange rate on the day the instrument is paid.141 The fluctuation of the exchange rate obviously does not change
the fixed amount for which the instrument is payable.
[7]

A Negotiable Instrument Must Be Payable on Demand or at a Definite Time

[a]
In General
Section 3-104(a)(2) requires that a negotiable instrument be payable on demand or at a definite time.142 These
phrases are defined in Section 3-108.
[b]
On Demand Defined
There are three ways in which an instrument can be made payable on demand:
(1)
when the instrument states that it is payable at sight or on demand;143
(2)
when the instrument otherwise provides that it is payable at the will of the holder;144 and
(3)
when no time for payment is stated.145
A demand instrument is payable immediately upon its execution146 and, for some purposes, the statute of
limitations will begin to run on the date of the instrument.147
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If an instrument is payable at a fixed date or on demand, it arguably should be treated as an instrument payable at a
fixed date subject to acceleration at the will of either the holder or the obligor.148 Thus, one court held that a note
which provided that it was payable on demand, but if demand was not made, then in 240 monthly payments
beginning on September 1, 1964, was not a demand note because the time for payment was stated in the
alternative.149 Similarly, an Oregon court ruled that a note payable on demand but no later than 180 days after
date was not a demand instrument, at least as a matter of law.150 Although the court found the on demand
language indicative of an intention that the note be payable on demand, the no later than 180 days after date
language created an ambiguity which the court felt was not susceptible to resolution as a matter of law. In a
Maryland case151 a note read On demand, the undersigned promises to pay to the order of the principal
sum of or so much thereof as shall have been actually advanced by the Bank. This revolving note is a demand
note, one in which no time for payment is stated. Payment may be demanded at any time by the payee-lender
because there is no fixed maturity date. In a Wisconsin case152 a note was payable to a trust in a specific amount; it
provided that it was to be paid with interest before maturity. However, the note did not specify a maturity date but
stated that If not paid in full at the time of the demise of Lillian E. Payleitner the total amount becomes due and
payable immediately. The court held that the note was payable on demand as it did not state a time for payment.
The additional statement did not make the note payable at a definite time, being payable upon an act or event that is
uncertain as to the time of occurrence. Article 3 specifies that if an instrument is payable both at a fixed date and on
demand made before the fixed date, it is payable on demand until the fixed date and is payable at a definite time on
the fixed date, if no demand has been made at that point. These cases should not be confused with the situation
where the instrument is payable at a fixed time after demand. Thus, an instrument due at request with 30 days
notice153 or payable thirty days after demand154 is a demand instrument under Section 3-108.
An instrument payable at sight is a demand instrument and language such as payable at sight when approved does
not render the instrumentnonnegotiable.155 In such cases, the instrument is payable on demand if approval is
acquired prior to issuance as evidenced by the signature of the person authorized to issue the instrument.
An instrument on which there is no maturity date or schedule of installments is a demand instrument.156 If the time
for payment is not stated, parol evidence offered to show that the instrument is payable other than on demand will
not be received.157 Thus, where the date of payment on a note is left blank, the payees unauthorized insertion of
the words on demand will add nothing to the instrument and so does not constitute a material alteration within the
meaning of Section 3-407.158
UCC Section 1-208 requiring good faith is not applicable to demand notes.159 A Kentucky appellate court160 held
that there is no duty of good faith in calling a demand note, observing that in so holding it joins the majority of
jurisdictions. The holder of a demand note may call it and demand payment with or without a reason, at any time.
To hold otherwise would prevent lenders from enforcing their legal rights. The court pointed out that its decision
is limited to pure demand notes and not other loan transactions.
[c]
Definite Time Defined
An instrument is payable at a definite time if it is either payable on lapse of a definite period of time or acceptance,
or at a fixed date or dates, or at a time readily ascertainable at the time that the promise or order is issued.161 In
each case, definiteness exists even though the holder has a right of prepayment or the obligor has a right of
acceleration or extension of the time for payment, or the maker or acceptor has a right to extend the time for
payment to a further definite time, or such further extension occurs automatically on or after a specified act or
event.162
The key to definiteness is the ability of the original holder readily to ascertain from the instrument the time for
payment at the time of issuance. Presumably, this determination must be made from the instrument itself. In
addition, the obligor may not have substantial discretion over when the payment is made, subject to the rights of
extension listed above. Nevertheless, a time of payment may be definite even though no specific date is mentioned.
Thus, a note that is payable 30 days after demand would be negotiable, even though the holder would not know
the exact date of payment prior to the making of the demand. Definiteness also should not be interpreted to
preclude a grant to the obligor of substantial latitude as to when payment is required. For instance, in Ferri v.
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Sylvia,163 the court held that an instrument requiring the maker to pay within ten (10) years after date was
payable at a definite time and no payment could be demanded until expiration of the ten-year period. Likewise, an
instrument payable on a date that can easily be computed, such as 120 days from date, is payable at a definite
time. An instrument is not negotiable when payable at the earliest possible time, as soon as circumstances will
permit, as soon as he could, or when he was able.164 A note payable upon the closing of a real estate
transaction,165 or in monthly installments beginning one month after a persons death,166 is not negotiable because
of the indefinite due date.
Where an instrument is payable upon the happening of an act or event and the time that the act or event will happen
is uncertain, however, the requisite definiteness is lacking.167 The fact that the act or event is certain to happen at
some time or that it has, in fact, already occurred does not render the time for payment certain.168 For example, a
note payable upon the death of the maker is nonnegotiable, even after the makers death. It has been held, however,
that an instrument payable on demand and then indorsed for Edward Joseph Smith Gentilotti My Son If I should
pass away The amount of $20,000 dollars Shall be taken from My Estate at death, is negotiable.169 The
indorsement merely modified the instrument to provide for acceleration of the time of payment.
Clauses accelerating or extending the payment date do not destroy negotiability. A negotiable instrument may
provide that it is payable at a definite time subject to any acceleration; or at a definite time subject to extension at
the option of the holder; or to extension to a further definite time at the option of the maker or acceptor; or
automatically upon or after a specified act or event.170 Such acceleration provisions are common in loan
transactions and are generally considered valid.171
Notes payable at a definite time may be subject to acceleration at will or when [a party] deems himself
insecure or in words of similar import.172 Where such language exists, the holder may accelerate payment only if
he or she believes, in good faith, that the prospect of payment has been impaired.173 The burden of establishing a
lack of good faith is on the party against whom the power has been exercised.174
Practical Hint:
Neither the prior version nor the current version of the Code discuss issues related to the manner in which to
effectuate an effective acceleration, such as what action or notice must be given by the holder. Such issues are left
to the common law of the jurisdiction whose law is applicable, which will govern the issue. Such lawprinciples
of law and equitysupplement the provisions of the Code. The basic principle is that the holder must comply with
the terms of the note (that may provide the holder with an option, or provide for automatic acceleration upon
default without notice, or require a notice of acceleration) in order to perform its obligations and have the right to
accelerate.175 Where the terms of the note provide the holder with an option, for there to be an effective
acceleration, the holder must take some affirmative action; an outward manifestation of the intent by the holder to
exercise the option is required.176
As explained above, a good faith requirement is not applicable to demand notes. However, with respect to time
notes, good faith has generally been held to apply. An Oklahoma court177 held that the good faith requirement of
UCC Section 1-208 was applicable to a time note containing an acceleration clause. In such a note, a good faith
belief by the holder that the prospect of payment of the note is impaired is required before the note may be
accelerated. The court further held that the makers had the burden to show by substantial evidence [that the]
Bank [holder] was not in good faith [citation omitted]. In In re Martin Specialty Vehicles, Inc.,178 the court held
that the implied obligation of good faith applied because the instruments at issue were not true demand
instruments.
While the requirement of a definite time is satisfied by making a note payable on or before a stated date, it
presumably cannot be met by language making the note payable on or after a stated date. The obligor under such
a note could assert at any time after the stated date that the maturity date had not yet arrived; in effect, payment of
the obligation would become discretionary.
The date of payment must be unambiguously apparent from the face of the instrument. Thus, notes that provided
for payment to commence on an estimated first payment date but also provided that the lender would send the
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maker notice of the actual first payment date were nonnegotiable. The parties clearly intended something other than
payment on demand, yet the conflicting provisions of the notes and the need to refer to some external document to
determine time of payment vitiated any claim that the notes were payable at a definite time.179
[8]

A Negotiable Instrument Must Be Payable to Order or to Bearer

[a]
In General
Section 3-104(a)(1) requires that a negotiable instrument be payable to order or to bearer. Thus, instruments
such as money orders that use the phrase Pay to a specified payee, and omit language of order do not constitute
negotiable instruments.180 Prior versions of Article 3 applied to an instrument that satisfied all of the other
requirements of Section 3-104, but that was not payable to order or to bearer. No person, however, could become a
holder in due course of the instrument.181 Thus, a party could be a holder of the instrument and have all of the
rights of a holder. Similarly, the liability of indorsers, drawers, makers and acceptors would be the same as if the
instrument had been payable to order or to bearer. The current version of Article 3 rejects this reasoning and wholly
excludes such writings from its coverage.182 Recall, however, the exception that allows a writing that otherwise
qualifies as a check but that is payable to a specified party, rather than to that partys order or to bearer, to qualify as
a negotiable instrument.183
[b]
Order Paper Defined
[i]
What Constitutes Payable to Order?
A promise or order is payable to order if it is payable to the order of an identified person or to an identified
person or order.184 The identified person is generally determined by reference to the intent of the person signing
as the issuer, that is, the maker or drawer of the instrument.185 Thus, in the case of a forger who issues a check
payable to the order of Jones, the forgers intent determines the identified person to whom the check is payable. If
the issuer makes the instrument payable in a name that is common to numerous persons, the issuers intent governs
which individual among those persons is the proper payee of the check. In addition, misdescriptions of the payee on
the instrument are subordinate to the issuers intent. If the issuer draws a check payable to the order of Jean Jones
to pay a debt owed to Jeane Jones, the latter person is still the proper payee and the identified person to whom the
check is payable. Where the signature of the issuer is made by an automated means, the payee of the instrument is
determined by the intent of the person who supplied the name of the payee.186 If the treasurer of a company
instructs Smith, a company employee, to issue a company check to Jones, intending that Jones will receive the
check, then the proper payee is the Jones whom the treasurer intends will receive the check.
Editors Note:
These principles are also discussed above; see 20.02[3]b][ii].
Obviously, contests about the proper identity of the payee become most important in cases of alleged forgery and
employee misconduct. Thus, the issue will be dealt with in that discussion.187
Arguably, the requirements of the current version of Article 3 are more liberal than those that previously existed
with respect to the creation of an order instrument. The current version permits identification of the person to whom
the instrument is payable to be made in any manner, including by name, account number, or other identifying
number.188 Conceivably, identification of the payee might require evidence outside the instrument itself. Prior
versions of Article 3 required that a payee be named with reasonable certainty.189 For example, aninstrument made
payable to the order of my best friend would not have been negotiable under Article 3, but might satisfy the
requirements of the Revision. If no payee is named and the instrument merely reads pay to the order of , the
instrument should be dealt with as an incomplete instrument under Section 3-115 (which will consider it to be a
bearer instrument).190
Prior versions of Article 3 provided that an instrument made payable both to order and to bearer was payable to
order unless the bearer words were handwritten or typewritten.191 Hence, a pre-printed instrument payable to the
order of or bearer was an order instrument on completion. The Official Comment suggested that this provision
was drafted to cover the situation where a drawer fills in the name of the payee on a printed order form without
noticing, or intending any ambiguity to result from, the presence of the word bearer.192 Article 3 currently
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considers an instrument containing both bearer and order language to state contradictory terms. An instrument
cannot be an order instrument at all unless it does not contain bearer language.193 The rule that an instrument
payable both to order and to bearer, which under the prior version was payable to order unless the bearer words
were handwritten or typewritten, is changed as a result of the elimination of this provision in the current version;
such an instrument is now treated as payable to bearer.194 The contradiction, therefore, is resolved in favor of the
holder who does not desire to obtain the indorsement of the identified payee. In addition, since Article 3 retains the
rule that typewritten terms control printed terms and handwritten terms control both, the contradiction of having the
term order written on what had been printed as a bearer instrument should be resolved by designating the
instrument as one payable to order.195
[ii]
To Whom May an Order Instrument Be Made Payable?
An order instrument may be made payable to the order of any person, including the maker or drawer who issues the
order.196
Specific recipients who may be the recipient of the instruction in the order include:
(1)
the drawee;197
(2)
a payee who is not maker, drawer or drawee;198
(3)
two or more payees together or in the alternative, but not in succession;199
(4)
an estate, trust or fund, in which case it is payable to the order of the representative of such estate, trust or
fund or the representatives successors;200
(5)
an office or an officer, and in either case the instrument runs to the incumbent of the office or the
incumbents successors;201
(6)
a partnership or unincorporated association, in which case it is payable to the partnership or association and
may be indorsed or transferred by any authorized person.202
An instrument payable either to an identified person or order is payable to order.203 The payee may be an
individual or an organization; it is not necessary that the payee be a legal entity.204 Thus, an order instrument
may be payable to a fund205 or to an unincorporated association such as a labor union or a business trust.206
Also, an order instrument may be payable to more than one payee.207 An instrument payable to A or B, however,
is payable to either individually.208 Any ambiguity about the proper payee of an instrument payable to multiple
parties is presumptively resolved in favor of the instrument being payable to the persons alternatively.209 Hence,
an instrument payable to A and/or B is presumptively payable either to A or to B alone.
[c]
Bearer Paper Defined
It is not necessary to designate a particular payee in a bearer instrument. Instead, the instrument may be made
payable in a manner that renders it an instrument payable to bearer.210
Instruments made payable in any of the following ways qualify as bearer paper:
(1)
pay to bearer;211
(2)
pay to the order of bearer;212
(3)
pay X or bearer;213
(4)
pay to cash;214
(5)
pay to the order of cash;215 and
(6)
pay bills payable.216
The Code does not designate as bearer paper an instrument on which the last indorsement is in blank. This result is
achieved, however, by Section 3-205(b) which provides, When indorsed in blank, an instrument becomes payable
to bearer and may be negotiated by transfer of possession alone until specially indorsed.
An instrument that states no payee is also payable to bearer. Although such an instrument is incomplete, it is
enforceable in its incomplete form and is payable to bearer.217
[9]

A Negotiable Instrument Must Contain No Other Promise, Order, Obligation or Power

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[a]
In General
As explained above (see 20.02[4]) the promise or order must be unconditional. This is a basic element or requisite
of a negotiable instrument as set forth in section 3-104(a). This requisite is then amplified and supplemented in
other sections. One of the traditional requirements of negotiability has been that the promise or order may contain
no other promise, order, obligation or power given by the maker or drawer. The holder of the instrument seeks only
to obtain payment and does not purport to be the obligee of any other obligation.218 This limited obligation
confirms the characteristic of an instrument as a money substitute that will flow easily through commerce and
permit parties to know the scope of their obligations from the instrument alone. Article 3 expresses this principle by
prohibiting a negotiable instrument from stating any other undertaking or instruction by the person promising or
ordering payment to do any act in addition to the payment of money.219 Thus, courts have declared nonnegotiable
notes that have contained clauses concerning late charges and rights to goods being sold;220 rights of repossession
without judicial process;221 refunds, rebates, and cross-collateralization;222 or the grant of a security interest.223
The Code does, however, permit certain exceptions to the general rule. These exceptions are set forth in Section 3104(a)(3).224 Since these exceptions are based on and intended to have the same meaning as their pre-Revision
counterparts,225 it is useful to consider the more complete statement of these exceptions under prior law.
[b]
Omissions Not Affecting Negotiability
An instrument is not rendered nonnegotiable because it fails to include a statement of the consideration for which
the instrument was given.226 Hence, there is no requirement that an instrument contain such language as value
received to indicate that consideration has been received in return for the issuance of the instrument. Negotiability
is also not destroyed because of the omission of a statement of the place where the instrument is drawn or
payable.227
[c]
Terms Not Affecting Negotiability
[i]
References in an Instrument to Collateral Do Not Affect Negotiability
Article 3 permits a note to contain an undertaking to give, maintain, or protect collateral without destroying
negotiability.228 Thus, promissory notes executed as payment for tracts of real estate and secured by a mortgage
over the real estate are negotiable instruments and their transferability as well as the rights flowing from such
transfers are determined by the legal principles unique to negotiable instruments.229
Section 3-112(1)(b) of the pre-Revision Code also permitted a clause authorizing the sale of the collateral upon the
obligors default of any obligation.230 The default may relate to an obligation on the instrument, or to any other
obligation owed to the holder.
[ii]
A Promise or Power to Maintain or Protect Collateral or to Give Additional Collateral Does Not Affect
Negotiability
A promise of power to maintain or protect collateral or to give additional collateral does not impair
negotiability.231 Such terms are often accompanied by a provision for acceleration if the collateral is not given.232
This gives the holder an immediate cause of action on the instrument instead of only the right to sue on the promise.
[iii]
Confession of Judgment Clauses Do Not Affect Negotiability Provided They Are Legal Under Non-Code
State or Federal Law
Section 3-104(a)(3) continues the practice of permitting confession of judgment clauses provided that they are not
otherwise illegal under non-Code state or federal law.233 Courts, however, have narrowly circumscribed the scope
of a confession of judgment clause that does not destroy negotiability. Courts have held that the right to confess
judgment is authorized in a negotiable instrument only where the instrument is not paid when due.234 Thus, an
early case235 held that a promissory note that contained a term giving power to confess judgment at any time
was nonnegotiable. In this case, the fact that the note was nonnegotiable precluded the plaintiff from being a holder
in due course. As a result, the defendants were allowed to assert a defense resulting in a verdict in their favor.
Moreover, a more recent case236 held that if the authorization of the confession of judgment is silent as to the time
when it can be exercised, it will be read to mean that it can be done at any time and, therefore, will render the
instrument nonnegotiable. Obviously, any confession of judgment clauses should be worded carefully and will be
strictly construed.237
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A confession of judgment clause may be coupled with an acceleration clause.238 Thus, the court in Broadway
Management Corp. v. Briggs239 held that a note containing clauses permitting acceleration in the event that the
holder deemed itself insecure and authorizing confession of judgment if the note was not paid at any stated or
accelerated maturity was a negotiable instrument. Section 3-108(b) establishes that an acceleration clause would
have made the note due, that is, mature at the time of acceleration.
In the majority of states, confession of judgment clauses are held invalid by statute.240 The inclusion of a
confession of judgment provision in these states, even though unenforceable, should not affect the negotiability of
the instrument.241
[iv]
Inclusion in an Instrument of a Term Purporting to Waive the Benefit of Any Law Does Not Destroy
Negotiability
The negotiability of an instrument is not affected by a term purporting to waive the benefit of any law intended for
the advantage or protection of any obligor.242 This provision is meant to include the waiver of benefits that arise
from other statutes for the protection of debtors. Thus, a homestead exemption can be waived as well as the right to
presentment or notice without affecting negotiability, but the validity of the waiver will be judged by non-Code
law.243
[v]
Negotiability Is Not Affected by a Provision in Draft That Cashing or Indorsing of Same Is an
Acknowledgement of Full Satisfaction of the Obligation Represented by the Draft
Pre-Revision Section 3-112(f) permitted a term in a draft providing that the payee by indorsing or cashing the draft
acknowledges full satisfaction of the drawers obligation.244 The Section did not determine what effect the clause
has on the rights and duties of the parties, but merely provided that such a term does not affect the instruments
negotiability. Thus, the Code left the issue of the effectiveness of full satisfaction clauses to other state law. This
clause, however, is not carried over into the current statement in Section 3-104(a)(3) of undertakings that are
exempt from the general rule that promises or orders must be limited to promises to pay money. Similarly, PreRevision Section 3-112(1)(g) provided that negotiability is not affected by a statement in a draft drawn in a set of
parts (Pre-Revision Section 3-801) to the effect that the order is effective only if no other part has been
honored.245 This provision was intended merely to ensure that a condition arising from such a statement will not
adversely affect negotiability.246 Again, this provision has no analogue in the current version of Article 3. It is not
clear, however, that these omissions were intended to make promises or orders that contained these undertakings
nonnegotiable. Rather, these limitations may be considered to fall outside the area of undertakings that any person
would believe would deny the possessor of holder status.
[vi]
Clauses Providing for Choice of Law, Venue, Jury Waivers, and Arbitration Are Enforceable and Do Not
Affect or Destroy Negotiability
The negotiability of an instrument is not affected by a provision in an instrument that the laws of a particular state
shall apply (choice of law provision); such a clause does not destroy negotiability; such provision is generally
effective as a contract between the parties.247 In a New York case,248 the note contained a provision as to venue.
The court held that the venue provision was enforceable so that venue in the county specified in the note was
proper. A severability clause is recognized as enforceable.249 Jury waivers are generally held to be enforceable,
although there is authority to the contrary.250 It is not uncommon for notes (or the underlying agreement) to
contain an arbitration clause. These clauses have been enforced by the courts, applying concepts of
unconscionability. That is, the clause is enforceable provided it is not, under the circumstances, unconscionable.251
Practical Hint:
All of these provisions are common provisions in notes, especially notes payable to a bank. Although the courts
cited above, generally, did not address the issue of negotiability, but only whether the provisions were enforceable,
such provisions specifying venue and a severability clause, arbitration, etc., are similar to other provisions (e.g.,
governing law, references to collateral, etc.) that expressly are provided in the Code, or have been held by the courts
not to affect negotiability. Accordingly, this author believes that such provisions should also not affect negotiability;
such provisions are not in the nature of a condition to the payment obligation that would destroy negotiability.
[vii]

Information in the Memo Portion of an Instrument Does Not Affect Negotiability

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It is not uncommon for the drawer to include instructions or other references in the memo portion of a check; such
references do not affect the negotiability of the check. An example of such a provision can be found in Anton Noll,
Inc, v. United States of America.252 The memo portion of a bearer check (it was payable to cash) contained the
phrase IRS $260, 892.54 and represented the amount of money owed by the holder to the I.R.S. The check was
negotiated to a bank for the purchase of a bank check.
[10]

Rules of Construction for Ambiguous Instruments

Given the vast numbers of instruments that are issued daily, it is inevitable that some will contain ambiguities.
Various provisions within Article 3 state general rules of construction that govern these cases. In some situations,
for instance, a drawer may purport to be drawing a draft on itself, thus creating questions about whether the
instrument constitutes a draft or a note. This question has arisen where a bank seeks to avoid liability on a cashiers
check and is confronted with the theory that the instrument was actually a note on which the bank bears the liability
of a maker.253 Section 3-104(e) provides that a person who is entitled to enforce an instrument that qualifies both
as a draft and as a note may treat it as either.
Alternatively, an instrument may clearly be a note or a draft, but contain ambiguous terms. For instance, a check
may be payable for an amount stated in figures as $100.00, but written out as One thousand dollars. In this
case, the Code provides that words control figures unless the words themselves are ambiguous. Further, there is a
hierarchy among written terms.254 Handwritten terms control typewritten and both handwritten and typewritten
control printed terms. These rules of construction, however, will not cure all cases. In United States v. Hibernia
National Bank,255 the bank received a check that contained the term 24844 DOLLARS/50 CENTS in the body
of the check where words are usually found and the figure $244844.50 on the right side of the check. The court
determined that even though the amount was nowhere stated in words, the figure stated in the body of the check
where words usually appear would be the controlling amount. The court further determined that if the ambiguity
were not resolved in the manner that it indicated, the check would be nonnegotiable for failure to state a sum
certain. Contract rules of interpretation and use of extrinsic evidence also apply, in addition to the rules set forth in
the Code, where there is ambiguity in the terms of an instrument.256 The general rule is that if there is ambiguity
(in a note) extrinsic evidence is not admissible to vary the terms of the contract (note), but such evidence is
admissible to ascertain the intent of the parties.257
If two or more makers, drawers, indorsers, or acceptors sign as part of the same transaction, they bear joint and
several liability on the instrument, even though it speaks in the singular, e.g., I promise to pay.258 Of course, the
mere fact that there are two or more indorsers on an instrument does not mean that they are jointly and severally
liable. To the contrary, indorsers are typically liable in the order in which they signed. If, however, the instrument is
payable jointly to two or more payees, they must all indorse and such indorsement binds them jointly and severally.
Alternatively, two or more indorsers may sign as accommodation parties. In such a case, they will also be jointly
and severally liable. If one indorser signs as an accommodation to another, however, the accommodation party will
have no liability to the accommodated party.259
Additionally, an instrument that provides for interest but that does not bear a specified interest rate will bear interest
at the judgment rate at the place of payment from the date of instrument or date of issue.260 A note that stated a
total amount of interest due, but not an annual rate of interest, has been considered a note that specifies interest
sufficiently to avoid use of the judgment rate as a gap filler.261

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Rene Tierney

20.03 The Holder of an Instrument*

[1]

Distinctions Among Possessors of Instruments

A party in possession of an instrument, which in Article 3 means a negotiable instrument,1 may fall into one of
three categories: transferee, holder, or holder in due course. These categories are distinguished by the rights to
which the possessor is entitled. A transferee has the least rights, although one with this status may still be entitled to
enforce the instrument against a party obligated on it. The transferee has whatever rights its transferor had; hence, a
transferee who takes an instrument from a transferor who is subject to defenses against payment will itself be
subject to those defenses, unless the transferee can avoid them by virtue of something other than its status as a
transferee.2 Similarly, a transferee who takes an instrument with a defect in title has all the burdens associated with
that defect. A transferee also obtains the transferors right to enforce the instrument.3
Practical Hint:
A transferee is a person who obtains an instrument, not through a negotiation, but through a contract assignment. It
is generally recognized that no requirement exists that a negotiable instrument only be transferred by negotiation.
An alternative would be for rights in and to the instrument to be assigned. A negotiable instrument can be assigned
(transferred by assignment), as can a nonnegotiable instrument.4 Rights obtained by a transferee through an
assignment include those of a holder in due course, unless the transferee engaged in fraud or illegality.5 The
consequence of the rule that the transferee obtains the rights of the transferor is that upon an effective transfer (by
negotiation or assignment) the transferor does not have any further interest in the instrument and has no rights to
enforce it.6
A transferee who also qualifies as a holder has both the rights of the transferor and the particular rights granted to
holders under Article 3. The primary such right is the right to negotiate the instrument.7 In addition, the holder is
entitled to procedural presumptions that facilitate recovery on the instrument.8
The holder in due course, who will be examined in depth in subsequent sections of this chapter, possesses the most
substantial rights. A party with that status may acquire rights even more substantial than those of the transferor.
Where applicable, this rule distinguishes negotiable instruments from nonnegotiable instruments and goods. Those
items are subject to the maxim nemo dat quod non habet, or one cannot give what one does not have. In the case of
negotiable instruments, a transferor who transfers to a party qualifying as a holder in due course can, in fact,
transfer greater title than the transferor possessed. For instance, a holder in due course who takes an instrument in a
chain of title that has been broken by a thief has a title to the instrument that is superior even to that of the original
owner. In order to be a holder in due course, however, the possessor must first satisfy the criteria of being a holder.
[2]

Becoming a Holder

One may qualify as a holder of an instrument either by satisfying the definition of holder set forth in the
definitional provision of the Code, Section 1-201(20), or by virtue of obtaining the instrument by negotiation.9
For the most part, qualification as a holder under one of these provisions will also constitute qualification under the
other. The major exception to this rule is that one who becomes a holder of an instrument on original issue by the
drawer or maker does not obtain the instrument through a negotiation. Negotiation requires a transfer by a person
other than the issuer.10 Indeed, there is some argument that the definition of Section 1-201(20) applies only to
one who takes the instrument on original issue. Official Comment 1 to Section 3-201 can be read to indicate that a
person can become a holder either through issuance or through negotiation, but that any post-issuance holder must
satisfy the requirements of obtaining the instrument through a negotiation. For the most part, as we will see, there is
little importance to this distinction, since a post-issuance transferee of an instrument who satisfies the Section 1201(20) definition of holder will also have received the instrument through a negotiation.
Under either provision, the holder of an instrument must be in possession of it. One who is not in possession may
still have a right to enforce the instrument, as where the instrument has been lost or stolen.11 But such a person is
not the holder of the instrument.
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[a]
What Constitutes Possession of the Instrument?
The possession requirement suggests that the holder must be in actual physical possession of the instrument, and
several cases so hold.12 The absence of possession, however, does not necessarily mean that a person has no rights
on the instrument. For instance, where the instrument has been lost or stolen, both courts and the Code permit
plaintiffs to recover if they are able to prove ownership of the instrument at the time of loss, facts that prevent
production of the instrument, and a reasonably exhaustive search.13 Section 3-309, whichspeaks in terms of a
person entitled to enforce the instrument rather than a holder, also permits courts to condition recovery on the
plaintiffs willingness to indemnify the party liable. This requirement avoids double liability for the liable party
should it subsequently develop that another person has become a holder of the instrument and is thereby entitled to
recovery against the same party. Thus, even a payee who has indorsed or assigned the instrument to another, but
who retains possession of the instrument, may enforce it against the maker.14 Special rules govern the right to
enforce certified checks, cashiers checks, or tellers checks that have been lost or stolen.15
In Scheid v. Shields,16 the court permitted the equivalent of another exception to a transferee seeking recovery on
an instrument. Although the court did not designate the transferee a holder, it granted recovery on the instrument
where the maker retained possession and the instrument had been introduced into evidence. The court held that in
these circumstances the maker could not be subject to double liability and no harm was done to the clarity of the
law of commercial paper by permitting recovery. Thus, the traditional reasons for limiting recovery to parties in
possession did not apply.
The doctrine of constructive possession has been utilized to permit a party not in actual possession to recover when
the instrument is held by an agent.17 If the agent does not act exclusively on behalf of the owner of the instrument,
however, difficulties may arise, as the person in possession may be entitled to transfer the instrument in a manner
that makes some other person a holder with a right to recover against the same party who paid the owner. Thus, in
Locks v. North Towne National Bank,18 the court refused to grant holder status to a party where the instrument was
in the possession of an escrowee. Indeed, if the instrument has been negotiated to the escrowee, that party will itself
be a holder with a right to recover against parties liable on it.19 Further, it is acknowledged by the cases that
delivery of an instrument to one payee, in the case of an instrument made payable to joint payees, constitutes
constructive delivery to, and possession by, the other joint payee, so that that joint payee is a person entitled to
enforce the instrument.20
[b]
Transfer and Negotiation of Bearer and Order Instruments
Whether a transferee of an instrument qualifies as a holder depends on the nature of the instrument and on whether
there has been a necessary indorsement of the instrument. To appreciate the subtleties of these requirements, one
must understand the jigsaw puzzle nature of the Code (as the inquiry requires perusal of various Code provisions)
and possess an appreciation of fine distinctions that generate substantial differences in legal result. Here the key
distinction is between the mere transfer of an instrument, which covers any voluntary conveyance of the instrument
from one person to another, and the negotiation of an instrument, which is a special form of transfer that converts
the transferee into a holder.
Before proceeding to examples to illustrate these principles, a broad overview of the relevant Code sections should
be informative. The two distinct events of issuance of an instrument and transfer or negotiation recognized under
the Pre-Revision remain unchanged under the current version. UCC Code 3-201 incorporates the concepts of PreRevision UCC 3-202. While the definition of negotiation in Pre-Revision UCC 3-202(1) used the undefined
term transfer and used the word delivery, defined in 1-201(14) to mean voluntary change of possession, in the
current version, subsections (a) and (b) use the term transfer of possession.21 Additionally, subsection (a) states
that negotiation can occur by an involuntary transfer of possession.22 Negotiation is a voluntary or involuntary
transfer of possession of an instrument by someone other than the issuer to a transferee who becomes a holder.23
The current version contains a section which defines the concept of transfer and states the rights, upon transfer,
obtained by the transferee.24 The case law with respect to assignments remains valid to the extent the Code does
not apply where an instrument is not negotiated following the rules prescribed in the Code.25
The current version does not change the manner of indorsement, although it does utilize the concept of transfer of
possession and method of delivery. Instead of referring to an instrument as an order instrument,26 the current
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version is framed in terms of an instrument payable to an identified person27 which is, in effect, an order
instrument.28 For the negotiation of an instrument that is payable to an identified person, there must be a transfer of
possession and an indorsement of the instrument.29 An instrument payable to bearer may be transferred by
possession alone.30 Blank and special endorsements are defined in Section 3-205, which section states the manner
of transfer of an instrument based upon whether it has been indorsed in blank or with a special indorsement.31
Editors Note:
Some of these principles are further discussed, as an introduction to the liability of an indorser, in section 20.15[1]
below. Anomalous and restrictive indorsements are discussed in section 20.15[1][b][iii] and [iv] below.
A series of examples may help clarify the analysis of this area. Assume that T is a dishonest former employee who
has recently been fired from the X Corporation. T returns to X and steals three checks from the Accounting Office.
One check has been made payable to cash and was to be used to obtain petty cash kept in the Accounting Office.
One check was made payable to the order of T, representing Ts last paycheck. The third check was made payable
to the order of B, another employee. T transfers the three checks to P, to whom T owed money in an amount
equivalent to the three checks. Prior to transferring the checks to P, T signed the back of the two order
instruments (the ones made payable to the order of T and to the order of B). If P is a holder in due course, P will be
able to enforce these checks against X, even though they were stolen. In order to be a holder in due course,
however, P must be a holder. Was P a holder of any of these instruments?
With respect to the check made payable to cash, P can be a holder if it satisfies the definition of Section 1201(20). That provision states that a holder of a negotiable instrument is the person in possession if the instrument
is payable to bearer. Recall that an instrument payable to cash is, in fact, payable to bearer. As a result, anyone in
possession of such an instrument, including P, is its holder. At least that is the case if one rejects the reading of
Section 1-201(20) that suggests that only those who take an instrument on original issue qualify as holders under
that provision. Indeed, at the time that T stole the check, T was also in possession of the bearer instrument and thus
arguably qualifies as its holder under Section 1-201(20). One may reject that conclusion, however. Even if Section
1-201(20) makes the possessor of a bearer instrument a holder on issuance, there appears to have been no
issuance of the check in this case. Issuance requires a delivery of the instrument by the maker or drawer, either
to a holder or nonholder, for the purpose of giving a person rights on the instrument.32 A delivery, however,
requires a voluntary transfer of possession.33 In this case, however, T stole the check rather than received it
through a voluntary transfer of possession. As a result, there was no issuance. This does not necessarily mean that P
cannot qualify as a holder, but it does mean that the drawer may have a defense of nonissuance against P.
Section 3-201 indicates that a person in possession of an instrument can also become a holder through a
negotiation. A negotiation requires a transfer of possession, whether voluntary or involuntary, of an instrument by
a person other than the issuer to another person. In the case of a bearer instrument, negotiation can occur by transfer
of possession alone. No further act by the transferor is necessary. In this case, P took the instrument from T rather
than from the issuer. As a result, that transfer constitutes a negotiation and P qualifies as a holder.34
Transfer of possession for purposes of negotiation may be either voluntary or involuntary.35 Indeed, theft of a
bearer instrument will constitute a transfer of possession of the instrument. Assume that T steals a check received
by X Corporation from the issuer Y Corporation, but that is made out to Cash. The theft would constitute an
involuntary transfer of possession by a person other than the issuer, so that T would become a holder through
negotiation.36 (Of course, this does not mean that T was a holder in due course with the right to enforce it against
X.)
If P was a holder of the check and satisfied the other requirements of holding in due course, P would be able to
enforce the bearer check against X, the drawer, free from most defenses and claims, including the defense that P
traced chain of title through a thief. For instance, as suggested above, X could contend that the bearer check was
never delivered and thus never issued.37 Some commentators argued earlier that an unissued instrument had no
validity, so that no transferee of the instrument could qualify as a holder. This result would disadvantage subsequent
transferees of the instrument, since a bearer instrument stolen before issuance would be treated differently than an
instrument stolen subsequent to issuance, although there would be no way for a subsequent holder to distinguish
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between the two situations. The current version of Article 3 makes clear that nonissuance does not preclude liability
by the drawer or maker of the instrument to all parties. Nonissuance would be a defense.38 But the defense would
not be valid against a holder in due course. Hence, T could not enforce the bearer instrument against X, but P could
(assuming, again, that P otherwise satisfied the requirements of being a holder in due course).
Consider next the check stolen by T and made payable to Ts order. Is P a holder of that instrument once it is
transferred to it by T? When T stole the instrument it was in possession of an instrument made payable to an
identified person. It was not an instrument payable to bearer. In addition, T was the identified person. Thus, T
satisfied the definition of holder under Section 1-201(20). Note that the check was not issued to T, since there
was no delivery of the stolen check. In addition, the check was not negotiated to T. This is because a negotiation
requires that the transfer (which, again, can be involuntary39 be made by a person other than the issuer.40 Here, the
transfer was made to T by the issuer, X.
What are the consequences for P of the fact that T is a holder? If T signs its name to the back of the instrument
before transferring it to P, then T has transformed what was originally an order instrument into a bearer instrument.
This is so because the signature of T constitutes an indorsement by a holder41 and the indorsement does not
identify a person to whom the instrument now becomes payable. Hence, the indorsement is a blank indorsement,
the effect of which is to make the instrument payable to bearer.42 Recall that negotiation of a bearer instrument,
sufficient to render the transferee a holder, requires only the transfer of the instrument. Thus, P has received the
instrument through a negotiation and is a holder. In addition, P is in possession of an instrument payable to bearer,
and thus satisfies the definition of holder under Section 1-201(20).43
Assume that T did not simply sign T on the back of the check, but signed, Pay to the order of P and then signed
T. Again, T has indorsed the instrument. This time, however, the indorsement is not in blank but identifies a new
personto whom the instrument is payable, P. Thus, the indorsement is special, because it has been made by a
holder, T, to a particular identified person.44 The instrument retains its nature as an order instrument; it does not
become a bearer instrument. Nevertheless, once P is in possession of the instrument bearing this indorsement, P is
again a holder. The instrument has been negotiated by T to P, because negotiation of an order instrument occurs
when it is transferred and it is indorsed by the holder.45 That has happened here because T was a holder.
Furthermore, P is in possession of an instrument payable to an identified person, and P is that identified person.
Thus, P also satisfies the definition of holder in Section 1-201(20). Just as with the bearer instrument, P can be a
holder of this stolen instrument, and thus can be a holder in due course.
Finally, consider the check that T stole and that was made payable to the order of B. If T signs Bs name on the back
of the check and transfers it to P, is P a holder? The check has not been negotiated to P and thus P cannot take as a
holder through negotiation. This is because the indorsement that purports to be in blank has not been made by
the holder. T is not a holder because this is not a bearer instrument and (unlike the previous example) T is not the
identified person to whom the check was payable. Thus, Ts signing of Bs name does not transform the instrument
payable to the order of B into a bearer instrument under Section 3-205(b). Hence, no negotiation can occur through
transfer alone. Furthermore, if T had indorsed the check Pay to the order of P and then signed B, that would not
constitute a special indorsement, because such an indorsement also must be written by the holder.46 Thus, Ts
signing of Bs name will not qualify as an indorsement by the holder necessary to negotiate an order instrument
under Section 3-201(b).
In addition, P cannot now satisfy the definition of holder under Section 1-201(20). Again, P is not in possession
of a bearer instrument. One might argue that P is in possession of an instrument bearing Ts indorsement that reads,
Pay to the order of P, signed B, so that P holds an instrument payable to a identified person and P is that identified
person. This argument, however, is incorrect. We have seen that the only way to indorse an instrument in a manner
sufficient to make it payable to an identified person is for that indorsement to be made by the holder.47 Since T
was not a holder, T cannot make an effective indorsement. Thus, P is not a holder because the instrument was never
effectively indorsed to P. Thus, P cannot be a holder in due course. Moreover, since P is itself not a holder, P cannot
indorse this instrument to a subsequent party in a manner sufficient to make that party a holder in due course. In
short, while anyone can be a holder of a bearer instrument that has passed through the hands of a thief, no one can
be a holder of an order instrument that has passed through the hands of a thief, unless the instrument was originally
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payable to the thief. While there may be exceptions to this rule under circumstances that make forged signatures
effective,48 this general rule governs most transactions in commercial paper.
Although the above example suggests that negotiation of an order instrument requires indorsement, one exception
to this principle exists. Assume B purchases a cashiers check, an instrument that is drawn by a bank on itself,
payable to the order of S. B is a remitter of the instrument, defined in Section 3-103(a)(11) as a person who
purchases an instrument from its issuer if the instrument is payable to an identified person other than the
purchaser.49 While B may sign the cashiers check as remitter, that signature does not constitute an indorsement.
Furthermore, Bs transfer of possession of the instrument to S will constitute a negotiation, even though no
indorsement is made.50 This is true because transfer of the order instrument by the remitter to S will provide S with
possession of an instrument on which S is the identified person to whom the instrument is payable; hence, as a
result of the transfer, S satisfies the definition of holder so that a negotiation has been effected under Section 3201(a). Section 3-201(b), which normally requires an indorsement in order to negotiate an order instrument, makes
an exception for negotiation by a remitter. The current treatment of remitters clarifies prior law with respect to the
relationship between remitters and issuance of the instrument. Section 3-105 makes clear that delivery of an
instrument by a maker or drawer to a remitter constitutes an issuance, even though the payee of the instrument (the
party intended to have rights on the instrument) is a different party.
In most cases, the indorsement will be written on the instrument itself. The Code permits an effective indorsement
to be made on a separate piece of paper, called an allonge, as long as it is firmly affixed to the instrument.51 Courts,
however, have disfavored any such form of indorsement. Prior to adoption of the current version of Article 3, some
jurisdictions recognized the effectiveness of the allonge only where no room for the indorsement remained on the
original instrument.52 An official comment to 3-204 rejects this line of cases and provides that an indorsement on
an allonge is valid even though there is sufficient space on the instrument for an indorsement.53 Nevertheless,
courtsmay still limit the utility of allonges, such as by strictly construing the requirement of firm affixation, so that
the purported allonge cannot simply be attached to a series of papers that includes the original instrument.54
In 1989 the United Nations Commission on International Trade Law completed the United Nations Convention on
International Bills of Exchange and International Promissory Notes, which has not been ratified by the United
States. Anticipating such future ratification, the 2002 Revision promulgated by N.C.C.U.S.L. includes comments in
several sections pointing out similarities and differences between Article 3 and the Convention, which would
facilitate implementation of the Convention should it be ratified by the United States. A proposed comment to 2002
Revision 3-205 recognizes that the rules for blank and special indorsements in this section and under Convention
Articles 14 and 16 are similar.55 Where an instrument is specially indorsed, thereby becoming payable to an
identified person (an order instrument under the terminology in the Code) and requiring an indorsement of that
person for further negotiation, the revised provision states that the principles with respect to identification of the
person to whom an instrument is payable in 3-110 are applicable.56
[3]

Rights of a Holder

A person who qualifies as a holder has certain rights with respect to the instrument beyond those of a mere
transferee. None of these rights is contingent on ownership of the instrument. The holders lack of ownership may,
however, be raised as a defense to payment by the party against whom enforcement of the instrument is sought, or it
may be the subject of a claim of a party who asserts superior ownership of the instrument.57
[a]
The Right to Negotiate the Instrument
As we have already seen, the holder has the exclusive right (with the exception of remitters) to negotiate an order
instrument and can do so only through indorsement.58 The holder also has the right to negotiate a bearer
instrument, of course, but this right is shared by mere transferors. In addition, a negotiation occurs when a remitter
transfers a cashiers check or tellers check to the payee. The right to negotiate is of particular importance to
transferees who wish to become holders in due course and thereby attain more rights than the transferor. For
example, a holder who has no authority to negotiate the instrument may transfer it to a holder in due course whose
rights in the instrument will not be impaired by the transferors lack of authority.59
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[b]
The Right to Secure a Discharge of the Instrument
An obligor on an instrument may obtain a discharge of that obligation by making payment to a person entitled to
enforce the instrument.60 While that phrase includes additional parties (such as a nonholder who has a holders
rights under the shelter principle and a person who has been the victim of a theft of an instrument),61 the most
common person to occupy that position is the holder. If the instrument has been given in exchange for an
underlying obligation, discharge on the instrument also discharges the obligor on the obligation.62 Thus, it is vital
for the obligor to know whether the party being paid is a holder or otherwise is entitled to enforce the instrument.
Payment to someone other than a holder may leave the obligor open to a second action for payment by a holder. If,
for instance, M issues a demand note to the order of X in exchange for goods, and X negotiates the note to H, H
becomes a holder. If M subsequently pays X the amount of the debt on the underlying obligation, M will remain
obligated on the note to H. Indeed, failure to recover the instrument or designate it as paid on payment will leave
the obligor liable to a subsequent holder in due course.63 Thus, if in the above example M paid X prior to
negotiation of the note but failed to get the note back, and X subsequently negotiated the note to H, who had no
notice of the prior payment, M would remain liable to H.
Payment to a holder may discharge the obligor even though the obligor is aware that some other party claims a
superior right to the instrument. Assume that M issues a bearer note to X and it is stolen by T. At maturity, both X
and T appear before M and claim a right to payment. Under Section 3-602, M can (exceptin special circumstances)
pay T with impunity, even though it knows of Xs claim, because T is a holder. This principle facilitates the use of
negotiable instruments because purchasers do not have to be concerned about a makers uncertainty over whom to
pay. X, however, can forestall this payment by supplying indemnity or obtaining an injunction against payment in
an action in which X and T are parties. Further, M will not be discharged if M knows that the instrument is a stolen
instrument and that the person receiving payment is in wrongful possession of the instrument.64 If, however, the
instrument is a cashiers check, a tellers check, or a certified check, the issuing or accepting bank will be
discharged on its obligation when it makes payment to the holder, even if the bank has been indemnified by a
competing claimant. The liability of the bank for making such payment in violation of an indemnity agreement is
not governed by Article 3.65
Nevertheless, the obligor on an instrument may face difficulty in determining the proper person to pay. Assume that
M issues a note payable to the order of X and that it is stolen by T. T forges Xs indorsement and transfers the note
to Y. On the maturity date, both X and Y appear before M and claim payment. If M pays Y, M will not be
discharged. Due to the intervening forged indorsement, Y will not be a holder, notwithstanding Ys possession of
the instrument. Thus, payment to Y does not constitute a discharge.
The 2002 Revision changes some of the concepts of payment, in part to conform to provisions concerning payment
in the Restatement of Mortgages and the Restatement of Contracts. A new Section 3-602(b) deals with the situation
in which a person entitled to enforce the instrument transfers it to a third party, but fails to give notice of the
transfer to the obligor, who then pays the transferor.66 The new provision makes that payment effective to
discharge the obligation, even though it is not made to a person entitled to enforce the instrument. A payment to the
transferor is effective if made prior to receipt of notice, even though it is not made to the transferee, who is the
person entitled to enforce the note. Notice to the obligor will be adequate if it is signed by the transferor or
transferee, reasonably identifies the transferred note, and provides an address to which subsequent payment is to be
made. For these purposes, signed in the case of a record that is not writing includes the attachment or logical
association with the record of an electronic symbol, sound, or process to or with the record with the present intent
to adopt or accept the record.
Payment is not the only way that an obligor can obtain a discharge. Discharge on a check may also be effected by
certification,67 and, with respect to some obligations, untimely action by the party entitled to enforce the
instrument may discharge prior parties.68
[c]
The Right to Enforce Payment of the Instrument
The third right of the holder is to enforce payment in the holders name.69 Again, nonholders may, under certain
conditions, also have the right to enforce payment of the instrument.70 Not all nonholders will have this right,
however. For instance, a transferee in possession of an order instrument payable to another may not enforce
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payment in the transferees own name without proving its right to the instrument and accounting for the absence of
necessary indorsements.71
[i]
A Holder Has Important Procedural Advantages Over an Ordinary Transferee or a Claimant Suing on the
Underlying Claim
[A]
A Holder Need Only Bring Action on the Instrument Itself
If negotiable instruments are to fulfill their roles as money substitutes, then the rights of parties to a transaction that
involves an instrument should be the same as the rights of parties to a transaction in which payment was made by
money. In a transaction in which goods are exchanged for money, for instance, a party dissatisfied with the goods
and unable to obtain redress from the seller would have to prove the existence of the contract and breach of the
contract in order to recover the money payment. One who gives a negotiable instrument and who is subsequently
dissatisfied might simply refuse to make the ultimate money payment to the holder. In such a situation, the holder
would be in a position inferior to that of the seller who took cash, diluting the money substitute characteristic of
the instrument. The Code assists the holder in this situation by providing certain procedural advantages in the
enforcement of an instrument. After dishonor of an instrument, the holder can enforce either the instrument or the
obligation; the holder is permitted to recover in a suit on the note or the check, respectively, or on the underlying
debt/obligation.72 The holder is not required only to sue on the obligation. However, a seller of goods, upon
dishonor of the instrument, may sue on either the instrument or the underlying obligation (contract of sale) provided
the seller has possession of the instrument.73 If another person has the right to enforce the instrument (a person
other than the seller), the seller may not enforce the underlying sales contract (payment of the price under the
contract) because that right is represented by the instrument, which is held by another person.74
[B]
Production of the Instrument Containing the Signature of the Obligor Gives the Plaintiff-Holder a Prima
Facie Right to Recovery
Production of the instrument containing a signature, the validity of which has been admitted or established, gives
the holder a prima facie right to recovery.75 The validity of each signature on an instrument is deemed admitted
unless specifically denied in the pleadings.76 If the issue is raised by specific denial, the party claiming under the
signature has the ultimate burden of persuasion,77 although the signature is presumed valid.78 The burden of
going forward with the evidence is initially on the party challenging the signature and unless such party
introduces evidence which would support a finding79 of nonvalidity, the presumption will prevail.
In addition, the defendant has the burden of establish[ing] a defense80 to the plaintiffs cause of action. In
response to a defense, the plaintiff-holder will have the burden of establishing holder in due course status.81 Thus,
it has been noted that the procedural presumptions of the Code effectively incorporate a burden-shifting principle
that makes a holder the functional equivalent of a holder in due course until a defense has been shown to exist.82
[ii]
A Comparison Between the Procedures in an Action on an Instrument and in an Action on the Underlying
Obligation
The full import of these provisions can be illustrated by comparing the procedures in an action on an instrument and
an action on the underlying obligation.83 Assume the following simple, though typical, fact pattern. A buyer
purchases a refrigerator from a seller. The sale is evidenced by a written contract. The buyer receives the
refrigerator and gives the seller a check in return. For some reason, the buyer is not satisfied with the refrigerator
and the buyer stops payment on the check. When the seller presents the check for payment, it is dishonored.
Since the instrument has been dishonored, an action may be maintained on either the instrument or the underlying
obligation.84 If the seller sues the buyer on the underlying obligation, the cause of action will be breach of contract.
The sellers complaint must show the execution of the sales contract, the terms of the contract, the furnishing of the
consideration that is, the refrigerator and the buyers breach. The buyers answer will include whatever
general or specific denials are deemed appropriate. At trial, the seller will have the burden of going forward as well
as the ultimate burden of proving the facts placed in issue by the buyers denials.
Now, suppose that the seller decides to sue the buyer on the check, i.e., the instrument. The elements of the sellers
complaint are simple. The seller must indicate the terms of the instrument and allege that the buyer signed as
drawer and that the seller is the holder.85 Because the instrument in question is a check as opposed to a note, the
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complaint must also allege due presentment to, and dishonor by, the drawee, as well as notice of dishonor if
required.86 The sellers complaint need not allege the making of the contract or that there was any consideration
given for the buyers check. Such matters involve defenses which must be raised by the buyers pleadings.87 The
buyers answer will have to include specific denials asserting the invalidity of the buyers signature or any other
affirmative defense. A general denial will only place in issue the existence of the instrument and the sellers
possession as holder. At trial, the seller merely needs to produce the instrument and offer testimony showing that
the seller is the holder of the instrument. Since the instrument is a check, the seller will also have to show due
presentment and notice of dishonor. The fact of the sellers possession as holder and the production of the
instrument allegedly signed by the buyer will raise the presumption that the buyer is liable to the seller for the
amount of the instrument. From that point on, the buyer has the full burden of going forward with the evidence as
well as the ultimate burden of persuasion.
[4]

Rights of a Non-Holder

[a]
Lost or Stolen Instruments
One who is the victim of a loss or theft of an instrument cannot be the holder of that instrument, since the victim is
no longer in possession of an instrument. Nevertheless, such a person is not without rights to the instrument and
will still be entitled to enforce the instrument on proving certain facts and taking certain steps to protect the obligor
on the instrument from multiple liability.88 Assume, for instance, that D issues a check to P from whom the check
is stolen by T and transferred to X. Ds initial obligation to P, for which the check was presumably issued in the first
instance, has been suspended by virtue of Ps taking the check.89 Thus, P cannot simply demand another check
from D in respect of that underlying obligation. If, however, P can demonstrate that it was in possession of the
instrument and entitled to enforce it when the loss occurred, that the loss was not the result of a volitional transfer
or a lawful seizure, and that P cannot reasonably obtain possession of the instrument, P can enforce the original
instrument against D.90 In Fales v. Norine,91 the court held that these elements, as well as the terms of the
instrument, must be proved by clear and convincing evidence ... [which is] that amount of evidence which
produces in the trier of the fact a firm belief or conviction about the existence of the fact to be proved. When an
instrument has been lost, the person seeking to enforce it can proceed under Section 3-309, provided the person can
meet the conditions set forth in this section. Only the instrument can be enforced; the person seeking to enforce
cannot initiate a suit on the underlying contract.92
The courts have not been uniform in interpreting this section as to the requirement of possession.
In Dennis Joslin Co., L.L.C. v. Robinson Broadcasting Corp.,93 the court ruled that purchasers of a note that had
been lost were not protected by Section 3-309 because the note had been lost by the previous owner. The court
claimed that the purchasers were not entitled to enforce a note they had never possessed. The 2002 Revision
reverses this result. It allows a person to enforce the instrument if the person was entitled to enforce at the time that
the instrument was lost or if the person had acquired ownership of the instrument at the time that loss of possession
occurred.94 Because P is not a holder in these situations, however, P will not be entitled to the procedural
presumptions of Section 3-308. Instead, P will be required to prove the terms of the instrument and the right to
enforce it. Only once that proof has been made will the procedural presumptions apply.95
Before a court can enter a judgment on behalf of the person seeking to enforce the lost instrument, it must find that
the obligor is adequately protected against loss if a claim is made by a third party; adequate protection can be
provided by any reasonable means.96 As is indicated in the Official Comment, The court is given discretion in
determining how adequate protection is to be assured the type of adequate protection that is reasonable in the
circumstances may depend on the degree of certainty about the facts in the case.97 This is a more flexible concept
than under the Code. A security bond indemnifying the obligor, the protection specifically authorized in the Code
section, is but one possible choice of a court; other means may be provided based upon the particular facts.98
Article 3 adds an additional wrinkle to the enforcement of lost or stolen instruments where cashiers checks, tellers
checks, or certified checks are involved. Under Section 3-312, a drawer or payee of a certified check or the remitter
or payee of a cashiers or tellers check may make a claim to receive the amount of the check by filing a
declaration of loss, made under penalty of perjury, to the effect that the declarer lost possession of the check
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through some means other than transfer or lawful seizure and that the declarer cannot reasonably obtain possession
of the check. The 2002 Revision permits the declaration of loss to be made in a record, which means that it could
be made either in a writing or electronically.99 A claimant who communicates his or her claim to the bank that has
issued the cashiers or tellers check or that has accepted the certified check (denominated the obligated bank)100
and who submits the declaration of loss to the bank is entitled to recover the amount of the check 90 days after the
date of the issuance or acceptance or when the claim is asserted, whichever is later. Until that time, the claim has no
legal effect and the obligated bank may make or permit payment to a person entitled to enforce the check.101 An
obligated bank that makes payment prior to the time that the claim is payable is discharged of all liability on the
instrument. Once the claim does become enforceable, the obligated bank must pay the amount of the check to the
claimant if payment has not previously been made to a person entitled to enforce the check. As long as the obligated
bank has satisfied the Article 4 requirements for timely action with respect to payment of checks, payment to the
claimant discharges the obligated bank of all liability on the check. If a person with the rights of a holder in due
course should subsequently present the check, however, the claimant must either refund the amount of the check to
the bank that pays, or pay the amount of the check to the holder after dishonor by the obligated bank.102 For
instance, a stolen cashiers check that has been issued to bearer may ultimately fall into the hands of a holder in due
course, and that party does not lose its right to enforce the instrument by virtue of the submission of a declaration of
loss by a claimant. The assumption of the Code, however, is that the instruments to which this provision applies
will be presented for payment within a 90-day period after issuance or acceptance, so that instances of later
presentment will be sufficiently rare that payment to the claimant at that time creates little risk.103
A claimant who qualifies for recovery under both Sections 3-309 and 3-312 may proceed under either provision.
Claimants should prefer the latter provision,104 since it avoids the need for giving adequate protection to the bank.
It is important to note, however, that not all parties to certified, cashiers or tellers checks will be able to make
claims under Section 3-312. For instance, assume that a payee of a cashiers check negotiates it to a third party and
that the check is stolen from that party. Since a declaration of loss may only be made by a drawer, payee, or
remitter, the victim of the theft cannot qualify under the special provisions of Section 3-312. This limitation allows
the obligated bank the ability to determine which persons are clearly entitled to assert a claim with respect to the
bank. In addition, any declaration of loss constitutes a warranty of the truth of the statements made in the
declaration,105 so that the bank has additional protection against fraudulent claims. There may, in addition, be
circumstances under which a party to an instrument cannot qualify for recovery under Section 3-309, but is entitled
to recovery on satisfaction of the conditions of Section 3-312. For instance, a remitter of a cashiers check who
suffers a loss before delivery of the instrument would not qualify under Section 3-309, because a remitter is not a
person entitled to enforce the check.106
Note that the obligated banks ability to pay the check on presentment prior to the expiration of the 90-day period
and thereby be discharged of liability on the check depends on its making payment to a person entitled to enforce
the instrument. Assume that a banks customer purchases a cashiers check made payable to the order of an
identifiable payee and that the payee loses the check.107 The payee submits a declaration of loss to the issuing
bank prior to the time that the check is presented for payment and within time for the bank to take action on the
check before paying it. A week later, the check is presented to the bank by a depositary bank which received the
check from its customer. That customer, however, took the check from the party who stole it, and who forged the
payees indorsement. Since the instrument bears a forged indorsement, neither the subsequent transferee nor the
depositary bank is entitled to enforce it. Should the obligated bank pay the depositary bank, it will not be
discharged of its liability to the payee under Section 3-312. The obligated bank, however, will have claims against
the depositary bank under both breach of warranty and conversion causes of action.108
[b]
The Shelter Principle
[i]
Scope of the Principle
Under certain conditions, the fact that one is not a holder does not preclude the assertion of the rights of a holder.
Assume, for instance, that the payee of an instrument made payable to the payees order transfers the instrument to
X, but fails to indorse it.109 In this situation, X cannot be a holder of the instrument in its own right, because it is in
possession of an instrument made payable to an identified person other than itself. Thus, any purported negotiation
of the instrument has failed. Nevertheless, X can enforce the instrument against the drawer, if X is a nonholder in
possession of the instrument who has the rights of a holder.110 X satisfies that requirement by virtue of the
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shelter principle embodied in Section 3-203(b).111 That provision grants to the transferee of an instrument any
right of the transferor to enforce the instrument.112 Note, however, that for purposes of the shelter principle, the
requisite transfer occurs only on delivery of the instrument by a person other than its issuer for the purpose of
giving the recipient the right to enforce it.113 Since delivery requires a voluntary transfer,114 a theft of an
instrument does not constitute a transfer that triggers the shelter principle.
A particular problem that has arisen under the shelter principle concerns the status of a depositary bank115 when it
receives a draft for deposit to its customers account. If the customer is a holder and properly indorses the
instrument in blank or to the depositary bank, or if the check is in bearer form, the bank becomes a holder during
the time when it is actually in possession of the instrument. The problem arises when the customer deposits the
instrument without first indorsing it. In order to speed up the check collection process by eliminating the necessity
of returning to the depositor any item lacking an indorsement, Section 4-205 currently provides that a depositary
bank that takes a check from its customer for collection becomes a holder at the time it receives the item if the
customer was also a holder. No indorsement by the customer is necessary to confer holder status on the bank.116
The bank may therefore become a holder in due course, notwithstanding the absent indorsement, if it satisfies the
other requirements of that status.117 Prior to the current version of Article 3 and Article 4, the Code permitted the
less inclusive right to the depositary bank to supply the missing indorsement of its customer.118 It was unclear
whether this ability to indorse on behalf of a customer granted the depositary only the rights of a holder,
necessaryto continue the check through the collection process, or also the status of a holder. If the bank has only the
rights of a holder, but is not itself a holder, the bank cannot become a holder in due course. The definition of holder
in due course requires that a party be a holder and not simply have the rights of one.119
This issue came to a head in the controversial case of Bowling Green, Inc. v. State Street Bank and Trust Co.120 In
that case, the plaintiff-buyer, as part of a sales transaction, negotiated a third-party check to the seller who, without
indorsing the check, deposited it in the defendant bank. The defendant bank never supplied the missing
indorsement, notwithstanding its right to do so under Section 4-205. The bank did, however, apply most of the
check against debts owed to it by the seller. The seller was adjudicated a bankrupt and the plaintiff never received
the merchandise in exchange for which it had delivered the check. The plaintiff brought an action to recover its
payment from the defendant bank on the theory that the bank held funds as constructive trustee for the plaintiffs
benefit. The defendant claimed that it was a holder in due course of the check and, therefore, took free of the
adverse claim. On appeal from a district courts determination that the bank was a holder in due course, the plaintiff
argued that the bank had not even met its burden of establishing that it was a holder of the check. In a creative, but
misguided, opinion, the court of appeals affirmed.
It was clear that the defendant bank could not qualify as a holder in its own right. The check had not been drawn or
indorsed to the bank, its order, bearer or in blank. The court thus permitted the bank to invoke the shelter
provision of thenapplicable Section 3-201. That provision, like current Section 3-203, conferred on the
transferee of an instrument whatever rights the transferor had. In most situations, the provision makes sense, as the
obligor on the instrument is not made worse offsince the obligor would have the same liability if the transferor
retained the instrumentand permits a transferor greater access to commercial paper markets. If, for instance, the
transferor took the instrument at a time when a defense was unknown, and therefore qualified as a holder in due
course, but a defense subsequently became widely publicized, the transferor who could not confer the rights of a
holder in due course on a transferee would have difficulty negotiating the instrument. The shelter provision permits
even a subsequent holder with notice to obtain those rights, and thereby facilitates commercial markets.121
In Bowling Green, therefore, the defendant bank convinced the court that its transferor was a holder, and therefore
it, too, was a holder under the applicable version of Section 3-201. The courts agreement, however, overlooks the
rights/status distinction. The shelter provision carefully confers on the transferee only the rights, not the status, of
the transferor.122 Thus, even if the court was correct in granting the bank the rights of its customer, that provided
little basis for vaulting the bank into holder, much less holder in due course, status. Indeed, it is to ensure that the
transferee does obtain the status of a holder that Section 3-201(3) provided that if the transferee has given value and
it is not otherwise agreed, the transferee has a specifically enforceable right to require the transferor to make an
unqualified indorsement of the instrument. Subsection (3) would be superfluous if the transfer of an instrument for
value by a holder automatically conferred on the transferee status as a holder. Furthermore, the rights of the
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transferor that were transferred to the bank were rather limited. The customer had, after all, never performed its
contract to deliver goods to the buyer. Thus, it is unclear that the customer had rights to the check at all that could
be conveyed to the defendant bank.
The court, however, was not through. It went on to confirm its conclusion that the bank was a holder by reference to
Section 4-205. The court noted that banks often comply with that provision by use of a stamp and concluded:
We doubt whether the banks status should turn on proof of whether a clerk employed the appropriate stamp, and
we hesitate to penalize a bank which accepted unindorsed checks for deposit in reliance on the Code, at least when,
as here, the customer himself clearly satisfies the definition of holder. U.C.C. 4-209 does provide that a bank
must comply with the requirements of U.C.C. 3-302 on what constitutes a holder in due course, but we think
this language refers to the enumerated requirements of good faith and lack of notice rather than to the status of
holder, a status which U.C.C. 3-302 assumes rather than requires. We therefore hold that a bank which takes an
item for collection from a customer who was himself a holder need not establish that it took the item by negotiation
in order to satisfy U.C.C. 4-209.123
This reading was problematic, at best. Even if the thenapplicable version of Section 4-205 could confer holder
status on a depositary bank, it purported to do so only where the bank has actually supplied the indorsement. There
is little basis for the courts conclusion that making the indorsement is superfluous.124 At the time the case was
decided, Section 4-205 permitted a bank to supply a customers indorsement only to confer holder status on the
bank. If the courts interpretation of Section 4-205 were correct, the depositary would already be a holder and the
provision would be unnecessary. Nevertheless, that view is confirmed by the current version of Section 4-205,
which eliminates the indorsement requirement.
The practical significance of the distinction is apparent from any example in which a holder in due course could
avoid defenses unavoidable by other parties. If an order instrument is deposited without indorsement on January 1,
the bank acquires notice of a defense against the instrument on January 2, and the bank supplies the missing
indorsement on January 3, the bank, but for the reasoningof Bowling Green, would not be a holder in due course
because when it took the instrument as holder it had notice of a defense. This suggests that an obligor on an
instrument should give notice as soon as possible to the holder or would-be holder of the instrument. Although the
physical transfer of the instrument may have been completed, the status of the transferee as holder in due course
may not yet be established. Conversely, it suggests to banks that they always obtain the indorsement of the
depositor.
Note, however, that the automatic conferral of holder status applies only where the item has been taken for
collection. Assume that a customer of a bank pledges a note on which the customer is the payee as collateral for a
loan from the bank. The customer, however, does not indorse the note to the bank. The bank is not the holder of the
note, since it did not take the instrument for collection as required to take the rights of a holder under Section 4205. The transfer of itself does not entitle the bank to enforce the instrument, notwithstanding the voluntary
delivery, since the shelter principle operates only to confer the rights of the transferor, not the status of the
transferor. Hence the fact that the transferor was itself a holder will not transform the transferee into a holder. The
part of the Bowling Green, opinion that ignored the rights/status distinction remains dubious even after the
Revision.
[ii]
Limitations on the Shelter Principle
The shelter principle is sensible in most contexts, insofar as it increases the market for commercial paper without
placing the obligor in a worse position than the obligor would have occupied had the transferor retained the
instrument. There are some contexts, however, in which the principle might generate unjust or inefficient results.
Assume, for instance, that M gives P a note payable to Ps order in return for goods that P knows to be defective. P
cannot qualify as a holder in due course. If P negotiates the note to X, who has no notice of the defect, X will
qualify as a holder in due course. Now assume that P repurchases the note from X. P still cannot claim holder in due
course status in Ps own right. If P were entitled to claim the rights of the transferor, however, P would be able to
overcome this disability. Nevertheless, such a result would induce the making of collusive agreements and would
frustrate the limitations on the holder in due course doctrine. Thus, Section 3-203 provides that the shelter provision
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does not apply to a transferee who has been a party to fraud or illegality affecting the instrument. The prior version
of Article 3 applied this limitation not only to a participant in the fraud or illegality, but also to one who, as a prior
holder, had notice of a defense or claim against the instrument.125

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20.04 The Holder in Due Course.*

[1]

In General

The primary distinction between a holder of a negotiable instrument and a mere assignee of a contract right is the
ability of the former to attain the status of a holder in due course. This favored child of the law enjoys many of the
same rights as the heralded bona fide purchaser of goods. Most importantly, the holder in due course can take good
title to the instrument and enforce it against the obligor notwithstanding some previous defect in the chain through
which the holder in due course makes its claim. Indeed, the holder in due course is elevated even beyond the bona
fide purchaser of goods. One who purchases goods from a thief must generally return them to the true owner,
notwithstanding purchase in good faith.1 The holder in due course, on the other hand, takes free from such claims.
In Georg v. Metro Fixtures Contrs., Inc.,2 the court succinctly summarized the objective of the holder-in-due course
doctrine as follows: [it] is designed to encourage the transfer and usage of checks and facilitate the flow of
capital. The principles of holder in due course status derive from a policy to encourage the use of negotiable
instruments in commercial transactions. To accomplish this policy, a holder in due course is insulated from nearly
all claims of any party.3 As stated in a California appeals case,4 the purpose of the holder in due course doctrine
is promulgating the integrity, certainty, and finality of commercial transactions [it] promotes the use and
circulation of instruments by protecting those who give value in good faith reliance on them.
The full scope and import of holder in due course status will become clearer as the succeeding sections investigate
in detail each of the requirements and consequences of achieving this commercial status. The reader should keep in
mind, however, that the favored position of the holder in due course often leads courts to construe narrowly the
prerequisites to a successful claim of that status. Indeed, commentators have noted that holders in due course often
are in the superior position to avoid losses from fraud or improper behavior in the transaction that generates the
instrument.5 If the function of Article 3 is to place losses on the party most capable of avoiding them, holder in due
course rights appear sometimes to be misplaced. This theme will be noted throughout the following discussion. For
the moment, it is sufficient to delineate the general criteria that a holder in due course must satisfy.
Section 3-302 sets forth the criteria for holder in due course status under current law. The person asserting holder in
due course status must:
(1)
be a holder
(2)
of an instrument that, at the time the person became a holder did not bear such apparent evidence of forgery
or alteration, or be so irregular or incomplete as to call into question its authenticity; and
(3)
take the instrument for value;
(4)
in good faith;
(5)
without notice that the instrument is overdue or has been dishonored or that there is an uncured default with
respect to payment of another instrument issued as part of the same series;
(6)
without notice that the instrument contains or unauthorized signature or alteration;
(7)
without notice of any claim to the instrument; and
(8)
without notice of any defense or claim in recoupment with respect to the instrument.
Nevertheless, even one who satisfies these requirements cannot acquire the rights of a holder in due course by
taking an instrument by legal process or purchase in an execution, bankruptcy, creditors sale; or by purchase as
part of a bulk transaction outside the ordinary course of the transferor; or as successor in interest to an estate or
organization (see below 20.08[1]). Of course, the purchaser under these circumstances may have the rights of a
holder in due course under the shelter principle if the transferor or predecessor in interest had the rights of a holder
in due course.6 In addition, a person who otherwise qualifies as a holder in due course may not have the rights that
normally attend that status if the instrument contains a statement required by state or federal law that makes the
holder or transferee subject to claims or defenses that the issuer could have asserted against the original payee.7
A few other general principles should be acknowledged. As noted earlier in this chapter, it is axiomatic that one can
only become a holder in due course if the instrument in issue is a negotiable instrument.8 A determination of
whether a plaintiff seeking to enforce a note is a holder in due course is a question of fact.9 A determination by a
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trial court that a plaintiff is a holder in due course is a finding of fact. A federal district court10 affirmed the
principle that the burden of establishing holder in due course status is on the party claiming to be a holder in due
course and that the party must establish each and every element.
As noted above (20.03[2][b]), the United Nations Commission on International Trade Law completed the United
Nations Convention on International Bills of Exchange and International Promissory Notes, which has not been
ratified by the United States. Anticipating such future ratification, the 2002 Revision includes comments in several
sections pointing out similarities and differences between Article 3 and the Convention. A proposed comment to
Code Section 3-302 recognizes the similarities between the Code (current version) and Convention. The comment
states that, The status of holder in due course resembles the status of protected holder under Article 29 of the
Convention...The requirements for being a protected holder under Article 29 generally track those of Section 3302.11
The following paragraphs discuss each of the requirements of holding in due course in detail.
[2]

A Holder in Due Course Must Be a Holder.

Section 3-302(1) requires that a holder in due course must first qualify as a holder, as that term is discussed in a
previous section of this chapter. One who is not himself or herself a holder may not qualify as a holder in due
course. If a nonholder is sheltered to the rights of a party who did qualify as a holder in due course, however, the
shelter principle will provide the nonholder with the same holder in due course rights. A nonholder transferee who
takes the instrument in good faith, for value, and without notice, however, will not be able to use the holder status
of a transferor who does not qualify as a holder in due course in order to merge the transferees due course status
with the transferors holder status and thereby obtain the rights of a holder in due course.12

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20.05 A Holder in Due Course Must Take an Instrument for Value*

A holder in due course must show that the instrument was taken for value.1 As used in Article 3, however,
value has a narrower definition than the same term as used in other Articles of the Code. Section 1-201(44)
defines value as coextensive with the common-law concept of consideration.2 Thus, outside of Articles 3 and 4, a
person gives value for rights whenever he or she has done enough to permit enforcement of a simple contract.
Value for purposes of Article 3, however, is defined in Section 3-303. The differences between the general Code
definition and the specialized Article 3 definition can be substantial. Under Section 3-303(a), for instance, an
executory promise does not constitute value, although it does under Section 1-201(44). Thus, a promise to pay will
serve as value for the due negotiation of a negotiable document of title under Article 7 but it will not support holder
in due course status with respect to a negotiable instrument under Article 3. The difference in treatment is due to the
ability of the holder of an instrument to avoid losses by avoiding the transaction. A holder who learns of a defense
against the instrument prior to the time that the executory promise has been performed has the ability to rescind the
transaction for breach of the transfer warranty under Section 3-416. Further, an executory promise is not value since
a holder who gives an executory promise and learns of the dishonor of the instrument has not suffered an out-ofpocket loss since he has not performed and can maintain an action for damages under Article 2.3 Thus, the holder is
not made worse off by failing to confer on him or her the status of holder in due course. At the same time, because
the holder in due course can cut off claims and defenses, the obligor on an instrument who has a defense against
payment would be unnecessarily disadvantaged by conferring due course status on the holder who has only made
an executory promise in return for the instrument. A common illustration is the bank credit not drawn upon, which
can be and is revoked when a claim or defense appears. The holder would suffer only where the executory promise
consisted of giving a negotiable instrument (for which the holder presumably parted with value) or making an
irrevocable commitment to a third person. Thus, those situations will constitute value under Section 3-303.
In short, since the holder who seeks to take advantage of due course status to overcome claims or defenses will
typically be enforcing the instrument against an innocent maker or drawer, little reason exists to require payment
where the holder neither has nor is required to incur a loss in exchange for the instrument. The less extensive
transfer warranties of Article 7 and thus the greater necessity for affording a holder of a document title the status of
a holder by due negotiation explains the broader definition of value employed with respect to such an instrument.4
Value under Article 3 should also be distinguished from consideration. The latter term is defined to include
any consideration sufficient to support a simple contract.5 Essentially, this incorporates the definition of value
outside of Article 3. The concept of consideration does little work within Article 3, however. A drawer or maker of a
note will have a defense against payment if no consideration was given for the instrument, but that defense will not
be effective against a subsequent transferee who has given value for the instrument and otherwise qualifies as a
holder in due course. As against one who has given neither value nor consideration, no special Article 3 rights are
necessary to avoid payment. Article 3 makes clear that any issuance of an instrument for value automatically
constitutes issuance for consideration.6 Thus, assume that obligor owes $500 to obligee and that the debt is not
evidenced by any instrument. Subsequently, obligee requests and obtains from obligor an instrument that testifies to
the debt. That instrument has been issued for value since it is issued for an antecedent claim.7 Hence, it is also
issued for consideration, even if the pre-existing obligation would not qualify as consideration under contract law.
[1]
A Holder Takes an Instrument for Value Only to the Extent That the Agreed Consideration Has Been
Performed
A holder takes an instrument for value to the extent that the promised consideration has been performed.8
(Promise, for these purposes, is used in its ordinary language sense, rather than in the specialized Article 3 sense
of Section 3-103.) This provision has permitted the courts to hold, in effect, that there can exist such an entity as a
partial holder in due course. Thus, in Halbert v. Horton,9 the plaintiff paid $8,000 and promised to cancel a $12,000
debt in return for defendants $20,000 check. The $12,000 credit was contingent on the $20,000 check being paid
by the drawee bank. The drawee, however, dishonored the check and suit was brought to recover on the $20,000
instrument. The court ruled that the $12,000 credit was not given, that an executory promise to give value is not
itself value under Article 3, and that the amount of consideration given for the check was $8,000. The court
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concluded that under Section 3-303(a) the plaintiff was a partial holder in due course, and entered judgment in the
amount of $8,000.
Potential difficulties arise where instruments are purchased at a discount. If a $1,000 note is sold for a contract price
of $900 to a holder who otherwise qualifies as a holder in due course, to what extent does the holder attain due
course status if only $450 has been paid at the time he or she brings a claim against the maker? One may argue
either that the purchaser has given value to the extent of the $450 outlay, or that the value has been given to the
extent of 50% of the obligation, entitling the holder to due course status for $500. In O.P. Ganjo, Inc. v. Tri-Urban
Realty Co.,10 the court declared the holder to possess due course status for a pro rata share of its discount as well as
the dollar amount of its payment. In that case, a holder had paid $1,000 of an agreed $2,800 for a note with a face
value of $3,000. The court found the holder had due course rights to the extent of $1,000, plus 1,000/2,800 of the
$200 discount, or an additional $71.43. Article 3 now clearly supports this result, which grants the holder in due
course the benefit of his or her bargain. Section 3-302(d) provides that if a promise of performance that is the
consideration for the instrument has only been partially performed (so that the holder will not be considered to have
given value for the entire amount), the holder may assert rights as a holder in due course only to the fraction of
the amount payable under the instrument equal to the value of the partial performance divided by the value of the
promised performance.11 Where the holder has purchased the instrument at a discount, this ratio will provide the
holder with the rights of a holder in due course for an amount greater than the amount that would be derived simply
by dividing the value of the partial performance by the face amount of the instrument.
The interaction of Section 3-303(a) with the other requirements of Section 3-302 is demonstrated by the following
hypothetical. Assume that on January 1, H agrees to purchase from X a $6,000 note made by M for face value,
payable in three equal monthly installments. On January 1, H pays X $2,000; on February 1, H pays X an additional
$2,000. On February 15, H receives notice that M has a defense to payment that would be valid against X. On
March 1, H pays X the final $2,000. H will be a holder in due course only to the extent of $4,000. Since all the
elements of Section 3-302 must be satisfied to assert due course status, and H obtained notice of a defense at a time
when H had only paid $4,000 in value, H cannot subsequently improve its position by giving additional value.
[2]
A Holder Takes an Instrument for Value if the Holder Acquires a Security Interest in or Lien on the
Instrument
One who acquires a security interest in or a lien on an instrument other than by legal process takes the instrument
for value.12 Thus, a secured creditor under Article 9 who extends credit and receives an instrument as collateral
may enforce the instrument as a holder in due course.13 Value is limited to the extent of the security interest or
lien.14 A person, therefore, can become a holder in due course by taking an instrument as collateral for a current
debt or purchase only to the extent of the unpaid current debt or purchase.15 The most important aspect of taking
for value by acquiring a security interest, however, lies in the application of this provision to banks. Although a full
elaboration of this application is beyond the scope of this chapter, a brief summary here may be useful.
Section 4-211 of the Code provides that a bank gives value for purposes of determining its status as a holder in due
course to the extent that it has a security interest in the item.16 The banks security interest, however, does not
usually arise as a result of an Article 9 secured transaction. Instead, Section 4-210 describes various ways in which
a bank obtains a security interest in an item.17 The effect of this section can be understood by examining the typical
situation in which a depositary bank receives a check for deposit from one of its customers. At the time that the
deposit is made, the customer may not be entitled to withdraw the funds as of right. That right will be conferred
either by the act of payment of the check by the drawee bank,18 or the passage of time that finalizes payment,19 or
the passage of a period under federal law that requires the bank to make funds available to its customer.20 At this
point, Section 4-210(a)(2) states that the depositary bank has a security interest in the deposited check, even if the
funds remain on deposit with the bank.
Although the customer of the depositary bank is not entitled to withdraw deposited funds as of right before the
drawee bank pays the check or the bank is statutorily required to make the funds available to the customer as of
right, a bank may permit withdrawal at some earlier point; such a practice is not uncommon. Should this occur, the
Code deems the withdrawn funds to be those of the depositary bank itself, and the bank obtains a security interest
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in the check to the extent of the withdrawn funds.21 Thus, a depositary bank that permits its customer to withdraw
funds prior to the time that the check has been paid not only provides a service to the customer, but also makes
itself better off by giving the value necessary to attain due course status. There seem to be valid reasons to protect
a bank with respect to advances and payments it may actually have made against items.22 The ability of a bank to
transform itself into a holder in due course by allowing withdrawals against uncollected funds, however, is more
vulnerable to criticism. Assume that Buyer purchases goods from Seller, giving a check drawn on First Bank in
return. Seller deposits the check in Second Bank. First Bank subsequently dishonors the check, because its
customer, Buyer, has issued a stop payment order on discovering defects in the goods that were the subject of the
underlying transaction. Second Bank, in the meantime, has permitted Seller to withdraw the funds represented by
the check. When Second Bank receives the check back from First Bank, it may bring a Section 3-414 action against
Buyer on her drawers contract. If we allow Second Bank to attain the status of a holder in due course, Buyer will
be unable to assert Sellers fraud as a defense in this action. Nevertheless, Second Bank arguably was in a superior
position to avoid the loss that Buyer now will suffer. Second Bank did not have to permit the withdrawal of funds
by its customer, Seller. Further, if Seller was a customer of Second Bank and Buyer was only an occasional or onetime customer of Seller, then Second Bank would have been in a better position to monitor Sellers conduct to
avoid fraudulent transactions. Second Banks incentive to take advantage of this position is obviously reduced if it
can enforce the check regardless of any underlying fraud. One may object, however, that it is better policy to allow
all customers to have ready access to their funds, which depositary banks are more likely to do if they attain holder
in due course status under these circumstances, than to increase depositary banks incentives to avoid the occasional
case of fraud. Of course, this response assumes that banks would, in fact, cease to allow discretionary withdrawals
if they did not have the benefit of holder in due course status. Banks might not take that drastic step; they might
instead limit the discretionary availability of uncollected funds to customers with good credit.
Finally, a bank will have a security interest in an item to the extent that it makes an advance on or against the
item.23
[3]
A Holder Who Takes an Instrument in Payment of or as Security for an Antecedent Claim Takes for
Value.
Where an instrument is taken in payment of an antecedent claim, the person taking it gives value.24 A most
common application of this section providing that an instrument is transferred for value when it is transferred as
payment of an antecedent claim, is when an instrument is received in payment of an outstanding loan obligation.25
Thus, if one party indorses and delivers a negotiablecertificate of deposit in exchange for a receipt which evidences
the indorsees claim against the indorser with the intent of extinguishing the antecedent debt, the indorser becomes
a holder for value of the certificate.26
A holder also takes for value when the instrument is taken as security for the payment of an antecedent claim
against any person, without regard to whether the claim is due,27 and even though there is no extension of time or
other concession involved.28 At least one court has held that this is true despite the holders knowledge that the
purpose of the transfer is to defraud other creditors.29
[4]

A Holder Takes for Value When Negotiable Instruments Are Exchanged

The Code provides that value is given when negotiable instruments are exchanged.30 This provision serves as an
exception to the general rule that executory promises of which negotiable instruments are evidence do not
constitute value.31 The stated reason for construing the giving of a negotiable instrument as giving value is that the
instrument may be negotiated to a holder in due course who may enforce the instrument against the obligor.32
In Bankers Trust Co. v. Wagner,33 a mortgage company, to whom notes were payable in connection with a loan and
several mortgages, sold the loans to a bank. The bank sent notices to the maker to thereafter make payments to the
bank. The maker defaulted, and the banks filed a suit to foreclose and then moved for summary judgment on the
complaint. The maker asserted claims based upon fraud and misrepresentation. The bank claimed holder in due
course status. With respect to the issue of value, the court held that the bank had given value for the note as it was
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exchanged for a negotiable instrument, by the purchase of the mortgages and the security interests in the real
property, that were done in the course of business of the bank.
[5]

A Holder Who Makes an Irrevocable Commitment to a Third Person Takes for Value.

Section 3-303(a)(5) provides another exception to the general rule that executory promises do not constitute value.
If the holder takes the instrument in exchange for making an irrevocable commitment to a third person, value has
been given. Official Comment 5 to Section 3-303 indicates that the section is meant to cover such cases as the
issuance of a letter of credit when an instrument is taken. Yet one could apply the rationale to the following
situation. Assume X gives Y a note in exchange for Ys promise to provide goods that Y must purchase from Z. If Y
has entered into an irrevocable contract with Z to purchase the goods at the time Y learns that the maker of the note
has defenses to payment, Y may still qualify as a holder who has given value for the instrument.
If the holder makes funds available to a third person at the transferors direction, the holder has made an irrevocable
commitment and given value for the instrument. In Ashburn Bank v. Childress,34 plaintiff banks sued to recover on
demand notes issued to the defendant for the purpose of making funds available to a corporation of which the
defendant was an officer and shareholder. The funds were made available to the corporation in the form of a bank
deposit with the knowledge and consent of the defendant. The court held that the plaintiffs had given value because
they made an irrevocable payment of consideration to a third person, the corporation, at the defendants direction.35
In order to constitute value, the commitment must be irrevocable. Thus, the delivery of stock certificates to an
escrow agent pursuant to an agreement for the sale of the stock was held to constitute an irrevocable commitment
by the seller where the stock in escrow was beyond the power and control of the seller and where there remained no
act for the seller to complete delivery.36
Another court37 has held that the commitment must be simultaneous with the holders taking of the instrument. The
plaintiffs car was wrecked while being driven by a friend with the plaintiffs permission. The friends insurer
issued a draft payable jointly to its insured and the plaintiffs mother, the record title holder of the car. Both payees
indorsed the draft to the plaintiff. The plaintiff deposited the draft and drew a postdated check on its amount which
he gave to a dealer in payment for a new car. The insurer stopped payment on its draft when it learned that it was
not liable. The court held that the plaintiff did not take the draft for value because there was not an irrevocable
commitment to a third person within the meaning of Section 3-303. That section, according to the court,
contemplates a simultaneous transaction a commitment to a third person made when the holder takes the
instrument.38 The commitment may not be made at a point subsequent to the taking of the instrument.
The Code offers no indication that the commitment must be simultaneous with the transfer of the instrument and
the court failed to cite any authority for its position. Indeed, the courts interpretation is inconsistent with the notion
that partial value may be given under Section 3-303(a) at successive times as the holder continues performance.
Nevertheless, it does seem reasonable to require that the transfer of the instrument and the making of the
commitment be at least related in the sense that they are both elements of one transaction. The court found no
indication that the plaintiffs commitment to the dealer was made at the transferors direction or even with their
understanding. It was a transaction unrelated to the transfer of the instrument and the court reasonably held that
value was not given.

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Rene Tierney

20.06 A Holder in Due Course Must Take an Instrument in Good Faith*

To qualify as a holder in due course, the holder must take the instrument in good faith.1 The current version of
Article 3 applies an objective standard of good faith, rather than a subjective one that depends on the actors state of
mind or actual beliefs. Given the judicial development of the good-faith requirement, however, the distinction
between objective and subjective views of good faith is likely to make little substantive difference.2
Earlier versions of Article 3 incorporated the subjective definition of good faith that was provided in Article 1. That
definition provided that good faith consisted of honesty in fact in the conduct or transaction concerned,3 a
concept sometimes referred to as the test of the pure heart and the empty head.4 The original drafters of the Code
had rejected an objective standard, espoused by the early case of Gill v. Cubitt,5 in favor of one that asked whether
the transferee of the instrument acted honestly. Thus, the transferees possible negligence, as where a bank gives a
customer with an overdrawn account credit for a check prior to collecting proceeds from the drawee, was irrelevant
to the issue of the banks good faith.6 Similarly, failure to inquire into suspicious circumstances or the basis for a
particularly inexpensive price did not necessarily indicate a lack of good faith.7
Good faith has been construed as the absence of bad faith8 or an honest intention to abstain from taking an unfair
advantage of another.9 Bad faith generally means actual bad faith by a subjective test of honesty, not an objective
test of diligence.10
Nevertheless, even under the subjective standard, some objective elements necessarily infiltrated the inquiry into
good faith. If by no other means, objectivity comes into play when a jury asks itself whether the party claiming to
have taken in good faith did in fact actually believe that the transaction was untainted. A lay jury is likely to answer
this question by whether any reasonable person under the circumstances could have held the belief claimed by the
holder. Thus, in Funding Consultants v. Aetna Casualty & Surety Co.,11 the court directed the trial court to admit
expert testimony to show what the value of a note would have been to a reasonable commercial party, allowing the
jury to compare that price to the price paid by the holder. The court concluded, The price actually paid, the present
value of the instrument actually bought, are elements which may be considered in determining a holders good
faith.
Article 3 now avoids the conflict between the idyllic appeal to subjectivity and the inevitable resort to an objective
standard. Instead, Section 3-103(a)(4) explicitly incorporates an objective test by providing that good faith
means honesty in fact and the observance of reasonable commercial standards of fair dealing. Thus, a holder who
takes an instrument under conditions that would violate reasonable commercial standards will not have acted in
good faith, even if the holder had no personal reason to suspect any lack of integrity in the underlying transaction.
Therefore, good faith now encompasses two distinct elements and a new standard: the element of commercial
standards is an objective test, while honesty in fact is a subjective test.12 Fair dealing, however, is not
equivalent to the absence of negligence. The Official Comment to Section 3-103(a)(4) indicates that fair dealing is
a broad term that must be defined in context, [but] it is clear that it is concerned with the fairness of conduct rather
than the care with which an act in performed. Failure to exercise ordinary care in conducting a transaction is an
entirely different concept than failure to deal fairly in conducting the transaction.13 Indeed, ordinary care is
defined in Section 3-103(a)(7) as the observance of reasonable commercial standards. Since that requirement
already exists in the new Article 3 definition of good faith, it would seem clear that fair dealing requires
something else. Just what that conduct comprises and the sources to which courts will look to complete the
definition remains to be seen. Potential sources of information about fair dealing are the customary practices of
the trade that actually exist in the area, or customary practices of the trade that the court believes should exist in the
area.
Other circumstances may also vitiate the holders claim of good faith. In a variety of cases involving consumer
transactions, courts have held that long-standing relationships between financiers and commercial sellers have
given the former sufficient information of the latters untoward practices that continued acceptance of instruments
made payable to the sellers could not occur in good faith. This close-connectedness doctrine14 has been codified
in the Federal Trade Commissions rulings eliminating holder-in-due-course rights in many consumer
transactions.15 It is applied less stringently in transactions between commercial actors.16 The rule seems to be
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justified by the notion that, as between the holder and the maker or drawer of the instrument, the holder by virtue
of its association with the payee is in the superior position to deter or detect fraud. This presumption does not
hold in other transactions, in which the holder who is not closely connected to the payee is unlikely to have
information superior to that of the maker or drawer concerning potential fraud or warranty claims in the underlying
transaction.17
Generally, what creates a transfer in bad faith is the holders knowledge that the transaction that generated the
instrument, or the instrument itself, is tainted.18 Thus, the question of good faith is inextricably entwined with the
question of notice.
The operation of the good faith requirement is exemplified in Buckeye Check Cashing, Inc. v. Camp.19 A check
casher cashed a post dated check; it did not verify the availability of funds, nor take any other action. The court held
that it should have made some attempt at verification before cashing a post-dated check. The court observed that the
check casher satisfied the honesty in fact portion of good faith, but it failed to satisfy the portion that requires it
to act in a commercially reasonable manner because it took no action to discover if the post-dated check was valid.
The nature of a post-dated check required the check casher to take minimal steps to protect its interests. This was
not done. [The check casher] was put on notice that the check was not good until [its date]Good faith,
requires that a holder demonstrate not only honesty in fact, but also that the holder act in a commercially
reasonable manner. Without taking any steps to discover if the post-dated check issued was valid, [the check casher]
failed to act in a commercially reasonable manner, and therefore, was not a holder in due course.
In Gerber & Gerber, P.C. v. Regions Bank,20 the employee of a law firm stole checks payable to the law firm,
forged the indorsements, and deposited the checks to her personal account, maintained at the bank where the law
firm maintained its account. First, the court noted the general rule that it is not a reasonable commercial banking
practice, as a matter of law, for a bank to fail to inquire when a person cashes a check payable to a corporate payee,
but deposits the proceeds in his or her personal account. The bank, because it maintained the law firms account,
also knew that the law firm normally used a restrictive indorsement stamp on checks payable to it, so that it was
on heightened notice of the irregularity of the indorsements on the checks deposited by [the employee]. A fact
question existed, therefore, as to whether the bank violated the reasonable commercial standards of fair dealing
when it violated these known commercial banking practices by permitting the employee to deposit the checks to her
personal account. Under these facts, it could be held that the bank dealt unfairly with the law firm by failing to
make inquiry into whether the indorsements were legitimate. This was a fact question for the jury so that the banks
motion for summary judgment was denied.
The 2002 Revision creates additional statutory rights for consumers. It adds to Section 3-305 new subsections (e)
and (f). The first provides that if an instrument is required by another law to bear a statement making the rights of a
holder or transferee subject to claims or defenses that could have been asserted against the original payee, but the
instrument fails to include such a legend, the instrument will be treated as if the statement had been inserted, and
the issuer will be able to assert against the holder or transferee all claims and defenses that would have been
available had the statement been included. Subsection (f) makes all of Section 3-305 subject to law other than
Article 3 that establishes contrary rules for consumer transactions. Section 3-103(a)(3) defines consumer
transaction as a transaction in which an individual incurs an obligation primarily for personal, family, or
household purposes.

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Rene Tierney

20.07 Notice as an Element of Holder in Due Course Status*

[1]

The Importance and Definition of Notice

To qualify as a holder in due course, one must take the instrument innocent of any underlying wrongdoing or
peculiarities with respect to the instrument or the underlying transaction from which it was generated. This
requirement is delineated in Article 3 by requiring that a holder in due course take the instrument without notice (1)
that it is overdue or has been dishonored or that there is an uncured default with respect to payment of another
instrument issued as part of the same series; (2) that the instrument contains an unauthorized signature or alteration;
(3) of any claim to the of a property or possessory right in the instrument or its proceeds; or (4) that any party has a
defense or claim in recoupment.1
The concept of notice as used in Section 3-302 requires some attention to the definition of that term in Section 1201(25). That definition combines a mixture of subjective and objective elements. Thus, a person is held to have
notice of a fact when that person has actual knowledge of it or has received a notice or notification of it.2 These
requirements suggest a subjective standard that would prevent the imputation of notice to a party who did not, in
fact, have the requisite knowledge. Section 1-201(25)(c), however, appears to relax the subjective standard. It
provides that a person has notice of a fact when, from all the facts and circumstances known to him at the time in
question he has reason to know that it exists.3 This suggests that notice of a fact can be imputed to a person who
does not in fact have actual knowledge of it, but should have notice given the underlying knowledge within the
persons possession. Even this part of the definition has a subjective element. However, knowledge of the
underlying facts exists only when a person has actual knowledge of them.4
To be effective for purposes of denying the holder due course status, the notice must be received at such time and in
such manner as to give a reasonable opportunity to act on it.5 More importantly, the relevant point at which to
determine the existence of notice for purposes of due course status is the time at which the instrument is taken by
the holder.6 Section 3-302 clearly defines a holder in due course as of the time one takes the instrument.
Subsequent notice of a defense to payment will not retroactively deny due course status to a holder who originally
took without notice.7 Recall, moreover, that one who takes with notice may still have the rights of a holder in due
course under the shelter principle if the transferor was a holder in due course or had the rights of a holder in due
course.
[2]

Notice Within An Organization

Different persons within an organization may have different information about an instrument or about facts
concerning the instrument. Thus, where the party who claims holder in due course status is an organization rather
than an individual, it is important to determine what information in the hands of employees can be attributed to the
organization. The Code provides that notice or knowledge received by an organization is effective for a particular
transaction when it is brought to the attention of the individual conducting that transaction, or when it would have
been brought to the attention of that individual if the organization had been exercising due diligence.8 For these
purposes, an organization exercises due diligence if it has procedures for communicating significant information to
the person conducting the transaction and there is reasonable compliance with those procedures. Due diligence,
however, does not require one individual within the organization to communicate information to another person
unless that communication is part of his or her regular duties, or unless he or she knows that the transaction is
occurring and that the transaction would be materially affected by the information.9
Assume, for instance, that P is the payee of a note in the amount of $10,000, and issued by M. P wishes to discount
the note to First Bank for $9500. The clerk at First Bank who is handling the transaction is aware that M has
complained that P received the note in return for goods of substandard quality and that M has said he does not
intend to pay the note when it is presented. That information is attributable to First Bank, which will be deemed to
have notice of a defense to payment. If a teller at First Bank with no responsibility for the transaction had the same
information, it is unlikely that the bank would be deemed to have notice of the defense.

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In American Fed. Sav. & Loan Assn v. Madison Valley Properties, Inc.,10 Bank A, that had received a cashiers
check in payment of a loan, secured by personal property with a security interest, was notified by telephone by
Bank B that issued the cashiers check that it was issued through a fraud (the check used to purchase the cashiers
check was stolen and bore a forged indorsement). The notice was taken by the person at Bank A who handled the
transaction, so that it was effective as to Bank A, having been brought to the attention of the individual conducting
the transaction.
[3]

When Is An Instrument Overdue?

Section 3-304 indicates when an instrument is overdue. Unlike prior law, the current version of Article 3 divides the
overdue issue into separate inquiries with respect to demand and time instruments. A transferee of an instrument
who has notice at the time of transfer that any of the events that render an instrument overdue has occurred will
preclude that transferee from taking as a holder in due course.11
Any demand instrument becomes overdue on the day after the day demand for payment is properly made.12 Hence,
any party who takes an instrument after that time with notice of the demand cannot be a holder in due course, even
if that party is willing to allow the obligor additional time to make payment. Even without a demand for payment, a
demand instrument, which is not a check, becomes overdue after it has been outstanding for an unreasonably long
period of time.13 Reasonableness for these purposes must be defined in terms of the circumstances of the
particular case, taking into consideration both the nature of the instrument and usage of trade in which the
instrument is used.14 Thus, a sight draft, which is expected to be cashed immediately might become stale in a
relatively short period of time, while a demand note that is given as security for some long-term obligation may not
become stale until performance of that obligation is expected. This reasonable length of time, which also marked
the period before which a demand instrument was overdue under prior law,15 is less flexible in the case of a check.
Checks become overdue 90 days after their date.16 Since checks may be postdated, however,17 the 90-day period
is not necessarily triggered by issuance.
The point at which instruments that are payable at a definite time become overdue depends on the nature of the
instrument and the existence of an acceleration. If the principal of the instrument is payable in installments and a
due date for any installment has not been accelerated, the instrument becomes due when a default for nonpayment
of an installment has occurred. Should payments subsequently become current, however, the instrument is no
longer overdue.18
If the principal is due in a single payment and no acceleration has occurred, the instrument becomes overdue on the
day after the maturity date stated on the instrument.19 Hence, no one who takes the instrument after that date can
attain the status of a holder in due course. Thus, if an instrument is payable on a fixed date or within a definite
period after a fixed date, taking the instrument after such fixed date or period is taking with notice that the
instrument is overdue.20 Similarly, if a purchaser has reason to know that an instrument payable at a fixed period
after sight has been presented for payment, the purchaser takes with notice that the instrument is overdue if the
period fixed for payment has elapsed since the presentment. A holder who has knowledge that a prior holder
brought suit on the instrument has been deemed to have knowledge that it was overdue.21
If a due date with respect to principal on an instrument payable at a definite time has been accelerated, the
instrument becomes overdue on the day after the accelerated due date.22 The provision within the instrument that
acceleration may occur, of course, does not of itself render the instrument non-negotiable for failure to be payable
at a definite time.23 Defaults in payment of interest, both under the Pre-Revision and under the current version, do
not make a note overdue.24
[4]
Purchasers Who Take With Notice That the Instrument Has Been Dishonored Cannot Be Holders in
Due Course
If an instrument is purchased with notice that it has been dishonored, the purchaser cannot be a holder in due
course.25 An instrument is dishonored when, on a proper presentment, the maker or drawee refuses to pay or
accept.26 But if the instrument is not properly presented, e.g., an endorsement is missing at the time that payment is
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demanded, the obligor on the instrument has a right to refuse to pay and, consequently, a refusal in such an instance
does not constitute a dishonor.27
The only reference to notice of dishonor for due course purposes is found in Section 3-302. Section 3-302
provides that one must take the instrument without notice that [it] has been dishonored [emphasis added]. The
word notice is used as it is defined in Section 1-201(25),28 that is, actual knowledge,29 notification,30 or reason
to know.31
[5]
Purchasers Who Take With Notice of a Defense or Claim to the Instrument Cannot Be Holders in Due
Course
[a]
Defense or Claim Defined
To qualify as a holder in due course, the holder must take the instrument without notice of any claim to the
instrument on the part of any person32 or of any defense or claim in recoupment.33 Defenses relate to contractual
liability on the instrument while claims relate to possible property rights of third parties in the instrument.34 Claims
in recoupment deal with situations such as where the obligee under the instrument has performed and the obligor
has accepted the performance, but the obligee has breached a warranty, entitling the obligor on the instrument to
redress.35
[b]
Voidability or Discharge of Obligation on Instrument
The current version of Article 3 omits a provision in earlier versions that attributed notice of a claim or defense to a
holder of an instrument who had notice that the obligation of any party to the instrument was voidable in whole or
part.36 No reference was made to defenses that rendered the instrument void because such defenses could be
asserted even against a holder in due course.37
Additionally, unlike prior law, the current version of Article 3 provides that discharge is not a defense, with the
exception of discharge in bankruptcy proceedings, which is specifically included in the list of real defenses that can
be asserted against all holders.38 Instead, notice of a discharge is effective against the holder seeking to enforce the
instrument even as a holder in due course.39 Having notice of discharge, however, does not preclude one from
being a holder in due course, even if that holder cannot enforce the instrument against the discharged party. The
difference, and its importance, may be illustrated by the following case. Assume that payee indorses a check and
negotiates it to H, a holder. H then has the instrument certified by the drawee bank and negotiates it to X, who takes
the instrument in good faith and for value, but knows that it has been certified after the payee indorsed. The payee
has been discharged by the certification.40 Thus, the fact that X knew of the existence of the indorsement at the
time of the certification confers notice of discharge on X. Nevertheless, X can still be a holder in due course of the
certified instrument.
[c]
Breach of Duty by Fiduciary
A holder of an instrument may also be denied holder in due course status if he or she has notice that the instrument
was negotiated in breach of a fiduciary duty. Section 3-307(a) defines fiduciary as an agent, trustee, partner,
corporateofficer or director, or other representative owing a fiduciary duty with respect to an instrument.41 The
Section then creates a series of rules for determining when one who takes an instrument will be deemed to have
notice of a breach of fiduciary duty.42 The possibility that a taker of the instrument will be deemed to have notice
of a breach of fiduciary duty is triggered by the occurrence of any of three events: (1) taking an instrument from a
fiduciary for payment, collection or value; (2) taking the instrument with knowledge that the transferor is acting as
a fiduciary; and (3) the assertion of a claim to the instrument or its proceeds by the person to whom the fiduciary
duty is owed (the represented person) on the grounds that the transaction of the fiduciary was in breach of
fiduciary duty.43 When any of these conditions is met, the transferee will be deemed to have notice of the claim to
the instrument if he or she has notice of an actual breach of fiduciary duty. Presumably, this notice must be related
to the transfer of the instrument rather than to some unrelated breach. A taker with knowledge of such a claim, of
course, cannot be a holder in due course of the instrument.44
Additionally, one who takes an instrument that is payable to the represented person or to the fiduciary in his or her
fiduciary role may be charged with notice of the breach of fiduciary duty under certain conditions. Notice will be
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imputed if the instrument is taken in payment for or as security for a debt known by the party taking the instrument
to be of a personal debt of the fiduciary, taken in a transaction known by the taker to be for the personal benefit of
the fiduciary, or taken for deposit to an account other than an account naming the transferor as fiduciary or naming
the represented person.45
The mere fact that the represented person or the fiduciary in his or her trust capacity has issued an instrument to the
fiduciary in his or her personal capacity does not, without more, constitute notice of the breach of fiduciary duty.46
That something more, however, will exist if the instrument is taken by the payee under the same conditions that
would provide notice to a taker that an instrument payable to the represented person or the fiduciary in his or her
fiduciary capacity was transferred in breach of fiduciary duty.47 Assume, for instance, that a corporate treasurer
drew a corporate check to his or her own order and sought to use the check to pay a personal loan at the drawee
bank. Even if the drawee bank had notice that the treasurer was a fiduciary for the corporation, that fact of itself
would not constitute notice of the breach of fiduciary duty. Assume, however, that the treasurer drew a corporate
check to the order of the drawee bank and sought to use the instrument to pay a personal loan at the drawee. Now, if
the drawee bank had notice that the treasurer was a fiduciary for the corporation, it would also be charged with
notice that use of the check in this manner was in breach of fiduciary duty. The underlying assumption is that while
it is not unusual for a represented party to draw checks to a fiduciary in his or her personal capacity, it is unusual for
the represented party directly to pay the debts of the fiduciary.
Practical Hint:
Numerous states have adopted the Uniform Fiduciarys Act (also referred to, and titled in some states, the Fiduciary
Obligations Act).48 This Act governs essentially the same situations as covered in Section 3-307 and provides
similar rules. Accordingly, many cases that have considered these situations have applied the Uniform Fiduciarys
Act, not the Code. The conclusions reached in these cases, generally, would be the same as if the Code section had
been applied.49
[d]
Knowledge That Does Not Constitute Notice of a Defense or Claim
Prior versions of Section 3-304(4) listed a number of facts of which the purchaser could have knowledge without
having notice of a defense or claim. While many of these specific statements are omitted from the current version
of Article 3, there is no reason to believe that the law of notice has changed with respect to them. The fact that an
instrument is known to be antedated50 or postdated51 does not prevent a holder from taking in due course.52
Similarly, knowledge that any party to the instrument signed for accommodation did not constitute notice of a
defense or claim.53
Notice of the existence of an executory promise or of a separate agreement also should not preclude holder in due
course status.54 This is true even if the notice appears in the instrument itself.55 If, however, the purchaser has
notice of any default in the promise or agreement that gives rise to a defense or claim against the instrument, the
purchaser is deemed to be on notice to the same extent as in the case of any other information with respect to the
existence of a defense or claim.56
Prior law specifically provided that knowledge that an incomplete instrument had been completed did not give
notice of a claim or defense unless the purchaser had notice that the completion was improper. Thus, a holder may
take in due course even though a blank is completed in the holders presence as long as the holder does not have
notice that the completion is improper.57 An authorized completion will not constitute a material alteration and the
instrument will be enforceable as completed.58
Knowledge that any person negotiating the instrument is or was a fiduciary does not of itself give the purchaser
notice of a defense or claim.59 If the purchaser knows that the fiduciary has negotiated the instrument in breach of
duty, however, such knowledge will constitute notice barring holder in due course status.60
[e]
Notice in New York and the Doctrine of Forgotten Notice
The Uniform Commercial Code, as enacted in New York, adds a subsection (7) to Section 3-304, which reads:

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In any event, to constitute notice of a claim or defense, the purchaser must have knowledge of the defense or
knowledge of such facts that his action in taking the instrument amounts to bad faith.
The added provision was meant to preserve the standard followed by the New York courts under the Negotiable
Instruments Law.61 The section was apparently intended to have specific application with respect to notice to
organizations.62 In particular, the section seems to revive the question of forgotten notice. The doctrine of forgotten
notice was first enunciated in Raphael v. Bank of England.63 In that case, notice of the theft of a certain note had
been given to a bank. The bank subsequently accepted the note for value and contended that it had forgotten the
notice. The court held that a jury question existed as to whether the bank had forgotten the notice and that such a
lapse of memory, if established, would constitute mere negligence which would not destroy the banks status as a
holder in due course. The forgotten notice doctrine was later adopted by the United States Supreme Court in a case
construing the Illinois Negotiable Instruments Law.64
The doctrine, though designed to promote negotiability, understandably received much criticism and its application
has not always been consistent. For example, one case held that the doctrine did not apply where the bank official
who received the notice gave his assurance that the instrument would not be discounted.65
The Codes application of an objective standard to the definition of notice implicitly rejects the doctrine of
forgotten notice. Where notice of a claim or defense is received and subsequently forgotten, the holder is precluded
from being a holder in due course. Apparently, however, this is not necessarily the result in New York. Under
subsection (7), there is no notice of a claim or defense, unless the holder has such knowledge that his action in
taking the instrument amounts to bad faith.66 Thus, notice received but innocently and negligently forgotten will
not constitute notice of a claim or defense. This view adopts the subjective standard of notice, notwithstanding the
more objective language of reason to know in Section 1-201(25)(c).67
The New York provision is arguably difficult to justify. It is certainly inconsistent with the policy of placing losses
on the party best positioned to avoid them. Once a party has received notice, others may be induced to rely on that
fact. Where the holder is entitled to recover on a doctrine of forgotten notice, that reliance will have been
unfortunately misplaced.68
[6]

Purchasers Who Take Instruments Bearing Irregularity Cannot Be Holders in Due Course

Section 3-302(a)(1) provides that no one can be a holder in due course of an instrument that, when issued or
negotiated to the holder, bears such apparent evidence of forgery or alteration, or is otherwise so irregular or
complete as to call into question its authenticity.69 Thus, although the Code does not use the term notice with
respect to irregularities in the instrument, holders will be charged with notice of any material irregularities,
forgeries, or alterations that the instrument may bear. The use of the phrase authenticity is intended to clarify an
issue left unresolved under prior law. If the irregularity would give a purchaser reason to believe that the instrument
is something other than what it purports to be, the fact that the defense raised is unrelated to the irregularity of the
instrument is irrelevant. Thus, assume that the amount of a check is written over what appears to be an erasure,
sufficient to constitute notice of an irregularity, but that the amount written in is, in fact, the proper amount. If the
drawer subsequently wishes to avoid payment for some defect unrelated to the amount of the check, e.g., the goods
paid for with the check were unmerchantable, and of which the holder had no notice, can the drawer deny due
course status to the holder on the basis of the erasure? In short, can one be denied due course status on grounds
relating to one defense when the holder had notice only of an unrelated and nonasserted defense? A significant
amount of opinion suggested that once a holder is denied due course status for one reason, the holder is denied that
status for all reasons. Thus, the holder cannot claim to be a holder in due course of an instrument simply because a
defense of which the holder had no notice was the only one raised. The holder in due course, who obtains such
substantial rights by virtue of that status, should not be favored and should instead be required to meet strict
standards of compliance with Section 3-302. Article 3 reaches this result by denying holder in due course status
altogether (i.e., wholly apart from specific claims or defenses) once the authenticity of an instrument is called into
question.

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Not every irregularity on an instrument will place authenticity into question, however. Assume, for instance, that H
is the transferee of a check bearing the date January 3, 2004, and that the 2004 term appears to be written over
an erasure. Since it is common for individuals to make misstatements of dates at the beginning of a year, the erasure
would not necessarily raise suspicions about a forgery or alteration. The same erasure on an instrument purporting
to be dated November 30, 2004 would be more likely to raise questions.
The decision in Hartsock v. Richs Emples. Credit Union70 is instructive in interpreting this section. The court
acknowledged that a person cannot become a holder in due course by taking an instrument that is materially
irregular on its face. An instrument would be irregular where it contains apparent insertions or erasures or the
apparent alteration of the name of the payee. Under the facts of this case, that involved an alteration of the name of
the payee, the face of the check contained mismatched fonts. The font of the payee name and address was different
from the font of the amount of the check. The payee address also contained a misspelling of the name of the town,
and when examining the check, one could see a whiteout or rub-off and a slight fade to the checks light blue
background in the payee and payee address sections. Based upon this evidence, the court concluded that a genuine
issue of material fact existed as to whether the check [bore] such apparent evidence of forgery or alteration as to
call into question its authenticity.
In order for the incompleteness, evidence of forgery or alteration, or irregularity to prevent a holder from being a
holder in due course, the defect must call into question the authenticity of the instrument.71 Doubt could arise as a
result of ambiguity in the terms or ownership of the instrument or ambiguity as to who is entitled to payment. Thus,
an ambiguity concerning the due date of a note may provide notice of irregularity.72 However, the fact that the
amount written in words is different from the amount written in figures does not put a purchaser on notice that the
instrument is irregular.73 The ambiguity is resolved by Section 3-114 which provides that the words control.
Although the concept of irregularity appears primarily concerned with defects or deficiencies that are apparent on
the instrument without reference to extrinsic facts, e.g., incompleteness or alteration, the section does not
contemplate purely intrinsic irregularities.74 Thus, an instrument which is otherwise irregular may preclude the
holder of the instrument from qualifying as a holder in due course.75 For example, an instrument may be irregular
because it fails to conform to some special custom or usage. In such a case, the burden of proving the existence of
such custom or usage is on the party challenging holder in due course status.76
In a New Jersey appeals case,77 a companys check stock was imitated, and the customers facsimile signature was
forged on these counterfeit checks. The checks had printed on their face a warning: THE BACK OF THIS
CHECK HAS HEAT SENSITIVE INK TO CONFIRM AUTHENTICITY. Each check directed the holder to touch
it, which would confirm its authenticity because the logo would fade when touched, because of the heat sensitive
ink. The counterfeit checks did not contain heat sensitive ink, and the fact they were counterfeit would be revealed
by simply touching the checks. The checks were cashed at a check casher that did not examine the checks, as
warned. The court addressed whether the check casher was a holder in due course, specifically applying these facts
to the requirement in Section 3-302(a)(1) that the instrument when negotiated to the holder does not bear such
apparent evidence of forgery or alteration or is not otherwise so irregular or incomplete as to call into question its
authenticity. The court found that the failure of the check casher to utilize the heat sensitive test which, if utilized,
would have unquestionably revealed that the checks were counterfeit as a matter of law, precluded the check
casher from obtaining the status of a holder in due course, in that the checks when presented to the check casher
bore evidence that they were not authentic. It is commercially unreasonable, the court held, for a check casher (a
person in the business of cashing checks) to fail to utilize the heat sensitive test when it is cautioned on the face of
the check to do so.

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Rene Tierney

20.08 Additional Issues Affecting Holder in Due Course Status*

[1]
Transfers Not in the Ordinary Course of Business That Prevent a Purchaser From Being a Holder in
Due Course
Section 3-302(c) provides that certain types of transfers, not in the ordinary course of business, cannot operate to
make the holder a holder in due course. Specifically, a holder does not become a holder in due course of an
instrument acquired
(1)
by purchase at a judicial sale such as an execution, bankruptcy, or creditors sale;1
(2)
under legal process;2
(3)
in taking over an estate or other organization3 or
(4)
by purchase as part of a bulk transaction not in the regular course of business of the transferor.4
In the last case, however, federal law may pre-empt the Code and confer on federal agencies that take over
insolvent institutions the rights of a holder in due course with respect to instruments owned by those institutions.5
These situations indicate unusual circumstances in which the holder is merely a successor in interest to the prior
holder and can acquire only the rights of the transferor.6 The transferee in these situations, however, is only barred
from claiming that its holder in due course status emerged from the transfer. If the transferor was itself a holder in
due course, the transferee can claim similar rights under the shelter principle of Section 3-203(b). That section
vests in the transferee of an instrument all rights of the transferor, as long as the transferee neither participated in
fraud or illegality affecting the instrument, nor had prior notice of a defense or claim to the instrument while a prior
holder of it.7 Thus, if Xs assets are sold at an execution sale and Y purchases a note of which X is a holder in due
course, Y obtains all the rights of a holder in due course. If X had not been a holder in due course, Y could not have
obtained the rights of such a party, even though Y purchased the note for value, in good faith, and without notice of
any defense or claim to it.
The prohibition on a holder who acquires an instrument in the process of taking over an estate from qualifying as a
holder in due course applies even though the holder is representing antecedent creditors.8 Finally, the limitations of
Section 3-302 apply to bulk purchases not in the regular course of business of the transferor.9 A bulk transfer under
this section refers to a purchase of commercial paper and, therefore, does not constitute a bulk transfer as defined
by Article 6 of the Code.10 The Official Comment indicates that the section has particular application to the
purchase by one bank of a substantial part of the commercial paper held by another which is faced with insolvency
and is seeking to liquidate its assets.11 The provision also applies to situations where there is a technical transfer of
commercial paper because of a change in the organization of a business.12
[2]

The Payee as a Holder in Due Course

Article 3 resolves a pre-Code debate about whether a payee could qualify as a holder in due course. Although
Section 3-302 does not contain an explicit statement that permits a payee to attain that status, as did the preRevision version,13 it is clear that a payee may be a holder in due course, as long as he or she satisfies the other
requirements of Section 3-302. Even so, in the typical case the payee will have dealt with the obligor of the
instrument. As a result, holder in due course status will afford little advantage to the payee. This is because Section
3-305 allows holders in due course to take free from most defenses and claims only if the holder has not dealt
with the party asserting the defense,14 or the claim or defense did not arise out of the holders conduct.15
Nevertheless, rare cases exist in which a payee takes an instrument for value from a third party and can, therefore,
benefit from holder in due course status. Thus, in Eldons Super Fresh Stores, Inc. v. Merrill Lynch, Pierce, Fenner
& Smith, Inc.,16 the plaintiff delivered to its agent a check, payable to the defendant brokerage, for the purchase of
stock. The agent used the check to buy stock for its own account rather than for the account of the drawer-plaintiff.
The court held that the defendant, as a holder in due course who had not dealt with the drawer, was not subject to
the defense that the check was wrongfully delivered. Official Comment 4 to Section 3-302 lists a number of other
instances in which the payee is a holder in due course who does not deal directly with the obligorand thus takes free
of defenses.17 Even where the payee has dealt directly with the maker or drawer, the payee who otherwise meets
the requirements of holder in due course status takes free of all claims to the instrument on the part of any
person.18
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Assume, for instance, that the remitter of a cashiers check purchased the instrument from a bank with a check
drawn on insufficient funds and had the cashiers check drawn to the order of a third-party payee. The issuing bank
would have a defense against the remitter if the remitter sought to cash the check at the bank. Once the cashiers
check was negotiated to the third-party payee, however, that party would have the status of a holder in due course,
assuming there was no notice of the underlying defense and the payee took the instrument for value. Thus, the
payee would be able to enforce the instrument free from the issuing banks defenses or attempt to reclaim the
instrument. The payee did not deal with the issuer of the cashiers check, and thus would not take subject to
defenses under prior versions of Article 3 either.19

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Rene Tierney

20.09 Causes of Action and Statutes of Limitation*

[1]

Pre-Revision Provisions

In earlier versions of Article 3, Section 3-122 established rules for determining when a cause of action accrued on a
negotiable instrument. The accrual date was important not only to determine when a holder of an instrument had an
action for nonpayment and when the statute of limitations began to run, but also, under Section 3-122(4), to
establish the date as of which interest at the judgment rate began to run.
The rules of Section 3-122 governed the accrual of a cause of action on an instrument. Although it may seem odd at
first glance, a cause of action against a maker or acceptor of a time instrument accrued not on the day of maturity,
but on the day after maturity.1 Presumably this permitted the maker or acceptor that received such an instrument
just as its business day is about to end time to marshal funds sufficient to pay the instrument. One might imagine,
however, that the maker or acceptor of the time instrument would have sufficient notice of the date on which
payment is due that it would be required to have funds available on that day. The delinquent maker, however,
should have realized that once the maturity date passed, the holder may bring suit or realize on collateral without
further demand on the maker.2
The maker or acceptor of a demand instrument received no such reprieve. A cause of action against these parties
accrued on the date of the instrument or if no date was stated, on the date the instrument is issued. No demand
requirement preceded the accrual.3 A special rule, however, provided that no cause of action accrues against
obligors on certificates of deposit, whether time or demand, until demand had been made and that no demand could
be made on a time certificate until the date of maturity.4
The drawer of a draft or indorser of an instrument was liable on the instrument only if the primary party, the drawee
or maker, failed to pay. Thus, a cause of action against a drawer or indorser accrued only after the instrument had
been dishonored and demand had been made for payment from the drawer or indorser.5 Such a demand could
consist of giving notice of dishonor.
While the accrual date established the period when the statute of limitations on an instrument began to run, the
Code did not provide any specific period within which the action, once accrued, had to have been brought. Rather,
the statute of limitations had to be discerned from other state law.6 Presumably the limitations period that applied to
contract actions generally governed actions brought against makers, acceptors, drawers, and indorsers on their
contracts under the instrument.
[2]

Current Provisions

The current version of Article 3 omits any special provision to define the accrual of a cause of action (although
accrual points are stated for breaches of warranty). Instead, the time of accrual is determined by the failure of a
party to satisfy an obligation in a manner that gives rise to a cause of action. The current version incorporates the
rules on accrual of cause of action within the rules setting forth the statute of limitations.7 For instance, the
obligations of a drawer include the obligation to pay an unaccepted draft after dishonor. Presumably, therefore, the
act of dishonor would simultaneously cause the action against the drawer to accrue.
In Section 3-118, however, Article 3 creates a statute of limitations period that, for most notes, commences on the
due date or dates stated in the note and expires six years after the date of commencement. If payment on the note
has been accelerated, the limitations period ends six years after the accelerated due date.8 In the event of a demand
note on which demand for payment has been made, the statute of limitations generally expires six years after the
demand. All actions on a demand note are barred if there has been no demand for payment and neither principal nor
interest on the note has been paid for a continuous period of 10 years.9
Liability on a draft is typically triggered by acceptance or, in the case of parties secondarily liable, dishonor. Where
a draft has not been accepted, the statute of limitations period runs for three years after dishonor or 10 years after
the date of the draft, whichever period expires first.10 An action to enforce the obligation on an accepted draft
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generally must be commenced within six years after the due date or dates stated on the draft or acceptance or, if the
obligation of the acceptor is payable on demand, within six years after acceptance.11
Exceptions to the above rules exist in the case of special forms of drafts or certificates of deposit. An action to
enforce the obligation of an acceptor of a certified check or the issuer of a tellers check, cashiers check, or
travelers check must be commenced within three years after demand to the acceptor or issuer.12 The statute of
limitations for bringing an action for payment against the obligor on a certificate of deposit is six years after
demand to the maker or, in the event that the maker is not required to pay before a stated date, six years after
demand has been made and the due date has passed.13
Where the action of an obligee is stated in warranty or conversion or other means of enforcing an obligation arising
under Article 3, rather than on the obligors contract liability, any claim must be brought within three years after the
cause of action or claim accrues.14
In Whittle v. McCorp Props.,15 the court stated general rules that govern the interpretation of a statute of
limitations. A statute of limitations: (1) does not confer a right of action; it restricts the time in which a claim can be
asserted; (2) is procedural in nature; it is not a rule of substantive law and does not create a right of action; (3) is a
plea in bar that prevents collection of the debt through legal process. Another important point to emphasize is that
the Code will replace any more general state statute which had previously been used to determine the appropriate
statute of limitations.16 Still another important principle is that the current version, being a statute of limitations, is
procedural in character, affecting only a partys remedy, is not substantive, and therefore can be applied
retroactively.17
Article 3 does not purport to resolve all procedural issues related to instruments, however. For instance, the
circumstances under which the statute of limitations will be tolled is subject to non-Code law.18
Practical Hint:
The statute of limitations provided for in the Code may be preempted by federal law. A federal statute provides for
the time for commencing actions brought by the United States. This statute provides, in relevant part, that every
action for money damages brought by the United States, or any agency thereof, that is founded upon any contract is
barred unless the complaint is filed within six years after the right of action accrues.19 This section has been
interpreted by the courts to apply to actions brought by the United States or its agencies on notes.20
The 2002 Revision, addressing the United Nations Convention on International Bills of Exchange and International
Promissory Notes (see 120.03[2][b] and 20.05[1]), contains a proposed comment to revised Code Section 3-118
to recognize that under Convention Article 84, the statute of limitations is generally four years, not the six years
provided in Section 3-118. The comment states that this is One of the most significant differences between this
Article and the Convention21

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Rene Tierney

20.10 Rights of a Holder in Due Course*

[1]

Assertion of Claims and Defenses Against a Holder in Due Course

[a]
In General
A holder who can establish holder in due course status attains substantial rights to the instrument not otherwise
available. In particular, holders in due course may obtain more rights than their transferors, thus avoiding the
common-law doctrine of nemo dat quod non habet, or one cannot give what one does not have. Thus, one who
qualifies as a holder in due course may obtain good title to the instrument, even if the holder traces chain of title to
a thief.
Basically, the rights of a holder in due course involve the ability to resist claims and defenses to the instrument that
would otherwise be available to parties liable on the instrument or parties asserting rights in the instrument.1
Nevertheless, these rights are not absolute; even the holder in due course is subject to certain defenses, often termed
real defenses. The defenses to which the holder in due course is not vulnerable are referred to as personal
defenses. Article 3 distinguishes between personal defenses and claims in recoupment, although it permits a holder
in due course to take free of each. Defenses comprise those specifically mentioned in Article 3 or otherwise
available in a claim for enforcement of a common-law contract claim. Thus, defenses include failure of
consideration where the party to whom the obligor issued the instrument never performed as promised, fraudulent
performance, nonissuance of the instrument, conditional issuance, or issuance for a special purpose. A claim in
recoupment is stated where the drawer or maker of the instrument agrees that performance occurred and the
instrument is in proper form, but the underlying performance was defective. An example is a performance that
properly gives rise to a breach of warranty claim against the seller by a buyer-drawer. In this situation, the drawer
may wish to reduce the amount of his or her obligation to the holder. Under Sections 3-305(a)(3) and (b), a holder
in due course is not subject to the claim in recoupment unless that holder is also the party against whom the
warranty claim is made. Thus, in the above example, a seller who qualifies as a holder in due course of the
instrument is still subject to a reduced payment if the sellers performance gave rise to a claim in recoupment. If, on
the other hand, the seller has negotiated the instrument to a third party who seeks to enforce it against the obligor,
and if that third party qualifies as a holder in due course, that third partys right to enforce the instrument will not be
subject to the claim in recoupment.
[b]
A Holder in Due Course Takes Free of All Claims
Section 3-306 provides that a holder in due course takes the instrument free from all claims to it on the part of any
person, and thus provides superior title against all liens, equities, or claims to a property or possessory right in the
instrument of any kind.2 Even one who claims to have been fraudulently induced to issue or negotiate an
instrument to another will be unable to recover the instrument if it was subsequently negotiated by the defrauder in
a manner that made the transferee a holder in due course.3
[c]
A Holder in Due Course Takes Free of Most Defenses Asserted Against Parties Other Than the Holder
A holder in due course takes free of most defenses to payment that the obligor may assert, as long as the defense is
not asserted as a result of some action taken by the holder. Nevertheless, the rationale that leads to this conclusion
has been changed in the current version of Article 3. Prior to the 1990 Revision, Section 3-305(2) provided that the
holder in due course took the instrument free from all defenses except those specifically listed, i.e., the real
defenses. Unlike the situation with claims of adverse parties, the holder in due course could only take the
instrument free of defenses asserted by parties with whom the holder had not dealt.4 The primary effect of this
restriction was to prevent payees, who may qualify as holders in due course,5 from avoiding defenses raised by
their makers or drawers. Thus, a maker who issued a note payable to the order of a vendor in return for goods
would be able to assert defenses to payment of the note if the goods did not conform to the contract. If, on the other
hand, the vendor negotiated the note to an unrelated party with whom the maker has not dealt and that party
satisfied the requirements of a holder in due course, the maker would be unable to successfully assert defenses to
payment.
More complex transactions, however, gave rise to questions concerning the scope of the dealt with clause.6 In
Chicago Title & Trust Co. v. Walsh,7 a debtor funded an escrow account with a forged cashiers check and the
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escrowee, without knowledge of the forgery, issued drafts drawn on the account to creditors of the debtor. Although
the escrowee negotiated with the creditors as to the timing of the execution of the underlying agreement by which
the debtors obligations were to be discharged, the creditors played no role in the disbursing arrangement reached
between the debtor and the escrowee. When the escrowee learned of the forgery, it stopped payment on the drafts
and filed an action to prohibit their further negotiation. The creditors, in turn, brought an action seeking to enforce
the instruments and to recover damages for injuries sustained in reliance on them.
The Illinois Appellate Court held that the creditors were holders in due course who could take free from the defense
of want of consideration, as they had not dealt with the escrowee.
Initially, the court conceded that the dealt with language of Section 3-305 was included to limit the impact of the
Codes provision that a payee may be a holder in due course.8 Nevertheless, the court reasoned that in order to have
dealt with the escrowee within the meaning of Section 3-305, the creditors would have to have been participants
in the immediate transaction by which the escrowee issued its drafts, that is, the exchange of the forged cashiers
check for the drafts. The creditors involvement was merely tangential to the transaction which gave rise to the
issuance of the instruments in question.
As the court noted, the facts of the case closely paralleled one of the illustrations, found in Official Comment 2 to
pre-Revision Section 3-302, of payees who qualified as holders in due course. Such examples would be an empty
gesture and, worse, a source of confusion if they were not also illustrative of payees who should not be deemed to
have dealt with a party within the meaning of pre-Revision Section 3-305. Clearly, it would have been difficult
for a payee who is a holder in due course ever to have taken advantage of Section 3-305 if the Codes language had
not been interpreted in the limited manner suggested by the court. Nevertheless, where a bank did not deal directly
with a maker of a note, but ratified the action of the bank president, who did deal with the maker, the bank was
deemed ineligible to take free from the makers defenses.9
The current version of Article 3 eliminates the dealt with language, but retains the same principle. The right of a
holder in due course to enforce an instrument is subject to the real defenses, but not to other defenses or claims in
recoupment. The holder in due course can cut off these defenses or claims, however, only when they arise from a
transaction involving a person other than the holder.10 The intent of the provision is to permit an obligor to assert
any defenses or claims against the person whose conduct gave rise to the claim, even if that person qualifies as a
holder in due course.11 Once this intent is understood, couching it in terms of parties with whom the holder has
not dealt is unnecessary.
[d]
Real Defenses That Can Be Asserted Against a Holder in Due Course
[i]
Infancy of the Obligor
The defense of infancy survives against a holder in due course to the extent that it is a defense to a simple
contract12 under state law. Thus, if state law renders a contract voidable by a minor, rather than void, the defense
will have the same effect under the Code. Presumably, the procedural basis of the defense will also be governed by
non-Code state law. Thus, if a minor must assert the defense affirmatively in order to avoid an obligation on a
simple contract, similar measures must be taken to avoid an obligation on an instrument. Finally, if state law holds
the minor liable for the reasonable value of benefits received under the disaffirmed contract, similar liability will
exist under the Code.
[ii]
Incapacity, Duress, and Illegality as a Defense
Unlike infancy, the defenses of incapacity, duress, and illegality may be raised only if state law renders obligations
made under such contracts null and void.13 If state law merely allows the obligor to elect nullification, the holder in
due course cuts off the defense.
The kinds of incapacity that may be asserted against a holder in due course include mental incompetence,
guardianship, acts ultra vires, and other statutorily imposed incapacities.14 Physical distress, inability to read,
disability, or pain are less likely to be construed as meeting the incapacity requirement.15

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Duress is similarly a matter of state law, so that its elements may vary from jurisdiction to jurisdiction. Threat of
physical harm may more readily satisfy the requirement than threat of economic loss. In any event, reference to
contract law in the governing jurisdiction will be necessary to determine whether any given situation constitutes the
kind of duress that renders the obligation a nullity.16
As is the case with the defenses of incapacity and duress, the illegality must be such as to render the obligation of
the party asserting the defense a nullity.17 The basic problem for the courts has been to decide what effect the
statute declaring the transaction in question illegal has upon the contractual obligation tainted by that illegality. That
a particular transaction is a crime is usually not enough and the statute must deal with the obligations specifically.18
Thus, one court held that a contract to have improvements made on certain property was not illegal and did not
render an instrument given pursuant to the contract voideven though the contract had been obtained by criminal
fraud.19 On the other hand, another court held that a holder in due course of a check given in payment for cattle
that later turned out to be stolen could not recover the value of the check from the maker.20 The court ruled that
under state law, a sale of stolen cattle is illegal and a check given as part of such a transaction is unenforceable.
Thus, such decisions will not only vary from state to state as statutes treat different statutes proscribing the same
kind of conduct differently, but also according to the construction courts in those states put upon those statutes. This
sometimes induces courts to rely on the vagaries of public policy and legislative intent, as illustrated by Pacific
National Bank v. Hernreich.21 In that case, notes were executed pursuant to a contract made by an unlicensed
foreign corporation in violation of a state penal statute prohibiting foreign corporations from doing business in
Arkansas without complying with certain statutory requirements. Although the court confused somewhat its
analysis of Sections 3-302 and 3-305, it held that the notes were void ab initio and that the bank to which the notes
had been discounted could not be a holder in due course entitled to recover from the maker. The basis for the
courts ruling was set forth in the following statement:
To reverse this case and permit enforcement of the notes here sued on would in effect repeal our penal statute
prohibiting unlicensed foreign corporations from doing business in this state. Weighing the possible hampering of
negotiability of commercial paper made in Arkansas against permitting fly-by-night foreign corporations to prey
unimpededly on our citizens, we conclude that it was necessarily the intention of the Legislature to render any
paper growing out of a transaction of this character defective so that it could not fall into the hands of an innocent
purchaser and be enforced in this State.22
In the absence of the inference of such a strong public policy, the decision may well have gone the other way. No
definite rules can be set forth in this area. The different kinds of illegality which may be raised are numerous and
their impact will vary from state to state.
[iii]
Usury as a Defense
Usury laws are contained in the statutes of all states, with wide variations as to the permissible interest rates and the
effect of a usurious loan on the underlying obligation and enforceability of the note. Interest rates depend upon
numerous situations, including the nature of the lender (financial institution, finance company, or other), the type of
borrower (consumer or business entity), the type of loan (mortgage loan, business loan, loan for personal or
household purposes, etc.), and the amount of the loan (with interest rates varying depending on amount). These
laws can be quite complex with respect to the interpretation of what is usurious; they deal with the calculation of
interest rates, etc. and generally provide for numerous exceptions and statutory exemptions. Accordingly, a detailed
comparison of the various state statutes and an exhaustive discussion of the law relative to usurious notes is beyond
the scope of Chapter. For illustrative purposes, some of these statutes will be discussed. The Code merely states that
illegality is a defense to an obligation under an instrument. Whether usury is an illegality, and its effect on the
enforceability of an instrument, are matters of other state law.
Notwithstanding these comments, and irrespective of the differing state statutes, there is a common understanding
as to what are the essential elements of a usury claim, which is appropriate to explain for the purpose of this
discussion on usury. For a usury claim to exist, the courts have identified three elements: the transaction must be a
loan or forbearance; the interest that is stated must exceed the maximum set by the relevant statute; and the
principal and interest must be absolutely repayable by the borrower.23 In other states, such as California, North
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Carolina, Florida, and Tennessee, a fourth element of usury (the element that is generally the most difficult issue to
determine) is required, that is: the lender must have a willful intent to enter into a usurious transaction (an intent to
violate the law).24
As stated above, the state usury laws vary widely. Similarly, the states are not uniform as to the effect of a usurious
note. Usury is a defense against a holder in due course only if the effect of the local state law is to make the note
entirely null and void.25 Whether a note is entirely null and void is often a complex question with distinctions
made as to interest or principal forfeiture and the capacity of the lender. Some states statutes declare a usurious
contract void, making usury a defense to a holder in due course.26 In other states, a usurious contract is considered
voidable and not void, and in those states usury is not a defense to a holder in due course.27 State statutes that
merely provide for a forfeiture or a penalty against recovery of interest do not void the instrument, and usury is not
a complete defense against a holder in due course.28 Exemptions from usury statutes may apply where the loan
amount exceeds a stipulated sum.29 Some states prohibit a corporation or other legal entities from asserting a
defense of usury.30
Based upon the preceding discussion, it is clear and obvious that counsel must research the non-Code law of the
appropriate jurisdiction when dealing with an issue of usury, as a defense to the obligations under a note.
[iv]
Fraud in the Factum as a Defense Against a Holder in Due Course
Perhaps the most litigated question under Section 3-305(2) is whether a given fraud constitutes fraud in the factum,
a defense which may be asserted against a holder in due course, or fraud in the inducement, which is unavailable as
a defense against a holder in due course. Article 3 currently distinguishes between types of fraud by defining as a
real defense that can be asserted against a holder in due course fraud that induced the obligor to sign the
instrument with neither knowledge nor reasonable opportunity to learn of its character or its essential terms.31 The
rule purports to exclude from instruments enforceable by a holder in due course those writings that the signer did
not intend to sign as a negotiable instrument at all. Such fraud differs from the situation in which a party knows
what it is signing, but is misguided as to what it will receive in return.
The drafters of the Code were apparently attempting to avoid imposing liability on makers or drawers who signed
instruments in excusable ignorance of the contents of the document. Thus, a document presented to the maker as a
receipt,32 or a statement of wages,33 might qualify. By itself, however, this rule would induce sloth or negligence
on the part of the makers and drawers. If they could subsequently avoid their obligations, they would have less
incentive to examine documents thoroughly before signing. Similarly, makers of commercial paper would suffer, as
holders in due course would have additional uncertainty about the enforceability of their instruments. Thus, the
Code limits the fraud in the factum defense to those situations in which the obligor had neither knowledge (a
subjective term requiring actual knowledge)34 nor reasonable opportunity (a more objective term) to obtain
knowledge concerning the true nature of the document. Only if reliance on the misrepresentation is excusable will
the fraud in the factum defense prevail.35 Further, a party who knows the nature of the instrument will be unable to
use the defense, even if the party is uncertain of the exact contents.36 These elements suggest that the fraud defense
follows the logic prevalent throughout most of Article 3 of placing losses on the party in the best position to avoid
their materialization. If the party signing the instrument had no reason to know of its true nature, there is little basis
for believing that the signer was in a position superior to that of the holder to detect the underlying fraud. A maker
of a note who possesses sufficient intelligence, education, and business experience to determine the nature of the
obligation to be undertaken and who is not in a situation characterized by pressure or duress, should be less able to
take advantage of the fraud in the factum defense.37 Fraud in the inducement, however, is perhaps more readily
avoidable by the drawer or maker than by a subsequent holder in due course. These claims, which are often in the
nature of failure of consideration or breach of warranty, arise from transactions in which the obligor could have
inspected the goods or bargained for limited payment prior to delivery or inspection. The relative ability of the
obligor to determine the adequacy of the consideration, compared to the ability of the holder in due course, suggests
that losses, or the burden of pursuing a remedy against the payee, should be placed on the former.38
[A]
Defense of Fraud in the Factum as a Vehicle for Consumer Protection
The rule has particular application to consumers who frequently are victims of high pressure tactics by door-to-door
sellers. In many cases of such door-to-door transactions, the court may be hard pressed to find that the consumer
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knew the nature or essential terms of the instrument. In American Plan Corp. v. Woods,39 for example, the maker
was told by a door-to-door salesman that a water softener was being given to her for advertising purposes, that she
was not obligated to buy the machine, that she would be paid $50 each for the names of prospective customers and
that the seller would credit the money toward payment of the machine. The court held that there had been a
misrepresentation including the nature and effect of the instrument and the maker was allowed to assert the real
defense of fraud in the factum.
The need to use commercial paper principles to rescue consumers from their ignorance in these circumstances has
dissipated substantially as a result of the Federal Trade Commissions promulgation of regulations eliminating the
holder-in-due-course doctrine in many consumer transactions and mandating a cooling-off period for door-to-door
sales. As discussed above,40 the holder-in-due-course regulations require that certain instruments issued in
connection with consumer credit transactions state that any holder is subject to all claims and defenses that the
debtor could assert against the seller.41 The Door-to-Door Sales Regulations require a cancellation period for the
consumer and prohibit a seller from transferring any note arising from such a transaction prior to the fifth business
day following the signing of the consumer contract.42
[v]
Discharge as a Defense Against a Holder in Due Course
Discharge of the obligor may prevent a holder in due course from recovering on the instrument under two
circumstances. First, a holder in due course takes the instrument subject to any discharge in insolvency
proceedings.43 The Code goes beyond discharge in bankruptcy and provides for discharge in insolvency
proceedings which include assignments for the benefit of creditors and other proceedings designed to liquidate or
rehabilitate a debtors estate.44
Second, a holder in due course who acquired that status with notice of a discharge of the obligation of a party may
not enforce the instrument against that party.45 This provision covers notice of any discharge, whether as a result of
insolvency proceedings, and whether discharge has been effected by the passage of time,46 certification of a
draft,47 or payment.48 Discharge may also be effected by an act or agreement with the obligor which would
discharge an obligation to pay money under a simple contract.49 Note that notice of the discharge will not
disqualify the holder from attaining due course status; nevertheless, that notice will have the same effect as such a
disqualification since the instrument cannot be enforced by the holder in due course.
A holder in due course has notice of a discharge when the holder has actual knowledge, has received notice, or has
reason to know of the discharge in connection with the instrument in question.50 It is possible for a holder to take
an instrument in due course even though the holder has notice that one or more parties have been discharged, so
long as any party remains liable on the instrument. Thus, the holder may take with notice that an indorser of a note
has been released, and still be a holder in due course as to the liability of the maker. In such event, the holder in due
course is subject to the defense of the discharge of which there was notice.51
[2]

Assertion of Claims and Defenses Against One Not a Holder in Due Course

The current version of Article 3 continues to delineate certain claims and defenses that can successfully be asserted
against one who is not a holder in due course and those that can only be asserted against a holder not in due
course.52 These provisions essentially incorporate into the Code a large bodyof contract law. Thus, Section 3-305
provides that persons who do not have the rights of a holder in due course take instrument subject to a defense of
the obligor that would be available if the person entitled to enforce the instrument were enforcing a right to
payment under a simple contract.53
[a]
One Who Is Not a Holder in Due Course Takes an Instrument Subject to the Defense of Want or Failure of
Consideration
[i]
What Constitutes Want of Consideration or Failure of Consideration?
An obligors promise on a negotiable instrument must be supported by consideration in order to be enforceable by
other than a holder in due course,54 that is, by transferees and holders. The consideration required by the Code is
presumably consistent with the common-law definition of the term, i.e., some benefit to the obligor or some loss or
detriment incurred in exchange for the obligors promise.55 It is not essential that the consideration be supplied by
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the holder or that it flow directly to the obligor.56 But if the obligor can establish a defense effective against the
holders transferor, the holder will be able to recover only by qualifying as a holder in due course. To do this, the
holder must have given value for the instrument, a term that, for Article 3 purposes, will not be satisfied by
executory promises.57 This marks the distinction between the concepts of consideration, which has to do with the
contract of the party sought to be held liable, and value which has to do with the status of the holder seeking to
enforce payment.58
A distinction must be made between the terms want and failure of consideration. Want of consideration
implies that no additional consideration was intended to pass.59 Failure of consideration implies that a
consideration initially sufficient has since become worthless.60 Courts have employed the term failure of
consideration to describe both situations in which no consideration has been forthcoming in return for the
instrument and where defective consideration has been forthcoming. Article 3 distinguishes between these
situations by limiting failure of consideration cases to the first category.61 Where consideration is provided and
accepted, but the obligor on the instrument claims that the consideration was faulty, Section 3-305 describes the
obligors right as a claim in recoupment. An obligor asserting such a claim attempts to set off the decreased value
of the defective performance against the amount owed to the holder. No substantive effect follows from this new
category, since claims in recoupment are treated the same as personal defenses.62
[ii]
Pleading and Proof Required in Assertion of Defense
Want or failure of consideration must be pleaded and established by the obligor as a defense.63 Thus, the Code
presumes in any action on an instrument that sufficient consideration has passed. It is common for notes to contain
a statement that it was given for value received. Courts have generally held that such a statement clearly indicates
its consideration for the makers promise and that the statement, alone, constitutes prima facie evidence of
consideration; a note that on its face purports to be for value received contains a sufficient statement of
consideration that will give the holder the right to recover on the note.64 An obligor seeking to establish the
contrary must bear the burden of proof.65 Should that effort be successful, however, the holder must bear the
burden of establishing its rights as a holder in due course.66 Additionally, a person in possession of an instrument
who does not have the status of a holder in due course, but who claims the rights of a person with that status under
the shelter principle, must prove that he or she is entitled to enforce the instrument under Section 3-301.67
[iii]
No Consideration Is Necessary Where the Instrument Is Taken in Satisfaction of an Antecedent Debt
Issuance of an instrument for an antecedent claim constitutes value and any issuance for value constitutes
consideration.68 Thus, no additional consideration is necessary where an instrument is given in payment of or as a
security for an antecedent obligation.69 Pursuant to this exception, an instrument may be given as security for an
antecedent debt of a third party.70 Renewal of an instrument on its original terms falls within this rule.71
[b]
One Who Is Not a Holder in Due Course Takes an Instrument Subject to the Defense of Nonperformance
of Conditions Precedent
[i]
Conditions Precedent to the Obligation on the Instrument
Indorsers and drawers undertake to pay only after dishonor and any necessary notice of dishonor.72 These, in
effect, are conditions precedent to their obligations on the instrument. A party seeking to enforce such obligations
must plead and prove performance of these conditions precedent, or show why and how their performance was
excused, in order to state a cause of action.73 Nonperformance of either affords the obligor a discharge74 and thus
may serve as a defense against a holder in due course who took with notice of the nonperformance.
[ii]
Conditions Precedent to the Underlying Obligation
[A]
Express Conditions Precedent
Conditions precedent to the underlying obligation, on the other hand, do not arise out of provisions of the Code. If
they have not been satisfied, however, they may still be asserted in an action on the instrument brought by one not a
holder in due course. Such conditions will often be express, as where the parties agree that certain acts must occur
before the duty of performance arises. The agreement may be oral or written.75 Where the agreement is written, it
in effect modifies the terms of the instrument, at least between the immediate parties.76
[B]

Implied or Constructive Conditions Precedent

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Constructive or implied conditions precedent are those a court finds from the nature of the obligations of the
parties. For example, in executory contracts, performance by one party is often a constructive or implied condition
precedent to performance by the other. The fact that an instrument is subject to implied or constructive conditions
does not render the instrument nonnegotiable,77 but failure to comply with such conditions may provide a defense
against payment to one not a holder in due course.
[iii]
Admissibility of Parol Evidence in Proof of Conditions Precedent
The existence of a condition precedent may be proved by parol evidence. Generally, parol evidence is not
admissible to contradict or vary the terms of the integrated written obligation.78 Nevertheless, courts have held that
parol evidence is admissible to show that the obligation never came into existence because of an agreed-upon
condition precedent that it not take effect unless and until such condition had been satisfied.79 But the proffered
evidence must be excluded if it contradicts or varies the terms of the writing.80
It is often not an easy issue, however, to determine whether the condition precedent contradicts the written
obligation. The opinion of the New York Court of Appeals in Long Island Trust Co. v. Rochman81 is illustrative.
Although this case specifically involved a conditional delivery, the condition was clearly in the nature of a
condition precedent. The plaintiff-bank had made a short-term loan for which it received a note indorsed by five
guarantors. The bank and the guarantors orally agreed that a renewal of the loan and note would require the same
five indorsements. The bank eventually agreed both to renew and to increase the amount of the loan. One of the
guarantors delivered a new note to the bank, but his note was indorsed by only four of the five guarantors. The loan
was not repaid and the bank brought an action against both the maker and the four guarantors who did indorse the
renewal note. The defendants claimed that their delivery of the new note to the bank was contingent upon
procurement of all five signatures and that since this was not done, the note was not enforceable as to them. The
issue presented was whether the oral agreement between the guarantors and the bank could be proved by parol
evidence.
A majority of the court found no contradiction between the obligation owed, that is, the guarantee, and the alleged
condition precedent. The court allowed the admission of the parol evidence to prove the condition precedent and its
final decision hinged on the fact that the defendants indorsement did not expressly state that the guarantee was
unconditional. In this case, then, it seems that more careful drafting on the part of the bank would have negated the
defense.
Chief Judge Breitel, in his dissent, found that the terms of the indorsement were clearly unconditional in nature and
would be contradicted by the offered parol testimony. Typical of the indorsements provisions was a statement that
Nothing except cash payment shall release the undersigned. The Chief Judge was obviously concerned that a
misapplication of the rules regarding the admission of parol testimony might tend to undermine the rules of
commercialand banking conduct and to suffer the devious devices of the untrustworthy who can always conceive a
less than flat contradiction to avoid their written obligations.82
[c]
One Who Is Not a Holder in Due Course Takes an Instrument Subject to the Defense of Breach of a
Condition as to Delivery
[i]
Nondelivery
The Code provides that nondelivery, nonissuance, or breach of a condition as to delivery or issuance may be
asserted as a defense against all holders except those having the rights of a holder in due course.83 Delivery
requires voluntary transfer of possession.84 Issuance occurs with the first delivery of an instrument by the maker
or drawer for the purpose of giving rights on the instrument to any person.85 Nondelivery refers to a failure to
deliver the instrument by the obligor.86 Parol evidence is admissible to show nondelivery.87
[ii]
Delivery for a Special Purpose
Delivery of an instrument to one other than a holder in due course on the condition that the instrument be used only
for a designated purpose is a defense good against the recipient where that purpose is not fulfilled.88 Title is vested
in the recipient, but only for the special purpose, and when that purpose is satisfied, or when the instrument is used
for other than the designated purpose, the instrument is not enforceable against one not a holder in due course.89
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[iii]
Conditional Delivery
Conditional delivery or issuance is similar to delivery for a special purpose. A conditional delivery vests no title in
the transferee until the condition is satisfied;90 and the transferee may not enforce the instrument until the
condition has been fulfilled.91 Article 3 specifically states that conditional issuance is a defense that can be asserted
by the maker or drawer.92
[iv]
Admissibility of Parol Evidence
Courts have generally permitted the introduction of parol evidence to show delivery in breach of a special purpose
or condition.93 If, for example, the plaintiff was a holder in due course, such delivery-related defenses could not be
raised and thus parol evidence regarding them would be irrelevant.
[d]
One Who Is Not a Holder in Due Course Takes an Instrument Subject to the Defense That It Was Acquired
by or Through Theft
The fact that the holder seeking to enforce payment stole the instrument or derived title from or through the thief is
a defense for the obligor against a person who does not have the rights of a holder in due course.94 This principle
applies equally to lost, as well as stolen instruments, but the obligor has the burden of proving that the instrument
was lost or stolen.95 If the obligor even suspects that the instrument has been stolen, this should be raised as a
defense to an action on the instrument. No attempt should be made to discharge the obligation by paying the holder
in possession unless the holder has the rights of a holder in due course.
The current version of Article 3 alters prior law with respect to payment of a holder who did not have due course
status, but who traced title through a thief. Under prior law, no discharge resulted from payment by a party who in
bad faith paid a holder who acquired the instrument by theft or who (unless having the rights of a holder in due
course) held the instrument through one who so acquired it. Bad faith was not defined by the Code, but the term
minimally implied an absence of good faith, that is, honesty in fact in the conduct or transaction concerned.96
Presumably, bad faith would be judged by the same subjective standard that informs the inquiry into good faith.
The current version of Section 3-602(b)(2) eliminates the requirement of bad faith in favor of aknowledge test.
Under that provision, no discharge occurs if the obligor makes payment to a person he or she knows to be in
wrongful possession of a stolen instrument.
[e]
One Who Is Not a Holder in Due Course Takes an Instrument Subject to Restrictive Indorsements
A holder or transferee takes subject to the defense that a payment or satisfaction of the instrument would be
inconsistent with the terms of a restrictive indorsement.97 A restrictive indorsement is one which either
(1)
is conditional; or
(2)
purports to prohibit further transfer of the instrument; or
(3)
includes words signifying a purpose of deposit or collection; or
(4)
otherwise states that it is for the benefit or use of some person.98
Payment or satisfaction in violation of a restrictive indorsement creates a cause of action by the indorser against the
indorsee. Payment or taking collection of an instrument in a manner inconsistent with a restrictive indorsement may
constitute conversion.99 Prior law stated specifically that the obligors payment does not effect a discharge if the
payment is inconsistent with the terms of the restrictive indorsement.100 Thus, the obligor remains liable on the
instrument.
[f]
One Who Is Not a Holder in Due Course Takes an Instrument Subject to the Defense That It Has Been
Altered
[i]
Alteration in General
[A]
Effect of Alteration
The rules with respect to alterations are contained in Section 3-407.101 Section 3-407(b) provides that an alteration
of an instrument discharges any party whose obligation was changed thereby unless that party assents to or is
precluded from asserting the alteration. An alteration is any unauthorized change in an instrument, whether it is a
modification of existing terms or the unauthorized addition of words or numbers.102 In order to effect the
discharge, however, the alteration must be made fraudulently.103 For instance, a payee who changed the date of a
check from January 3, 2003 to January 3, 2004 in order to correct the drawers error in writing the incorrect
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date would not be making a fraudulent alteration. Thus, the alteration would not effect a discharge. A discharge for
fraudulent alteration would also discharge the obligor on the underlying obligation.104 The defense is not fully
effective against a holder in due course, however, and in all cases a subsequent holder in due course may enforce
the instrument according to its original tenor, that is, its tenor at the time the obligor signed it.105 A payor bank or
drawee that pays a fraudulently altered instrument in good faith and without notice of the alteration may also
enforce the instrument according to its original terms. No other alteration results in a discharge and the instrument
may be enforced according to its original tenor.106 In the case of an incomplete instrument that has been completed
in an unauthorized manner, these same parties (payors and drawee banks and holders in due course) may also
enforce the instrument as completed.107 Thus, the risk of fraudulent completion lies on the party who left the
instrument incomplete, presumably on the theory that such a person was in a superior position to avoid the loss by
not issuing an incomplete instrument.108
Practical Hint:
While a holder in due course can always enforce an instrument that has been altered in its original terms, the
instrument may also be enforceable in the form as altered (as in a raised amount) if the drawer or makers
negligence substantially contributed to the material alteration.109 A bank, under the same circumstances, may have
the right to charge the drawers account in the tenor of the instrument as altered.110
The requirement that the alteration be unauthorized in order to have these effects is consistent with the provisions
on completion of instruments. If an incomplete instrument has been completed in an authorized manner, a payor
bank or drawee may enforce the instrument as completed.111
[B]
Pleading and Proof
A discharge pursuant to alteration is personal to the party whose contract is changed and anyone whose contract is
not affected cannot assert the defense.112 As with any defense, the burden is on the defendant-obligor to establish
by apreponderance of the evidence that there has been a discharge based on an alteration or unauthorized
completion of the instrument.113
[ii]
The Nature of the Alteration
Qualifying alterations in a partys contract include changes in the number or relations of the parties, completing an
incomplete instrument in a manner other than authorized, and adding or removing any part of a writing as
signed.114 Thus, adding an interest rate to a previously signed note will constitute a material alteration,115 as will
change in or addition to the name of the payee.116 The courts have been consistent in holding that raising the
amount of an instrument will generally constitute a material alteration.117 Excluded from such alterations would be
the addition of a co-maker or accommodation party, which generally does not change the contract of existing
parties, or the addition,118 removal or omission of words that have no bearing on the contract.119 The addition of
words that merely restate the existing obligations of a party do not alter the contract and are therefore not
alterations.120
[iii]
The Alteration Must Be Fraudulent
The alteration, however, must be made fraudulently in order to effect a discharge.121 Alterations committed in the
good faith that they were authorized will not result in a discharge. Whether an alteration is fraudulent is a question
of fact for a jury122 and thus even though a court finds that there has been a material alteration, a summary
judgment is not in order.123 The test is whether there was a dishonest and deceitful attempt to impose an obligation
or obligations upon the maker or other party against whom enforcement is sought additional to such partys
obligation on the instrument at the time the instrument was signed.124 If the alteration is made in the honest belief
that it is authorized, or with a benevolent motive such as a desire to give the obligor the benefit of a lower interest
rate, it is not made with fraudulent intent.125 As one court stated, there must be more than a misguided purpose.126
Changes made to conform the instrument to the agreement of the parties are not made with any fraudulent intent.
Thus, a notation made for the purpose of correcting an error in the instrument is not a fraudulent alteration.127
Similarly, there is no fraudulent intent when one payee crosses out the name of a co-payee when the intent of the
parties was that the remaining payee be the designated payee.128 But any alteration which increases the burden of
the party affected thereby is at least presumptively fraudulent.129
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[iv]
When the Defense Is Barred
[A]
Assent to an Alteration Will Bar Assertion of It as a Defense
The holder or person seeking to enforce an instrument may avoid an alleged discharge by alteration by showing that
the obligor assented to the alteration or is otherwise precluded from asserting the defense.130 Assent may be
expressor implied and may come before or after completion or alteration of the instrument.131 Thus, a maker or
indorser who becomes liable on an instrument knowing that terms have been deliberately left blank subject to
approval by the payee will be estopped from claiming a material alteration when those terms are supplied.132 A
simple example of assent would be where the obligor is asked about the change and agrees to it. Preclusion, on
the other hand, means some sort of estoppel, whether by words or conduct.133 A party whose negligence
substantially contributes to the alteration may also be precluded from asserting it under Section 3-406.134
[g]
Jus Tertii
[i]
Denial of Claims Based on Rights of Others
On occasion, a party liable on an instrument may attempt to avoid payment by asserting that the holder obtained the
instrument by violating a right of some third party. For instance, in Dziurak v. Chase Manhattan Bank,135 a bank
that issued a cashiers check, on which it was considered both the drawer and drawee, sought to avoid payment to
the payee when the banks customer complained that the payee had misapplied the funds. Could the bank have
resisted payment by asserting the remitters defenses or claim to the cashiers check? The Code responds with a
resounding No. Section 3-305(c) permits a party liable on the instrument to assert another persons rights, known
as jus tertii, only in limited circumstances. That provision prohibits the assertion of another partys defenses, claims
to the instrument, or claims in recoupment unless the other party joins in the action and personally asserts the
claim.136 Where all parties are joined, the obligor may avoid further liability by paying the amount due into court
and allowing the court to decide the proper recipient of the funds.137 The obligor may avoid payment, however, if
the person seeking to enforce the instrument does not have the rights of a holder in due course and the obligor is
able to prove that the instrument was lost or stolen.
The issues relating to the doctrine of jus tertii generally deal with cashiers, tellers, bank, and official checks and
money orders, and arise in connection with the right of the customer/remitter to order the issuing (obligated) bank
to stop payment on the instrument, or the right of the bank to stop payment on its own right to assert its, as opposed
to its customers, defenses to its obligation on the instrument. Stop payments are provided for in Article 4 and are,
consequently, beyond the scope of this Chapter.138
[ii]
Interpretative Difficulties in Section 3-305(c)
[A]
Claims vs. Defenses
Some confusion long existed with respect the interpretation of the scope of jus tertii. A literal reading of the preRevision version of Section 3-306(d) permitted a third person to defend on behalf of the party liable on the
instrument only where that third person had a claim to the instrument. Some commentators asserted that the
quoted term was intended to distinguish between claims and defenses and to permit third-party intervention only in
the former case.139 On this reading, a claim could be asserted to the instrument itself, as in a claim of title, or to
the proceeds of the instrument, as where a negotiation is rescinded. A defense, on the other hand, admitted the
completion of the underlying transaction, but asserted that the contemplated performance was defective, as in a
breach of warranty.
Some support for the distinction could be found in the Official Comments to the disputed provision. The Official
Comment illustrated the operation of subsection (d) by reference to claims, not defenses in common law. The
current provisions concerning jus tertii, which are found in Section 3-305(c), distinguish quite clearly among
defenses, claims in recoupment, and claims to the instrument and to permit the use of jus tertii only in the last case.
After denying the use of a third partys rights in all three cases, the provision permits joinder of the third party and
assertion of that partys claim to the instrument.140
Nevertheless, it is difficult to understand what the policy for the distinction might be. If a person with a valid
defense is willing to intervene in the litigation between a holder and a party liable on the instrument, it would
appear unduly expensive to bar the intervention and require that person to initiate a separate action on the defense,
even though the same person could have intervened had the objection to payment risen to the level of a claim. Of
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course, the additionalaction will be necessary if the holder is not the person whose conduct gave rise to the defense.
Assume, for instance, that X draws an instrument to the order of P, who indorses it to the order of Y in return for
goods that turn out to be defective. If Y negotiates the instrument to Z and Z presents it for payment to X, Ps
intervention to assert Ys breach of warranty defense would only bar payment from X to Z. Z would then bring a
separate action against Y for breach of warranty of transfer.141
[B]
Section 3-305(c) Is Not Confined to the Claims and Defenses of Third Parties to the Instrument
A second interpretative difficulty involves the question whether the provision is confined to claims and defenses of
third persons who are parties to the instrument. For example, will a bank which is an obligor on a cashiers check
be able to assert the claims and defenses of its customer against the holder of the check if the customer has not been
made a party to the litigation? Arguably, Section 3-305(c) should not be limited to the claims and defenses of
persons who are parties to the instrument. Thus, in the case of the cashiers check, the bank should be precluded
from raising the claims and defenses of its customer.142
The section itself refers to third persons, not third parties. Both party143 and person144 are terms of art in the
Code, and it must be presumed that the use of one rather than the other was deliberate. Moreover, no policy justifies
the restriction. In fact, such a restriction would be inconsistent with the rationale underlying the Codes limitation
of jus tertii arguments. There is no reason to suggest that the claims of other parties to the instrument are not the
obligors concern but that those of other persons who are not parties to the instrument are.145
[iii]
Jus Tertii Arguments May Be Used to Attack the Plaintiffs Status
A jus tertii argument is raised as a defense to liability. It attacks the right of the plaintiff to enforce payment on the
instrument, not the status of the plaintiff. Thus, there is nothing to prevent a defendant from attempting to show that
there exists a third person claim or defense which precludes the plaintiff from qualifying as a holder in due course.
Even if the defendant successfully rebuts the plaintiffs holder in due course status, however, the plaintiff may still
qualify as a holder entitled to recover on the instrument. Although the plaintiff will now be susceptible to additional
claims and defenses, the jus tertii claim or defense itself cannot be asserted as a bar to plaintiffs recovery.146

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20.11 Signatures and Forgeries*

[1]

Necessity of Signature for Liability to Attach

Section 3-401(a) sets forth the basic rule with respect to liability on an instrument: A person is not liable on an
instrument unless (i) the person signed the instrument1 or (ii) the person is represented by an agent or
representative who signed the instrument and the signature is binding on the represented person. The name of
the obligor is not required to appear on the instrument, provided the agent who signs is authorized and the signature
is binding on the obligor.2 Parol evidence is inadmissible to demonstrate that an individual whose signature does
not appear on the instrument is the real party in interest or the party who is liable for payment. In the most frequent
situation, a payee may attempt to demonstrate that the signer was an agent for some other party who ought to be
liable for payment.
[2]

What Constitutes a Signature?

A signature may be made in any manner and by any mark or symbol that is executed or adopted by a person with
present intention to authenticate the writing.3 cases concerning signatures are discussed above in the section
concerning the requirements of negotiability, since an instrument must be signed to fall within Article 3.4
[3]

Whose Signature Is It?

Although the Code restricts liability to those individuals whose signature appears on the instrument, the identity of
the true signer is not always clear. The problem arises in two situations: unauthorized signatures and agency
relationships.
[a]
Liability for Unauthorized Signatures
Section 3-403(a) confirms the rule established in Section 3-401 by declaring an unauthorized signature
ineffective as that of the person whose name is signed. Thus, where a debtor forged his wifes name on a note,
she incurred no liability on the instrument.5 The forger, however, incurs liability on the instrument, even though his
name appears nowhere on it. Section 3403(a) also provides that the unauthorized signature operates as the
signature of the signer against any person who in good faith takes the instrument for value or pays it.6
A missing signature is an unauthorized signature.7 An Oklahoma appellate court8 held squarely that where the
agreement between the bank and customer requires two signatures for payment of an item, the absence of one of the
signatures constitutes an unauthorized signature for purposes of Section 3-403(a).
The Code in Section 3-403 adds a subsection, (c), which codifies case law interpretations under the Code to provide
that The civil or criminal liability of a person who makes an unauthorized signature is not affected by any
provision of this Article which makes the unauthorized signature effective for the purposes of this Article.
The cases have generally recognized that an unauthorized signature is a forgery.9 An unauthorized signature,
however, is not necessarily a forgery.10 An agent may mistakenly assume authority to sign the principals name
when such authority does not in fact exist. Any signature made in excess of the agents actual or apparent authority
is unauthorized, and, hence, unenforceable against the supposed principal. The signature is not rendered
unauthorized by the fact that the person with authority to sign the instrument subsequently abuses his or her
authority by negotiating the instrument to a holder in due course for the agents personal benefit or otherwise
misappropriates funds.11 Thus, any agents authority to sign an instrument on the principals behalf must be
carefully delineated and documented.
Occasionally the question of lack of authority will arise because the signatures of fewer than all persons required to
sign for the drawer appear. One might claim that these cases do not easily fit the description of unauthorized
signature, since the instrument contains no forgery or signature of a person who was not authorized to sign.12
Section 3-403(b), however, makes clear that the signer or signers of an instrument bearing an insufficient number of
signatures have no authority to draw or indorse for the organization that they represent. If a signature required by an
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organization is missing, the signature of the organization itself is unauthorized.13 While this provision will have
its most significant impact in business settings, the use of the term organization is not limited to those situations.
That term is defined to include two or more persons having a joint or common interest, or any other legal or
commercial entity.14 Thus, if a husband and wife enter into an agreement with their drawee bank that their checks
must be jointly signed, the bank will have paid over an unauthorized signature if it subsequently pays a check
drawn by the husband or wife alone.
[i]
Ratification of Unauthorized Signatures
Signatures that were unauthorized when made may be ratified after the fact by the party from whom authorization
would initially have been sought.15 The word ratified makes clear that the adoption of the signature is retroactive
to the time of its making.16 The ratification, however, only has the effect of validating the signature, and thereby
relieving the signer from liability on the instrument.17 The signer remains liable to the person whose name is
signed.18 In addition, any criminal liability of the signer, e.g., for forgery, is not affected.19
A signature can be ratified expressly, as where the obligor admits it to the holder. Alternatively, the ratification may
be implicit, as where there has been conduct that can be explained only if there has been a ratification,20 or where
the ratifying party has accepted proceeds or other benefits received in the transaction.21 Generally, however, a
ratification will be found only if the ratifying party has the appropriate intent and full knowledge of the material
facts.22
On a related point, some jurisdictions have determined that a payee from whom a check is stolen and who
subsequently brings a conversion action against a collecting bank that has handled the check thereby ratifies the
collection of the check proceeds from the payor bank. This doctrine permits the payee to avoid the claim that the
collecting bank is holding the payor banks money rather than the drawers, a claim thatif successfulwould
vitiate the payees conversion action. The same doctrine, however, precludes the payee from bringing an action
against the drawer or drawee whose conduct has now been ratified.23
[ii]
Preclusion to Deny Authorization
Prior to enactment of its current version, Article 3 provided that a person whose name was signed to an instrument
could be precluded from denying that the signature is authorized.24 The quoted words referred to the possibility
that the person whose name was signed could be estopped from denying that the signature was his or her own or
that of an authorized representative.25 For example, the obligor may expressly or impliedly represent to an
innocent purchaser that the signature is genuine.26 The phrase also recognized that negligence substantially
contributing to an unauthorized signature could preclude a denial of the lack of authority under Section 3-406.27
Similarly, a customer who failed to examine bank statements and return checks within the limits established by
Section 4-406 could be precluded from denying unauthorized signatures on checks.28
The application of that preclusion language to forgery cases, however, proved to be the source of some confusion
since preclusion under that section referred to a wider range of acts by the purported signer than just negligence.
Thus, the current Section 3-403(a), the analogue to prior Section 3-404(1), omits any mention of preclusion.
[b]
Liability for Signature by an Authorized Representative
[i]
A Signature May Be Made by an Authorized Representative
Section 3-402(a) provides that a signature may be made by an authorized representative. Two questions arise in this
context. First, in what manner must the principal be designated in order to be held liable on the instrument? Second,
in what manner must the representative be designated in order to avoid liability on the instrument? Subsidiary
questions involve the kinds of evidence that are admissible to establish or disestablish the liability of parties to the
instrument. As a preliminary matter, it is important to note that the Code does not purport to resolve the
determination of authority of a representative. That issue must be addressed by reference to the law of agency.
Thus, the authority to sign for another may be express, implied in law, or apparent and it may be established as in
any other case of representation.29
[ii]
[A]

Failure Both to Indicate Representative Capacity and Name Principal

Personal Liability of Principal and Representative
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Assume that an authorized representative30 signs the instrument without indicating that the signature is made in a
representative capacity or naming the principal. Under prior law, because the principals signature does not appear
on the instrument at all, the principal owed no obligation on it. This conclusion applied even though the
representative signed the instrument at the direction of the principal. The representative whose name was signed to
the instrument, on the other hand, was personally liable.31
The Code in Section 3-402 effects a significant change in the concept of liability on an instrument executed by an
agent or purported agent acting with authority of a principal or purported principal. In an exception to recognized
agency rules under which an undisclosed principal is liable on a simple contract (as indicated in the preceding
paragraph), Pre-Revision UCC 3-403 provides that an undisclosed principal is not liable on such an instrument.
Consequently, it is possible to have no one liable on a note where, for example, the principal is undisclosed
(because the proper technical form of designation of agency is not used) and the immediate parties to the note did
not intend the agent to be liable. Under Section 3-402 the principal is liable in this situation.32 Section 3-402(a)
instead incorporates general principles of agency law and binds the represented person to the same extent that he or
she would be bound on a simple contract, notwithstanding the absence of that partys signature.33
[B]
The Use of Parol Evidence to Disestablish Signers Personal Liability
Earlier versions of Article 3 precluded the use of parol evidence to disestablish the personal liability of the signer
on the instrument when there has been a failure both to indicate representative capacity and to name the
principal.34 That rule was of questionable propriety. Especially when the litigation is between those who were
parties to the original bargain, there seems to be no reason to preclude the admission of all relevant evidence, and a
number of courts were reluctant to do so.35 Accordingly, some courts recognized that parol evidence may be
admissible between the immediate parties to show the capacity in which one has signed an instrument.36 It is only
when an instrument is uncertain, doubtful, or ambiguous with respect to the capacity in which a person has signed
that extrinsic (parol) evidence is admissible by the maker who wishes to show he signed not in his individual, but in
a representative, capacity.37
Article 3 currently allows a representative to disestablish personal liability more readily. This is in part due to the
change of the rule with respect to undisclosed principals. Since the principal will now be liable on the instrument,
there is less fear that allowing the representative to avoid liability will mean that there can be an instrument on
which no one is liable. Under Section 3-402(b)(2), a representative whose signature does not show unambiguously
that the signature is made in a representative capacity will remain personally liable to a holder in due course who
took the instrument without notice that the representative was not intended to bear liability. Against any other party,
however, the representative will be able to avoid liability by demonstrating that the original parties did not intend
the representative to be personally liable. The availability of parol evidence as between the immediate parties to the
instrument as used by the cases decided under prior law would also apply under the current version of Article 3.38
[iii]
Liability of Representative Where Principal Is Named
A representative who, with authority, signs the name of the represented person thereby makes an authorized
signature of the represented person and imposes liability on that person.39 But what about the liability of the
representative in this situation? Unlike prior law, which made personal liability dependent on the exact form of
signature used,40 Article 3s current treatment of representative liability rejects specification of particular forms of
signature in favor of a general rule that depends on the clarity with which the signer has indicated the true obligor
on the instrument. If the agent indicates unambiguously that his or her signature is made in a representative capacity
and identifies the represented party, the agent incurs no personal liability on the instrument, as long as the
representative had the authority to bind the represented party.41 Thus, a signature that reads Pringle, by Adams,
Treasurer, would impose no liability on Adams.
Where the signature creates ambiguity in the status of the signer or fails to identify the represented person,
however, different rules apply. Ambiguity may intrude in a number of ways. The agent may sign his or her name
alone without any indication of representative status (e.g., Adams); the agent may indicate status without
identifying the principal (e.g., Adams, Agent); or the representative may sign both names without indicating
representative capacity (e.g, Pringle, Adams). In each case, the issue of the agents personal liability depends on
who is attempting to enforce the note. The representative in each case is liable on the instrument to any holder in
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due course who took the instrument without notice that the representative was not intended to be liable. The
representative, however, is entitled to prove against any other party that the original parties to the instrument did not
intend the representative to be liable.42 Again, parol evidence of the parties original intention in this regard would
be admissible under Section 3-117.
[iv]
Signature on Behalf of an Organization
The rules under Section 3-402(b) with respect to signatures on behalf of a corporation, or other entity, are illustrated
in Augee v. Hunter.43 The court summarized the effect of the rules set forth in this section by stating that the
persons who signed a note (purportedly on behalf of a limited partnership) are not personally liable on the note if
the entity is identified in the note, the individual signatures are authorized signatures for the entity and the form of
the signatures shows unambiguously they signed as representatives rather than in their personal capacities. The
court found that all three elements were present. The signature block was signed as follows:
Grafs Court Ltd., a California Limited Partnership
BY: [Signature] BY: [Signature]
Ian Hunter Cleo Hunter
Naming of the entity satisfied the identification requirement. The signatures were authorized signatures under
agency law, and the entity was bound. The form of the signature was not ambiguous, and the form used shows a
representative capacity demonstrated by the use of the qualification by immediately before their signatures and
the placement of the signature line directly under the identification of Grafs Court, Ltd.
In Walker v. Smith44 notes issued by a corporation were signed as follows:
FACECAKE MARKETING TECHNOLOGIES, INC.,
a California corporation
By: /s/ Linda Smith
Name: Linda Smith
Title: CEO
The court, citing Section 3-402(b)(1), stated that This type of signature line, in which a corporate officer, clearly
identified as such, signs on behalf of a corporation, is understood as binding only the corporation, and not the
officer personally. This form of signature showed unambiguously that it was made on behalf of the represented
person that was identified in the instrument. An unambiguous way to sign an instrument that is an obligation of a
corporate entity is, as was done in this case: the principals name, followed by a signature line preceded with the
word by to be signed by the agent, and a line for the title of the agent.
The courts, in determining representative capacity, are not in agreement as to whether they must look only to the
form of the signature, or to the note as a whole.45
The above discussion applies to signatures on any type of negotiable instrument; the cases cited dealt specifically
with notes. Different considerations are present when the issue involves a check.
In early decisions under Article 3, several courts found that a corporate officer who signed a check without
indicating representative capacity bore personal liability, even though the name of the corporation appeared on the
printed check form.46 For instance, in Griffin v. Ellinger,47 the court imposed personal liability on the president of
a corporation who had signed corporate checks that were drawn on insufficient funds. The president had signed
only its name without indicating the corporate office. The checks, however, contained the preprinted name of the
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corporation in the upper left-hand corner. In addition, the check writer that imprinted the amount of the check
simultaneously imprinted the corporations name in the center of the check. Nevertheless, the court held that the
fact that the instrument was an authorized draft drawn on a corporate account did not constitute disclosure of the
signers representative capacity.48
On the other hand, in Pollin v. Mindy Manufacturing Co.,49 the court denied recovery by a third-party indorser
against one who signed its name to a payroll check directly beneath the corporate name without indicating its
representative capacity. Although the suit was not between the immediate parties to the instrument, the court
examined the entire instrument and determined that the signature had been made in a representative capacity. The
rationale of the opinion appeared to be the continuation of commercial practice to examine the instrument as a
whole rather than to rely on the form of the signature alone.
Article 3 currently resolves this dispute in cases of checks by providing that a representative who is authorized to
bind the principal under agency law, but who signs as drawer without indicating representative status will still not
be personally liable if the check is payable from an account of the principal and the principal is identified
somewhere on the check.50 Even a holder in due course of the check will be unable to hold the representative
liable. This provision, therefore, reverses decisions such as Griffin v. Ellinger, in which signing a corporate check
without more has been deemed insufficient notice of the signers agency status.
In Billingsley v. Smith,51 a check was drawn on a company account at a bank and was signed by the appellee in his
capacity as the accountant for the company, at the request of the person who was the sole proprietor. The court held
that Section 3-402(c) was applicable, so that the appellee was not liable on the check.
In Raid, Inc. v. Andrew,52 the court expressed the rational supporting the rule. The court recognized the substance
of Section 3-402(c) and noted that [V]irtually all checks used today are in personalized form which ide ntity the
person on whose account the check is drawn. In this case, nobody is deceived into thinking that the person signing
the check is meant to be liable. In this case, the checks were printed business account checks of a corporation, and
they were drawn (signed) by the secretary/treasurer of the corporation, in payment of goods ordered by the
corporation.
[4]

Burden of Proof Regarding Signatures

[a]
Specific Denial Required to Place Authenticity of Signature in Issue
A signature is deemed admitted unless it is specifically denied in the pleadings.53 The denial provides the plaintiffholder with notice that there is a claim of forgery or lack of authority as to the particular signature and affords the
plaintiff an opportunity to investigate and obtain evidence.54 The denial should be made in accordance with local
rules of pleading and, where such rules permit, the denial may be made on information and belief or it may be a
denial of knowledge sufficient to form a belief.55 Local procedural rules also determine whether the denial need be
under oath or whether the denial may be included in an amended pleading.56
[i]
Effect of Failure to Deny Specifically
Although a defendants failure to deny specifically the authenticity of a signature results in the admission that the
signature is genuine,57 it does not preclude the defendant from establishing that the signature, though genuine, is
invalid, as where the instrument has been signed under duress.58 In addition, one court has held that where the
plaintiff is not only placed on notice of the defense, but also fails to object to the introduction of evidence in
support of the defense, the signature will not be deemed admitted even though there was no specific denial.59
[b]
Burden of Establishing Genuineness Is on the Party Claiming Under the Signature
[i]
Presumption of Genuineness
Once the authenticity of a signature on an instrument is placed in issue by a proper denial, the burden of
establishing it is on the party claiming under the signature.60 The signature, however, will be presumed genuine
unless the action is to enforce the obligation of a purported signer who has died or become incompetent before
proof is required.61
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The existence of a presumption of genuineness means that until some evidence is introduced which would support a
finding that the signature is forged or unauthorized, the party claiming under the signature is not required to prove it
is authentic. The presumption rests upon the fact that in ordinary experience forged or unauthorized signatures are
very uncommon, and normally any evidence is within the control of or accessible to the party seeking to avoid
liability. That party is, therefore, required to make some sufficient showing of the grounds for the denial. Once such
evidence is introduced the burden of establishing the signature by a preponderance of the total evidence is on the
party claiming under the instrument.62
Section 3-308 also allocated the burden of establishing an agency relationship where a person seeks to enforce the
instrument against an undisclosed principle. Under that provision, the burden of establishing the relationship lies on
the person seeking to enforce the instrument.
[ii]
Plaintiffs Burden of Establishing Defined
If the defendant denies the genuineness of the signature, the plaintiff has the burden of establishing its validity.63
Burden of establishing a fact means the burden of persuading the triers of fact that the existence of the fact is
more probable than its nonexistence.64
[5]

Capacity in Which Signature Is Made

[a]
A Signature Is Presumed to Be an Indorsement
As discussed below,65 the liability of a party to an instrument varies with the capacity in which the party signs. A
makers liability differs from a drawers liability, and both differ from an indorsers liability. Nevertheless, even
where the authorization or authenticity of a signature is settled, the capacity of the signer may be in doubt. In any
such case, there exists a presumption that any signature not otherwise unambiguously made for some other purpose
constitutes an indorsement.66 If ambiguity exists, this presumption prevails notwithstanding the intent of the signer
to become liable on the instrument in some other capacity. Thus, not only will ambiguities be resolved in favor of
treating the signature at issue as an indorsement, but any party seeking to establish some other capacity for the
signer will have the burden of showing that the signature was not an indorsement.
[b]
Parol Evidence Is Inadmissible to Explain the Intended Liability of the Signer
The instrument itself must show in what capacity it was signed. The intent of the parties may be determined by
words accompanying the signature, the place of the signature, or other circumstances.67 The capacity of the signer
may be determined through usage and custom.68 For example, a signature in the lower right corner of a note
customarily indicates that the signer was a maker of the note.69
[6]

Liability for Unauthorized Signature Caused by Negligence

Notwithstanding the general principle that a party who has not signed an instrument is not liable on it, the Code has
created certain exceptions in which an unauthorized signature of another can trigger liability. These exceptions
appear initially to constitute attempts to place losses on parties in the best position to avoid them. The validation of
these signatures, therefore, appears to create an incentive for parties to take advantage of their superior ability to
prevent others from making unauthorized signatures. Nevertheless, there appears to be some variation from this
general principle.
[a]
Effect of Negligence
Section 3-406 provides that any person who by his or her failure to exercise ordinary care substantially
contributes to an alteration of the instrument or to the making of an forged signature is precluded from asserting
the alteration or forgery against a person who, in good faith, pays the instrument or takes it for value or for
collection. In Bank of Tex. v. VR Elec., Inc.,70 the court recognized that Section 3-406 applies to a claim for breach
of contract when the agreement concerns negotiable instruments; specifically, the section applies as a defense to a
claim against a drawee bank for payment of a check with an unauthorized signature (which is a breach of contract
claim). In Nisenzon v. Morgan Stanley DW, Inc.,71 the court characterized the negligence defense under this
section as a provision [that] essentially creates a conditional estoppel shielding a bank from liability where a
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plaintiffs negligence substantially contributes to the forgery. Section 3-406 can be used as a defense to a claim by
a customer-drawer against a drawee bank that it paid a check bearing a forged signature.72
Ordinary care in the case of a person engaged inbusiness is not simply the absence of negligence, but also
observance of reasonable commercial standards prevailing where the person is located with respect to the business
in which the person is engaged.73 This provision, therefore, provides an escape valve for a drawee that has made
final payment on an instrument bearing a forged drawers signature and is therefore strictly liable for the amount of
the instrument, even though the drawee paid in good faith and in accordance with reasonable commercial
standards.74 If the drawee can establish that the drawer negligently permitted an unauthorized party to sign the
drawers name, and that the drawers negligence substantially contributed to the making of that signature, the
drawee will be able successfully to resist an action to recredit the drawers account.75
Nevertheless, the drawer who acts without ordinary care is not always in this superior position. There is, for
instance, a substantial difference between a drawer who negligently drops a checkbook out of a pocket and
subsequently discovers that the finder of the checkbook has forged the drawers signature on checks, and the drawer
who leaves an uncompleted but signed check where it can be easily obtained by an unscrupulous employee.76 The
Code, however, speaks in broad strokes about the ordinary care of actors and thus arguably encompasses all such
acts.
[b]
Substantial Contribution and Proximate Cause
As indicated above, the failure to exercise ordinary care must substantially contribute to the forged signature. The
official commentary to the revised Code more directly addresses the issue and states that the substantially
contributes test in the Code is continued in the revised Code.77 The comment states that the test is less stringent
than a direct and proximate cause test. Rather, the test is whether negligence is a contributory cause and a
substantial factor to the forgery or alteration.78
Thus, where the drawer of corporate checks ignored warnings of an employees history of alleged embezzlement
and signed checks that could readily be raised in amount, the court found that the drawers negligence was the
proximate cause of, and thus substantially contributed to, the employees alteration of the check.79 Where the
drawer had negligently misdelivered the check to a party who forged the payees indorsement, however, the court
held that Section 3-406 did not render the drawer liable because his act did not substantially contribute to the
forgery.80 While some courts seek to distinguish between negligence that contributes to the actual signing by the
unauthorized signature and negligence in the issuance of the check,81 the former could not occur without the latter.
Alternatively, some courts treat the substantially contributes clause as a proximate cause issue and allow the
drawers negligence to cut off the drawees liability only where the former is a superseding cause.82 Under any of
these rationales, it may be that the courts, in a somewhat inarticulate way, are intuiting toward some other
distinction. It may be that the distinction, an appropriate one to draw, is between those instances in which the
negligent party is and is not clearly in a superior position to prevent the loss that materializes.83
Some additional support for this proposition appears from the requirement that a person asserting the preclusion of
Section 3-406 must have exercised ordinary care in paying or taking the instrument. Section 3-103(a)(7) defines
ordinary care as observance of reasonable commercial standards, prevailing in the area in which the person is
located, with respect to the business in which the person is engaged. Thus, a drawee that pays an instrument
bearing obvious signs of alteration or forgery,84 or that accepts checks signed by someone clearly not the payee,85
or that fails to make proper inquiry about the deposit of corporate checks in a personal account,86 avoids an
opportunity to prevent a loss even though the drawer has failed to take adequate precautions. Since the drawer has
already underinvested in safeguards, only the drawee can avert the loss. The requirement that the person asserting
the preclusion must have acted in accordance with reasonable commercial standards imposes on the drawee the
obligation to take advantage of the possibility that, at the time of payment, it occupied the superior position to avoid
the loss. In effect, this requirement is the functional equivalent of the last clear chance doctrine in tort law. Under
that doctrine, even a party who would otherwise be barred from recovering against a negligent defendant because of
its own contributory negligence may recover if the negligent defendant had the last opportunity to avoid the harm.
[c]

Comparative Negligence Standard and Burden of Proof

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Where both drawer and drawee have negligently caused the loss, Section 3-406(b) provides that the loss is
allocated between the person precluded and the person asserting the preclusion according to the extent to which the
failure of each to exercise ordinary care contributed to the loss.87 This comparative negligence principle changes
prior law, under which a contributorily negligent drawee or other party that paid the instrument bore the entire loss.
The Code contains a provision on burden of proof88 which was not contained in the prior version. This new
provision changes the decision of the cases that dealt with the burden of proof and holds that the bank has the
burden of proving it complied with reasonable commercial standards.89 Pursuant to the Code, the bank has the
burden of establishing the customers negligence (failure to exercise ordinary care) to preclude the customers
claim, and the customer has the burden of proving the banks failure to exercise ordinary care in order to effect an
allocation of the loss.90
[d]
Availability of Defense to Depositary Bank
The drawee bank that pays over a forged indorsement as opposed to a forged drawers signature may have some
recourse other than refusing to recredit its negligent customers account. It may instead bring a warranty action
against the depositary bank that accepted the check bearing the forged indorsement.91 That bank, however, may
attempt to shift the loss back to a negligent drawer by using Section 3-406.92 This raises two questions. First, can
the drawee proceed in warranty against the depositary if the drawee has failed to assert a valid claim that it has
against its customer? Second, may the depositary resist warranty liability to a drawee by invoking Section 3-406
against a drawer whose negligence substantially contributes to the making of an unauthorized signature?
The court in Girard Bank v. Mount Holly State Bank,93 thoroughly addressed each of these issues. In that case, a
depositary bank that accepted a check witha forged indorsement attempted to avoid warranty liability to a drawee
that had paid the check by alleging that the drawee had failed to assert a valid defense against its customer, the
drawer. The depositary bank noted that under the then-existing version of Section 4-406(5), a payor bank that fails
to assert a valid defense against a claim of a customer may not subsequently assert against any prior party a claim
based on the unauthorized signature giving rise to the customers claim.94 The defenses specifically referred to in
that version of Section 4-406(5) involved a customers failure to notify the drawee of an unauthorized signature
within specified time limits. There is no specific analogue to that provision in Section 3-406, but the depositary
bank in Girard attempted to convince the court to find such a limitation. The court, however, refused. The court
recognized that failure to apply to warranty actions a limit such as the one contained in Section 4-406(5) would
permit a drawee to prefer its negligent customer and recover from an innocent depositary. Nonetheless, the court
believed that the clear language of the Code mandated a restrictive reading of Section 4-406(5). While the courts
rationale and reliance on Code language is reasonable, one is not led inexorably to the courts conclusion. The
drawer in this situation is often the party in the best position to prevent the loss from materializing. The current
version of Section 3-417(c), therefore, does permit a depositary bank sued for breach of warranty by a payor bank
to defend on the ground that the drawer is precluded from asserting the unauthorized signature against the drawee.
If the courts concern is with loss spreading rather than loss avoidance, however, the depositary bank, which will
have a better idea than the drawer of the frequency of such occurrences and thus best be able to factor such losses
into its charges, would seem a better risk bearer than any given drawer.
When the court turned its attention to the second questionthe availability of Section 3-406 to the depositarys
claim against the drawerit properly held that the depositary bank could not utilize Section 3-406. The court
reasoned that that provision applied only to drawees, payors, or holders in due course. The depositary was clearly
not the drawee, and could not be a holder in due course, as it was in possession of an instrument bearing a forged
indorsement. Nevertheless, the court opined that the depositary would still have a common-law negligence action
against the drawer under Section 1-103.
[e]
Imposter Rule and Fictitious Payee RuleIntroduction
Under certain circumstances, a forged indorsement in the name of the named payee will be considered effective,
notwithstanding the forgery. The effectiveness of these instruments creates two legal consequences that would
otherwise not result. First, the forger may pass good title to these instruments as if no forgery existed. Thus, a
transferee may become a holder and a holder in due course of these instruments and neither transfer nor
presentment warranties are violated. Second, these instruments are properly payable notwithstanding the presence
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of the forgery; thus, a drawee bank that pays these instruments may debit its customers account under Section 4401.95
The circumstances under which a forged indorsement is effective are set forth in Sections 3-404 and 3-405. These
circumstances correspond to doctrines that have become known as the imposter rule, the fictitious payee
doctrine, and the padded payroll cases. Moreover, Article 3 expands the conditions under which an indorsement
will be effective beyond what was possible under prior law.
In each of these situations, a drawee bank or other party96 seeking to assert the effectiveness of the forgery need
not demonstrate that negligence contributed to the forgery. Nevertheless, one rationale for these doctrines is that
they describe circumstances in which the drawer was likely to have been negligent. Thus, one analysis of these
cases would consider them as subsets of Section 3-406. Alternatively, one may consider that in each of these
situations, even a nonnegligent drawer was in a superior position, relative to the drawee, to avoid the forgery that
subsequently materialized.97 Thus, in padded payroll cases, it may be appropriate to impose losses on an employer
who makes out checks to nonexistent employees as a cost of doing business, even if the employer is not negligent
in failing to know the name of each employee.
[i]
Scope of Imposter Rule
Section 3-404(a) provides that an indorsement by an imposter who, by use of the mail or otherwise induces the
issuer to issue the instrument to the impostor, or to a person acting in concert with the imposter, by impersonating
the payee of the instrument or a person authorized to act for the payee is effective as the indorsement of the payee
in favor of a person who, in good faith, pays the instrument or takes it for value or for collection.98
An imposter exists where one with no interest in the instrument presents itself as a party entitled to the instrument
in order to obtain it. A thief who steals a check made payable to another who then presents himself as the named
payee is not an imposter. Thus, where the drawer delivered a check relating to an oil lease to a person alleging to be
an employee of a geophysical company that had an employee with the same name as the named payee, the
subsequent unauthorized indorsement by the recipient of the check did not impose any liability on the drawee or
collecting banks.99
The prior version provided that an indorsement made in the name of a named payee is effective.100 The Code
provides that an indorsement in the name of the payee is effective.101 Some cases interpreted the prior version to
require the indorsement to be in the exact form as the payees name. These cases are rejected under the current
version; an indorsement is made in the name of the payee if it is made in a name substantially similar to that of the
payee.102
Applying prior version, the courts concluded that the impostor rule did not render the instrument bearer paper, and
most held that an indorsement was necessary for the impostor defense to apply. Pursuant to the current version, an
indorsement is considered made in the name of the payee, so that the defense applies if the instrument whether or
not indorsed, is deposited in a depository bank to an account in a name substantially similar to that of the
payee.103
Under prior law, the rule that made indorsement by an imposter effective was directed solely at the situation in
which the purported indorser had impersonated the named payee. It did not operate to make effective an
indorsement by a party who misrepresented his or her authority. According to the Official Comment to the prior
version of Section 3-405, The maker or drawer who takes the precaution of making the instrument payable to the
principal is entitled to have his indorsement.104 Thus, where the drawer delivered to the principals dishonest
employee a check payable to the order of the principal, the drawee bank that paid over the unauthorized
indorsement by the employee had no defense to a conversion action, as the impostor rule did not cover the
situation.105 Nor was one an imposter within the rule if one never pretends to be anyone other than oneself, but
obtains the check under fraudulent circumstances. Thus, there was no imposter where an attorney obtained
checks payable to himself and to various clients, misrepresenting the clients desire to settle claims, and
subsequently forged the clients signatures.106 Even if the drawer made the check payable to the order of a fictional
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entity of which the forger purports to be an agent, the forgery in the name of the payee was ineffective and Section
3-405(1)(a) did not apply.107
The scope of the imposter rule is expanded under the current version of Section 3-404. The power to make an
effective indorsement is given to an imposter who obtains a check by impersonating a person authorized to act for
the payee. Thus, the person who impersonates an agent and obtains a check payable to the order of the principal
can make an effective indorsement of the principal.108
The difference in the two versions is explained in Intelogic Trace Texcom Group, Inc. v. Merchants National
Bank.109 In that case, England held himself out to be a representative of Hawks Sales Corporation., and obtained
three checks payable to Hawks. England indorsed each check in the name of Hawks Sales Corporation and
transferred the checks to Zebone for amounts that England owned Zebones principal. Zebone confirmed the
authenticity of the checks with the drawer and the checks were subsequently paid by the drawee bank. Intelogic, an
assignee of the drawer, subsequently brought conversion and breach of warranty actions against the depositary bank
and Zebone. The court first held that an imposture had occurred, even though England had held himself out as
Hawks by virtue of forged corporate documents rather than in a face-to-face transaction.110 The court then
addressed the plaintiffs claim that England had simply misrepresented his authority. Prior law provided that if an
imposter impersonated X, an agent of Y Corporation, but obtained a check made payable to Y Corporation rather
than to X, Xs signing Y Corporations indorsement was not effective.111 Current law makes the imposters
signature effective in both cases. In Intelogic, decided under the prior version of Article 3, the court held that even
that law denied the effectiveness of the indorsement only where there had been only a misrepresentation of status
and not where an imposture had occurred. The court concluded that [t]he situation where a person impersonates an
authorized agent of the payee and that impersonation results in the issuance of an instrument to the imposter or
confederate in the name of the purported agents principal is indistinguishable from that where the imposture
involves an impersonation of the named payee. The court cited the recently adopted changes to Article 3 as
support for this proposition. A misrepresentation of authority, insufficient to permit the wrongdoer from making an
effective indorsement, would exist, according to the court, only where the indorser honestly identifies him or
herself, but falsely states that he or she is an agent of another. While the court may have been correct in its
rationale, its reasoning appears inconsistent with the limitations on the imposter doctrine under prior law.
[ii]
The Fictitious Payee Doctrine
The Code also makes effective certain indorsements on instruments that are made payable to fictitious payees or
others who are not intended to have any interest in the proceeds of the instrument by the person whose intent
determines to whom an instrument is payable. In order to understand the evolution and significance of these
provisions, however, it is useful to begin with pre-revision law.112 That law made effective any indorsement made
by any person in the name of the payee if (i) the person signing as or on behalf of a maker or drawer intended the
payee to have no interest in the instrument; or (ii) an agent or employee of the maker or drawer supplied him with
the name of the payee intending the latter to have no such interest.
The typical case covered by the first scenario involved a dishonest employee who is either in charge of issuing
checks of the employer or had access to the employers check writing facilities and who makes checks payable to
the order of fictitious creditors of the employer. When the employee subsequently forged the indorsement of the
payee, the signature was rendered effective.113 The legal consequence of effectiveness is that any subsequent
transferee of the check can be a holder, notwithstanding the unauthorized indorsement, and the drawee bank can
debit the drawers account for the amount of the instrument, because it is properly payable, again,
notwithstanding the unauthorized indorsement.114 The typical case covered by the second scenario involves a
dishonest employee who supplies the authorized signatory of the drawer with the name of a real or fictitious person
to whom the supplier never intends to deliver the check. Instead, the dishonest employee intends to purloin the
check once it is properly completed with the drawers authorized signature. Here, as well, when the employee
subsequently forges the indorsement of the intended payee, the signature is effective.115 Nothing in the statutory
language of the section restricts the fictitious payee doctrine to employer-employee situations, however, and the
logic of the doctrine applied with equal force even though the wrongdoer is not associated with the drawer.116

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The prior version provides that an indorsement is necessary;117 it does not, however, specifically address whether
the indorsement must be identical to the named payee. Under other sections of the prior version,118 an exact
indorsement is not a necessity in situations where fictitious payees and impostors are not in issue. However, the
courts were not in agreement as to this issue when it came to applying the fictitious payee rules; some courts held
that for the indorsement to be effective under the fictitious payee and impostor rules, it must be exactly the same as
the named payee,119 while others held that the exact name was not required, adopting a substantially similar
test.120
To the extent that these doctrines were predicated on the superior ability of an employer to detect and deter
employee negligence,121 or on the capacity of the employer to absorb the loss as a cost of doing business,122
Section 3-405 introduced certain anomalies into the Code. A dishonest employee who forged indorsements on
incoming checks is presumably equally subject to the scrutiny of the employer. Similarly, a dishonest employee
who stole a properly prepared check was also subject to employer supervision. Nevertheless, unless the employer
could be shown to have acted in a negligent manner within the meaning of Section 3-406, prior law did not place on
the employer the loss of employee-forged indorsements on checks in either of these situations.123 The prior version
of Section 3-405, however, rendered the employer liable for forged indorsements on outgoing checks that fit within
that provision regardless of the employers negligence in hiring, retaining, or supervising the employee. If the true
rationale of loss allocation with respect to forgeries is to place losses created by dishonest employees on the
employer as a cost of doing business, then this disparate treatment of the same employee with respect to incoming
and outgoing checks is difficult to justify. In addition, cases involving Section 3-405(1)(b)124 depended on the
intent of the person when signing. If the intent to steal the check was formed only after the check was signed,
Section 3-405(1)(b) arguably did not apply.125 That provision literally covered only situations where the signer of
the check drew it with the intention that the payee have no interest in it. Thus, the Section introduced difficult issues
of proving when the relevant intent was formed.
Finally, to the extent that it was predicated on the assumption that an employer should know the identities of its
creditors, and thus be able to detect checks payable to persons to whom money is not owed, pre-revision law poses
an additional difficulty. Assume that an employee provides the employer with a request for payment from an actual
creditor. At the time, the employee intends to steal the check and forge the creditors indorsement. In other words,
the employee who provides the name intends the named payee to have no interest in the check. Substantial debate
existed as to whether the subsequent forgery was effective under Section 3-405. Various courts held that where an
employer issues checks for money owed to an actual creditor, the dishonest employee who requests the check and
absconds with it has not supplied the name of the payee as that term is used in pre-Revision Section 3-405(1)(c).
Rather, these cases concluded, the names had been supplied by the creditors themselves by virtue of their
performance that gave rise to the obligation.126 This conclusion wascertainly consistent with the rationale behind
the provision, even if it required some straining of the statutory language. Under this rationale, an actual debt must
be owing. The mere existence of an actual payee to whom no obligation is owed would not suffice to remove the
drawer from Section 3-405. Thus, where an employee had checks issued in the names of real payees, but based on
false invoices, courts held that the dishonest employee was the supplier of the payees name for purposes of that
Section.127
The current version of Article 3 avoids these anomalies and semantic distinctions, and makes other important
changes in the analysis of the fictitious payee doctrine and employee supervision cases.
In National Union Fire Ins. Co. v. Allfirst Bank,128 the court recognized that Section 3-404 addresses three
situations. The first situation, the imposter situation, whereby an imposter induces the issuer of an instrument to
issue it to the imposter, by impersonating the payee, is addressed in subsection (a); the second situation, where an
instrument is issued and the person whose intent determines to whom it is issued does not intend the payee to have
an interest, is addressed in subsection (b)(i); and the third situation, where the payee is fictitious, is covered in
subsection (b)(ii). In the case of an instrument made payable to a fictitious person, anyone in possession of the
instrument qualifies as a holder.129 An indorsement of the instrument by any person in the name of the payee is
effective as the indorsement of the payee in favor of anyone who either takes the instrument for collection, such as
a depositary bank, or who pays it, such as a drawee bank, as long as that action is undertaken in good faith. These
rules will apply whether the check was prepared by an employee of the named drawer or not and whether the
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drawers signature was forged or not. Thus, where the indorsement has been forged, the employer will bear the loss.
In the case of a forged drawers signature, of course, the drawee will not be able to charge the drawers account.
The drawee will also not be able to claim a breach of warranty by a collecting or presenting bank, because the
provision makes the payees signature effective for warranty purposes. The drawee, therefore, will bear the loss.
Outgoing checks to persons intended to have no interest in the instrument are covered by the same rules. Recall that
the current version of Article 3 defines the person whose intent determines to whom an instrument is payable.130
Typically, this will be the person signing as or on behalf of the issuer of the instrument, such as a corporate officer.
When that person signs the check without any intent that the named payee have an interest in the check, any person
in possession of the instrument can again be a holder and an indorsement by any person in the name of the payee is
again effective for collection and payment purposes. It is irrelevant whether or not the named payee was a creditor
of the issuer. Regardless of how the name was supplied, if, at the time he or she drew the check, the authorized
signer intended to steal it after completion, indorsement by the thief will be effective.
Current law also resolves the inconsistency between outgoing and incoming checks. Current Section 3-405 makes
effective as the indorsement of the named payee any fraudulent indorsement made either by an employee who has
responsibility with respect to the instrument or by a person acting in concert with that employee.131 An
indorsement by a person with responsibility is also effective in favor of a person who pays it or takes it for
collection in good faith. An unauthorized indorsement under this provision may be an indorsement of the employer
where an incoming check is involved or an indorsement of a named payee where an outgoing check is involved.132
Thus, Article 3 now explicitly covers both checks drawn by and to the order of the employer.133 There is no need
in either case to demonstrate any negligence on the part of the employer. Both depositary and drawee banks will be
able to resist claims of conversion by the employer.
Furthermore, Article 3 makes an indorsement effective regardless of when the intent to steal the check was formed.
Assume, for instance, that the corporate officer whose intent determines to whom the check is payable draws a
check to an actual creditor with the intent that it be properly delivered. Before the instrument is delivered, however,
the officer decides to steal it. This case would not be covered by Section 3-404(b)(i), dealing with outgoing checks,
because the intent was formed at the wrong time. It would, however, be covered by revised 3-405(b), which deals
more generally with supervised employees and which covers checks that were bona fide when written by later
intercepted by a dishonest employee.134 Thus, a pleading in the alternative should avoid the difficult inquiry into
the time when the requisite intent was formed.
Section 3-405 also covers situations that previously involved the supply of the name of the payee to the drawer of
the check. Assume, for instance, that a corporate officer whose intent determines to whom an instrument is payable
the signer of the checkreceives the names of payees from another employee charged with receiving invoices. If
the nonsigning employee provides the corporate officer with the name of a fictitious person, the case is governed by
Section 3-404.135 If, however, the nonsigning employee provides the corporate officer with the name of an actual
person and subsequently steals and indorses the check, that indorsement is effective under Section 3-405(b). It is
again irrelevant whether money is actually owed to the payee.
Not every employee is covered by the proposed provision, however. Instead, the forgery is effective only when
made by an employee who has responsibility with respect to the instrument.136 Responsibility exists only where
an employeehas authority to sign or indorse on behalf of the employer; to process instruments for bookkeeping,
deposit, or other disposition; to prepare instruments for issuance by the employer; to supply information concerning
names and addresses of payees; to control the disposition of instruments issued by the drawer; or to act otherwise
with respect to instruments. The fact that an employee has access to blank or incomplete instruments or forms does
not, of itself, constitute responsibility.137
Smith v. AmSouth Bank, Inc.138 makes an extremely important point with respect to the interpretation of this
section. Because the section sets forth several factors that are separated by the connector or, it means that an
employee will be found to have responsibility if any one of the several factors is present. There is no requirement
that there be a predominance of factors in order for the employee to have responsibility. Under the facts of this
case, the employee was found to have responsibility where the employee had authority, at least on some occasions,
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to sign and indorse checks on behalf of the employer, and to process instruments for deposit to the employers
account. The employee most likely could act with respect to instruments in a responsible capacity. Thus, a
forged indorsement by a janitor who found a check made payable to the employer on the presidents desk would not
be effective as the employers indorsement unless negligence could be demonstrated under Section 3-406. The
same result would follow if the janitor found the checkwriting machine and check stock used by a firm and
imprinted a check with the firms authorized signature. Although the checkwriting machine imprinted a facsimile of
an authorized signature that could not easily be detected by the drawee bank, that signature would be unauthorized
and the indorsement of the janitor in the name of the named payee would not be effective under Section 3-405.
Employees with responsibility, however, are not limited to employees of the firm. The definition of employee
is broad enough to include an independent contractor or employee of the independent contractor.139 Thus, if a firm
contracts out its payroll preparation, employees of that contractor will be employees of the firm for purposes of
Section 3-405.
As explained above, the courts were not in agreement, in interpreting the Pre-Revision, whether and indorsement
must be exactly the same as the named payee. Notably, the current version of the Code rejects those cases requiring
the indorsement to be in the exact name of the payee. Pursuant to the revised Code, the indorsement is only
required to be in a name substantially similar to that of the payee.140
[iii]
The Consequences of Negligence
Pre-Revision Section 3-405 presented one other potential inconsistency with seemingly related Code provisions.
Even a drawer whose negligence substantially contributed to the making of an unauthorized signature could recover
from the drawee bank if the latter had failed to conform to reasonable commercial standards in its handling of the
instrument.141 Yet Section 3-405 made no mention of a comparable doctrine of last clear chance. It would appear
that the policies that dictated the last clear chance doctrine in Section 3-406 should apply with equal force in the
situation of fictitious payees. Nevertheless, some courts refused to permit drawers responsible for instruments under
Section 3-405 to avoid liability by demonstrating lack of due care or commercial unreasonableness by drawee
banks.142 The California Supreme Court, however, permitted a drawer to shift the loss that it would otherwise have
incurred under pre-Revision Section 3-405 to a depositary bank that failed to use due care in handling the
instrument.143 Further, a court could find that the drawee bank failed to exercise good faith and was therefore
liable to a drawer otherwise precluded from recovery under Section 3-405.144 In Getty Petroleum Corp. v.
American Express Travel Related Services Co. Inc.,145 a transferees gross negligence in accepting forged checks
did not relieve drawer of liability. The court ruled that the drawer would have had to prove commercial bad faith in
order to make the transferee liable.
Some courts held that negligence of a bank in the handling or paying of an item, unlike bad faith, does not preclude
the bank from availing itself of the fictitious payee rule as a defense.146
These judicial machinations are unnecessary under current law. Sections 3-404 and 3-405 apply the same
comparative negligence standard to imposter, employee forgery, and fictitious payee cases that exists under the
general negligence provision of Section 3-406. Thus, a person who takes the instrument for collection or who pays
it under conditions that would otherwise render forged indorsements effective, may still be liable for part of the
loss if that person exhibits failure to exercise ordinary care. If that negligence substantially contributes to loss
resulting from the fraud, the employer or drawer may recover from the negligent person to the extent that the failure
to exercise ordinary care contributed to the loss.147

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20.12 Liability of the Maker or Issuer*

[1]

The Maker or Issuers Obligation

The basic obligation of the maker1 (referred to as the issuer of a note in revised Section 3-412, but as the
maker in the Official Comment to that Section) is set forth in Section 3-412.2 This provision imposes on the
maker the obligation to pay the instrument according to its terms at the time it was issued or as completed pursuant
to Section 3-115 on incomplete instruments.3 The same obligations govern the issuer of a cashiers check. Although
first made explicit by the 1990 Revision of Article 3, the effect is the same as prior law, under which a cashiers
check, a draft drawn on the drawer, was effective as a note.4
[a]
The Maker or Issuer Promises to Pay According to the Terms of the Instrument as Issued
The makers promise is to pay the instrument according to its terms at the time it was issued or, if not issued, at the
time it first came into the possession of a holder.5 Issuance occurs when there is a delivery by the drawer or maker
to any person who is intended to have rights in it.6 In the case of a cashiers check, therefore, issuance will occur
when the remitter obtains the instrument from the issuing bank, not when the remitter delivers the check to the
payee. The instrument is deemed delivered when the maker voluntarily transfers its possession.7 Thus, if a maker of
a note completes the instrument and hides it in a desk from which it is stolen by a thief, the instrument has not been
issued since the maker never voluntarily transferred possession. Nonissuance of an instrument, however, is only a
personal defense that a maker or drawer can assert against one who is not a holder in due course. If the instrument
is not issued and the defense is unavailable, the maker is liable according to terms of the note when it first came
into possession of a holder.8 Thus, if the maker completes an instrument payable to bearer and it is stolen prior to
delivery, a subsequent transferee, who can be a holder in due course, can enforce the note against the maker.
The effect of alterations of an instrument on a partys obligation (that would include a maker) are provided in
Section 3-407(b) and are discussed above in 20.10[2][f].
Each makersliability, moreover, is for the full authorized amount of the instrument; a co-maker cannot successfully
maintain that it is liable only for a pro rata share. Section 3-116(a) presumes that each maker is jointly and severally
liable, even though the obligation to pay is stated in the singular, e.g., I promise to pay.9
[b]
The Maker of Issuers Liability Is Primary
Although the Code does not use the phrase, the maker and issuers liability is often described as primary.10 This
means that the holder of the instrument anticipates payment from the maker or issuer in the first instance and has an
immediate cause of action against a maker who fails to pay when the instrument falls due.11 Thus, a promissory
note may be described as an unconditional contract of the maker to pay the holder according to the terms of the
instrument.12 The note is complete as written and there are no conditions to its payment other than what appear on
the face of the instrument.13
[c]
A Note is a Contract; Makers Obligation Is Subject to Contract Law
Notably, a note has been universally acknowledged by the courts to be a contract.14 Recognition that a note is a
contract, which is a rather obvious and logical conclusion given that notes contain numerous terms and conditions
no different than other contracts, means that common law contract principles will apply to the note, to the extent
that the issues are not provided for in the Code.15
In Galvin v. McCarthy,16 the court observed that although notes are governed under Article 3 they are treated like
contracts in many respects a note is interpreted like a contract under Colorado law Furthermore, a party
may enforce a promissory note through a breach of contract claim. In Quan v. Delgado,17 the court observed that
a note is a unilateral contract, under which the promisor is the only party that is obligated to perform.
Another incidence of the rule that a note is a contract can be found in Mayer v. Medancic.18 The court recognized
that a note is a contract, and therefore an appellate court reviews lower court decisions regarding notes de novo.
Since a note is a contract, where issues arise as to the meaning of any terms of a note, the general rules of contract
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construction and interpretation will apply in interpreting such terms.19 Further, the contract rules on damages,
including liquidated damages, will apply to a note.20

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20.13 Liability of the Acceptor or Payor (Drawee)*

[1]

Drawee as Acceptor

[a]
The Nature of a Draft
Unlike a note, which is a two-party instrument in which a promise to pay runs directly from the maker to the payee,
a draft contains three essential parties. The drawer of a draft does not issue a promise to pay. Rather, the drawer
issues to a drawee an order to pay a sum, usually held by the drawee for the drawers benefit, to the payee.1 In
order to receive the funds represented by the instrument, the payee must present the draft to the drawee. The most
familiar type of draft is the common check in which the drawee is a bank and the draft is payable on demand.2
Notwithstanding that holders typically look to drawees for payment of drafts, a drawee that fails to honor the
instrument does not, by that fact alone, face liability to the holder. Section 3-408 provides that a draft does not of
itself operate as an assignment of any funds in the hands of the drawee. Thus, the holder of a draft has no claim to
those funds by virtue of its possession of an instrument drawn on them. Even if the drawees dishonor of a draft is
wrongful as against the drawer, the holder has no action against the drawee.3 Indeed, a drawee bank that is aware
that a check is outstanding may with immunity from the holder continue to pay other checks that have been
drawn on the same account, even if doing so leaves insufficient funds to pay the outstanding check of which it has
notice.
While the Code provides that a check alone is insufficient to constitute an assignment, it does not preclude the
introduction of other evidence to create an obligation running from the drawer to the holder. For instance, payees in
some cases have alleged that special circumstances make them third-party beneficiaries of the customer agreement
between the drawer and drawee,4 or have claimed that the drawers deposits could not be used to set off debts owed
to the drawee rather than to pay outstanding checks.5 In W.B. Farms v. Fremont National Bank and Trust Co,6
payees of checks drawn on insufficient funds claimed that the drawees oral promise to honor the checks when
funds were next deposited in the drawers account constituted an assignment of those funds. The court found that
the promise by the banks agent was binding on the bank so that the bank incurred liability to the payees when it
paid those funds to other parties. In First National Bank v. Ford Motor Credit Co.,7 Ford had refused to honor a
sight draft presented to its collecting bank by a depositary bank. The depositary sued on a theory of promissory
estoppel, alleging that Ford had created an oral understanding that the drafts could be treated as cash items or, in
the alternative, that Ford had impliedly promised to honor the drafts. Although the court recognized that estoppel
theory could bind Ford under some circumstances, it concluded that holding a drawee liable simply because it
furnished drafts would be inconsistent with the general rule that a drawee is not liable until acceptance.
[b]
The Acceptors Obligation
The liability of the drawee to the holder is triggered when the drawee accepts the instrument.8 At that point, the
acceptor is obligated to pay the draft as presented. In this event, the acceptors liability becomes the same as that of
the liability of a maker on a note. This liability applies even if the acceptance states that the draft is payable as
originally drawn.9 In the case of an instrument that is incomplete, acceptance of the draft means acceptance as
completed pursuant to Section 3-115 on incomplete instruments.10 Note that while the maker is obligated to pay
the note according to its tenor as of the time it is issued, the acceptors obligation is linked to the terms of the
instrument at the time of acceptance. If acceptance varies the terms of the instrument, the acceptance applies
according to the terms of the draft as varied.
[2]

Acceptance

[a]
What Constitutes Acceptance?
Acceptance consists of the drawees signed engagement to honor the draft as presented.11 It must be written on the
draft itself, but specific words indicating acceptance need not appear. Instead, the drawees signature alone will
suffice. If the drawees signature is accompanied by words indicating an intent not to accept, however, no
acceptance will result.12
[b]

Personal Money Orders

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Although the requirements of acceptance seem relatively simple, they give rise to difficulties in the case of personal
money orders. The nature of personal money orders is discussed above in 20.02[1]. The issue usually arises in
connection with a consideration of the right of the bank to stop payment. The courts interpreting the Pre-Revision
are divided on the issue due to the difficulty of determining whether a money order is akin to an official, cashiers,
or certified check or to an ordinary check and due to the difficulty of reconciling policy issues as to the
understanding of the effect of money orders by the public and commercial establishments.
Several New York courts have addressed this issue, and have had difficulty in formulating a consistent rule of law,
although the majority appears to permit the bank to stop payment.13 Some courts did not allow the bank to stop
payment.14
This conflict is resolved in the current version of the Code, where a money order is defined as a check. Since it is a
check it is subject to a stop order by the purchaser-drawer. As drawee, the seller bank is not obligated to a holder to
pay it.15 Personal money orders are instruments that can be purchased from financial institutions for an amount that
represents the face value of the order plus a service fee. The purchaser typically signs in the lower right-hand corner
of the order, where drawers sign checks. Because the purchaser is not usually drawing funds out of an account at
the bank, however, the purchaser does not constitute a drawer; rather the purchaser is referred to as a remitter, as
it has remitted funds to the bank in return for the order. The issuing banks name usually appears in printed form at
the top of the money order, but the bank does not otherwise sign the money order after the sale to the remitter.
[c]
Certified Checks; Certification as Acceptance
A holder of an instrument may wish to retain or negotiate a check and yet be certain that the check will be paid
when finally presented. Alternatively, a payee or other holder will often be willing to accept a check in satisfaction
of an underlying obligation only if convinced that the check will ultimately be honored by the drawee. In either
case, the solution is the same: the drawee may certify the check and thereby accept it in advance of paying the
check.16 Nevertheless, under pre-Revision law, important differences do exist in the cases where the drawer and
the holder obtain certification.
A bank has no obligation to certify a check,17 and thus, a refusal to certify does not constitute a dishonor.18 If the
bank chooses to certify, it will likely debit from the drawers account the amount of the check and credit its own
account to ensure that funds are available to pay the certified check when presented.
Since the drawee has the ability to debit the drawers account, the act of certification discharges the drawer and all
prior indorsers. The holder may look only to the drawee for recovery, and is, in effect, relying on the drawees
credit when it takes a certified check. Prior to the Revision, this result would obtain only when the holder procures
certification. Current law discharges the drawer of the obligation on the accepted draft and all preacceptance
indorsers regardless of who secures the acceptance,19 as long as the acceptor is a bank. If the acceptor is not a
bank, dishonor by the acceptor imposes on the drawer the same liability that would be imposed on an indorser.20
[d]
Refusal to Pay Instruments on Which Bank Is Obligated
The current version of Article 3 attempts to eliminate any ambiguity concerning liability for instruments on which
banks are obligated and to set a standard for damages in such cases. Section 3-411 applies to a drawee bank that has
certified a check and the issuer of a cashiers check or a tellers check. A holder or transferee of such an instrument
who is wrongfully denied payment or, in the case of a tellers check, discovers that the issuing bank has wrongfully
stopped payment on it, is entitled to compensation for expenses and loss of interest.21 These damages may include
attorneys fees.22 If the obligated bank is informed that failure to pay will cause consequential damages, a
continued failure will render the bank liable for those damages.23
Wrongful failure to pay in these circumstances includes any situation in which the obligated bank cannot assert the
claim of the remitter or customer seeking certification, or in which the claim of the remitter or customer is not
upheld, or in which an adverse party has obtained an injunction against payment by the bank.
Under certain conditions, the obligated bank will be able to avoid payment of damages, notwithstanding its
wrongful failure to pay. If the bank is unable to pay its debts generally, no additional damages will be assessed for
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failure to honor these instruments. If the banks obligation is unclear, because it asserts a claim or defense that it
reasonably believes is available against the person seeking to enforce the instrument or because the bank reasonably
doubts that that person is entitled to enforce the instrument, damages are also inappropriate. The latter case may
exist, for instance, if the bank cannot corroborate the identity of the person seeking to enforce the instrument.
Finally, a bank can avoid any payment prohibited by law without incurring additional damages for nonpayment.24
[e]
When Acceptance Becomes Effective
An acceptance becomes operative when completed by delivery or notification to the holder, presumably whichever
occurs earlier.25 Thus, even though delivery is essential to trigger liability for a maker, drawer or indorser, an
acceptor may become liable by notification to the holder without delivery. The acceptor notifiesthe holder by
taking such steps as may be reasonably required to inform the [holder] whether or not such [holder] actually comes
to know of it.26 Thus, where a bank issued to a customer a cashiers check payable to a third party, no acceptance
of the check existed (even if a cashiers check otherwise constitutes an accepted draft)27 until delivery to the
payee.28
[3]
Acceptance at Variance With Terms of Draft
[a]
Disclaiming the Obligation
A drawee may not at once accept an instrument and disclaim the obligation it creates. Acceptance without liability
would be the same as refusing to accept, that is, dishonor. Consequently, the Code makes no provision for accepting
without recourse.
[b]
Modifying the Obligation
The Code does, however, allow an acceptance that varies the terms of the draft.29 Where a drawee offers an
acceptance at variance with the terms of the draft, the holder has two options. First, the holder may reject the offer,
insist on acceptance of the draft as presented and treat the varied acceptance as a dishonor.30 The drawee may
thereupon cancel the acceptance. Second, the holder may accept the offer. If the holder does accept the varied
acceptance, however, any drawer or indorser of the instrument who does not also assent to the variance is
discharged.31 Further, where the variance is accepted, the acceptors obligation applies; the acceptor is obligated to
pay the draft according to its terms as varied.32
[c]
Acceptance Varying Place of Payment
A drawee may specify in the instrument the place of acceptance or payment.33 If the place of acceptance or
payment is not specified, it is at the place of business or residence of the expected acceptor.34 An agreement by the
acceptor to pay at a particular bank or place in the United States does not constitute a variance on the draft, unless
the acceptance states that the draft is only to be paid at that bank or place.35
[4]

Finality of Payment or Acceptance Rule

[a]
Mistaken Payment and Restitution
A party that has accepted an instrument may come to regret that action when it discovers, for instance, that the
instrument was subject to a stop payment order or contained a forged drawers or makers signature. The ability of
the acceptor or payor to receive restitution on discovering that its acceptance or payment occurred as a result of a
mistake has been a source of substantial debate and conflict. Section 3-418 clarifies some of these issues, but
introduces new questions. To understand the issues and their resolution, some background on prior law is necessary.
On first glance, any restitutionary remedy would appear to have been foreclosed under pre-Revision Section 3-418.
That provision stated that, subject to special rules that govern recovery of bank payments and breaches of
warranties on presentment (such as the warranty that the instrument contains no forged indorsements),36 payment
or acceptance was final in favor of a holder in due course, or a person who has in good faith changed his position
in reliance on the payment. The effect of this final payment rule was to place on an acceptor (or drawee who
otherwise pays the instrument) the risk of loss that resulted from a mistaken payment. The section codified the rule
of Price v. Neal,37 which held that a drawee who accepts or pays an instrument on which the signature of the
drawer is forged is bound by the acceptance or payment. That result did not occur, however, where the person who
had obtained payment was not a holder in due course and had not changed position in reliance of the mistaken
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payment or acceptance.38 The rationale seemed to be that any restitutionary action that the payor or acceptor could
bring in these circumstances would not impose any hardship on the holder. If the holder has not given value for the
instrument, it can return the funds from the mistaken payment without suffering any out-of-pocket loss. If the
holder did not take the instrument in good faith, it cannot make an equitable claim superior to that of the payor to
funds that the holder never thought it had the right to obtain. In short, if the holder could return the acceptor or
payor to status quo ante without suffering any personal harm, there is little reason not to undo the mistake. Thus,
where a bank notified a recipient of check proceeds that the check had mistakenly been paid despite the absence of
sufficient funds in the drawers account, the recipient, which had given only an executory promise (not value) for
the instrument could not resist that banks claim for restitution on the grounds that, subsequent to receiving notice
of the mistake, it used the funds to extinguish a debt.39
One rationale often given for the rule is that the acceptor or drawee is in the best position to avoid payment on a
forged drawers signature because it generally possesses an actual copy of the drawers signature that can be
compared to the instrument as presented for acceptance or payment. The Official Comment to pre-Revision Section
3-418 considered this rationale fictional, presumably because drawees, such as banks that must process thousands
of items daily, cannot be expected to compare every instrument to a signature card. In addition, some forgeries may
be undetectable even by diligent bank personnel. Thus, the final payment rule is potentially at odds with the
principle of placing losses on the party in the superior position to avoid them. Nevertheless, the rule of Price v. Neal
does induce the acceptor or drawee to determine whether the signatures on some drafts, e.g., those with a face value
over a certain amount, should be verified prior to acceptance or payment. Comments to the pre-Revision provision
stated as an appropriate rationale for the rule the desire to end the transaction when it is paid rather than to reopen
the transaction when the forgery is subsequently discovered.40 This rationale was somewhat hollow, however.
Completed transactions are reopened in the case of payment over forged indorsements, for warranty actions against
prior transferors and presenters are then permitted to throw the loss back onto the party who took the instrument
from the forger.41 No reason was given why there should be a deviation from this rule in the case of a forged
drawers signature.
The denial of a right of restitution, moreover, was inconsistent with pre-Code law in some jurisdictions that
permitted recovery of mistaken payments.42 Some acceptors and payors have claimed that their common-law rights
survive enactment of the Code, so they can recover mistaken payments even if made to a holder in due course.
The debate over the survival of the restitutionary right is well-illustrated by Morgan Guaranty Trust Co. v.
American Savings and Loan Association.43 A corporation had issued two notes in the amount of $5 million each,
payable at Morgan. American Savings and Loan purchased the notes shortly before the corporation declared
bankruptcy and presented the notes to Morgan for payment at maturity. Due to missed communications within
Morgan, that company failed to make a timely dishonor of the notes and was deemed to have paid them. The
district court found that American Savings and Loan became a holder in due course when it purchased the notes and
that subsequent knowledge of the makers bankruptcy could not strip it of that status. The court concluded that
Section 3-418 displaced any common-law restitutionary action for payment made under mistake of fact and that,
therefore, American Savings and Loan was not required to return the $10 million payment. The court of appeals
reversed.44 That court determined that Section 3-418 was augmented under Section 1-103 by common-law
principles that granted common-law restitutionary rights to recover mistaken payments. The common-law policy
was particularly implicated here, the court concluded, because the payee had actual knowledge that the maker had
filed for bankruptcy and thus had no reasonable expectation of payment. Although the holder of the note retained its
status as a holder in due course, the fact that the payor did not dishonor did not deprive it of its ability to recover the
mistaken payment.
Current law alters this scheme significantly. The Official Comment to Section 3-418 suggests that the original
drafters of the Code intended to permit a common-law restitutionary right to payment by mistake even though the
prior version of Section 3-418 did not explain the parameters of that right. The Comment further indicates that the
revised provision affirmatively states the restitutionary right. Under current Section 3-418(a), recovery (or
revocation of acceptance) is permitted where the drawee pays or accepts a draft on the mistaken belief that payment
had not been stopped or that the signature of the drawer was authorized. The drawee can only recover the funds,
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however, from the person to whom payment was made. The fact that the drawee failed to exercise ordinary care in
committing the mistake is irrelevant to exercise of the restitutionary right.45
In any case other than a draft paid or accepted by a drawee under the above conditions, the payor or acceptor is
entitled to recover from the recipient of the payment under non-Code principles governing mistake and restitution
or to revoke acceptance. Hence, common-law principles are explicitly incorporated into Code jurisprudence.
Assume, for instance, that a drawee bank paid a check in the mistaken belief that the drawer had sufficient funds in
its account to cover the instrument. Since this case involves neither an unauthorized drawers signature nor payment
over a stop payment order, it does not fall within revised Section 3-418(a). Thus, appeal must be had to non-Code
principles. The Restatement of Restitution, Section 29 provides that one who pays a draft by mistake is generally
entitled to restitution. Section 33 of the Restatement, however, creates an exception for a drawee who pays a goodfaith holder for value if the recipient did not know of the mistake at the time of payment. Thus, a court applying
common-law principles under the Restatement would deny restitution to the drawee.
In no case, however, may a recovery or revocation of acceptance be had against a person who took the instrument
in good faith and for value or who, in good faith, changed position in reliance.46 Such parties remain subject to
presentmentwarranties, including a warranty that they have no knowledge that a drawers signature is unauthorized.
The fact that payment has been recovered does not necessarily mean that the party subject to the restitutionary right
bears the loss. Under Section 3-418(d), recovery or revocation of acceptance is equivalent to dishonor.47 Thus, the
party from whom recovery or revocation was sought may enforce the instrument against prior parties.
[b]
What Constitutes Payment Under the Final Payment Rule?
Whether an instrument has been paid within the meaning of Section 3-418 so that the payment is final as against
the parties mentioned in that section is a question that requires investigation of Section 4-215. Under that
Section,48 payment occurs when a bank pays an item in cash, settles for the item in a manner that precludes a
subsequent revocation of that acceptance, or takes such action as to indicate an intention to pay the item (e.g.,
completing the process of posting). Thus, a holder in due course of an instrument that has been paid, as defined in
Section 4-215, will be able, under Section 3-418, to resist any attempt by the drawee to recover the amount of the
payment.49 To avoid interpretive difficulties that have arisen, Section 3-418 makes clear that an amount mistakenly
paid can be recovered, even if finally paid under Section 4-215, unless the payment was in favor of a person who
took the instrument in good faith and gave value for it or who in good faith changed its position in reliance on the
payment.
[c]
Change of Position in Reliance on Payment or Acceptance
Even a party who is not a holder in due course may obtain the benefits of the Section 3-418 final payment rule if
the party has changed position in reliance on the payment or acceptance. The rationale seems to be that the
restitutionary action that the acceptor or drawee would otherwise have for mistaken payment would impose no
hardship on the holder. If the holder could return the acceptor or drawee to status quo ante without suffering any
personal harm, there would be little reason not to undo the mistaken act. Thus, where a bank notified a recipient of
check proceeds that the check had mistakenly been paid despite the absence of sufficient funds in the drawers
account, the recipient could not resist the banks claim for recovery by arguing that, two weeks after receiving
notice of the mistake, the recipient used part of the funds to extinguish a debt.50 Once the holder has taken action in
reliance on the payment or acceptance, however, that position cannot be attained and the mistaken actor must bear
the loss.
[d]
Negligence of the Holder Does Not Preclude Application of the Finality of Payment Rule
Negligence of the holder in taking the instrument will not preclude application of the finality of payment rule unless
the negligence amounts to a lack of good faith51 or to such notice as would deny to the holder the status of a holder
in due course.52 Otherwise, the holders negligence does not affect the finality of the payment or acceptance.53
Thus, a failure to adhere to reasonable commercial standards should not alone prevent the payment or acceptance
from being final. For example, a failure by the holder to make inquiries regarding the genuineness of the instrument
would not release the drawee from the final-payment rule.54
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Rene Tierney

20.14 Liability of the Drawer*

[1]

The Drawers Obligation

Section 3-414 supplies the basic promissory obligation of the drawer.1 That obligation is to pay an unaccepted draft
once it has been dishonored. The current version of Article 3 omits the language of secondary liability that
defined the drawers obligation under prior law.2 Instead, the drawer is the primary party liable on the draft. The
drawers contractual obligation to pay, however, relates only to unaccepted drafts. While the drawee is not liable on
the draft at the time of issuance and becomes liable only on its acceptance of the draft,3 once the draft has been
accepted by the drawee, the drawers liability is either discharged (if the drawee is a bank),4 or is limited to an
indorsers liability.5
[a]
Conditions Precedent to the Drawers Obligation
Unlike prior law, Section 3-413 does not require that the drawer receive notice of dishonor before the drawers
contractual obligation is triggered.6 The onlyexception to this rule, pursuant to Section 3-414(d), exists where a
draft has been accepted, the acceptor is not a bank, and the acceptor subsequently dishonors the draft. Thus, as a
general matter, dishonor alone is necessary to hold the drawer liable. This change eliminates technical requirements
of presentment and notification that pervaded pre-Revision law.7
Presentment will still be required in order to determine whether or not a dishonor has occurred. Presentment
consists of a demand made by or on behalf of a person entitled to enforce an instrument to pay the instrument or to
accept it.8 Presentment may be made at the place of payment and may be made by any commercially reasonable
means.9 This includes presentment by electronic communication.10 The person to whom presentment is made may
demand that the instrument be exhibited and the presenter be identified.11
Dishonor occurs if a proper presentment is made and timely payment does not occur. In the case of a check,
dishonor of which would trigger the drawers obligation under Section 3-414, dishonor occurs if the draft is duly
presented and the payor bank makes timely return of the check or sends notice of dishonor in accordance with the
timing requirements of Article 4.12 The refusal of a bank to certify a check, however, does not constitute
dishonor.13 Should the bank certify the check, however, the drawer is discharged. This result occurs regardless of
whether the drawer or some other holder obtained certification.14 This represents a change from pre-Revision law,
under which discharge through certification occurred only when the holder obtained acceptance.15
Presentment may be excused (i) if the person entitled to present the instrument cannot make the presentment with
reasonable diligence; (ii) where the maker or acceptor has repudiated its obligation to pay the instrument; (iii)
where presentment is not necessary to enforce the obligation of a party under the terms of the instrument; (iv)
where the drawer or indorser has waived presentment or has no reason to expect that the instrument will be paid, as
where the drawee is insolvent; or (v) where the drawer instructed the drawee not to pay or accept the draft or the
drawee was not obligated to the drawer to pay the draft.16
One timing issue remains for drawers liability, although it will affect the rights of parties only in limited
circumstances. If a check has not been presented for payment or given to a depositary bank for collection within 30
days after its date, presentment will be untimely and the drawer will be discharged. This discharge, however, occurs
only if the drawee suspends payments after expiration of the 30-day period without paying the check, and the
discharge operates only to the extent that the suspension of payment deprives the drawer of funds maintained with
the drawee to cover the check. In these days of federal deposit insurance, few instances of loss will occur, and it is
even less likely that they will coincide with untimely presentment. Even in these situations, the drawer who seeks
discharge must make a written assignment to the holder of its rights against the drawee in respect of the lost
funds.17 Lost funds, of course, will be those that were not compensated through insurance, typically federal
insurance.
[b]
Disclaiming Liability
A check may not be drawn without recourse.18 Since an instrument drawn with those terms would not carry the
contractual liability of any party because no contractual liability attaches to the instrument until it is either
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indorsed19 or accepted,20 such an instrument would be an anachronism. Thus, Section 3-414(e) provides that a
drawers attempt to disclaim liability is not effective if the draft is a check. The explanation provided in the Official
Comment is there is no legitimate purpose served by issuing a check on which nobody is liable. A drawer
continues to have the right to draw without recourse on drafts other than checks, such as documentary drafts.
Assume, for instance, that a seller ships goods to a buyer under a contract term that requires the buyer to pay
against a sight draft. This document is drawn by the seller on the buyer as drawee and is attached to other
documents that the buyer will need in order to obtain the sold goods from the carrier, e.g., a bill of lading. The
documents, with the sight draft attached, will be sent through banking or other commercial channels and will
typically be presented to the buyers financial agent, such as a bank,prior to the arrival of the goods. The buyer will
be contractually obligated to pay the draft on sight. Assume that the seller draws the draft and negotiates the
documents to a finance company. The seller may wish to ensure that it is not liable on the draft in the event that the
buyer dishonors it. Hence, the seller will draw the draft without recourse. While the buyer may still dishonor the
draft, the holder of the sight draft will not suffer a windfall loss, since it will continue to control the goods
represented by the documents.21
Practical Hint:
A drawer may also be liable for penalty damages for dishonored checks. Some states have added sections to the
official text of the Code to provide for such damages.22 Other states have enacted statutes outside the Code that
provide that merchants may recover penalties (liquidated and other damages) for dishonored checks.23 The
statutory citations above are only illustrative; no attempt is made to cite the statutes of every state. This practical
hint is to make counsel aware of the existence of these provisions, so that counsel can research the appropriate laws
when an issue arises as to the dishonor of an instrument and the liability of the drawer.

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Rene Tierney

20.15 Liability of the Indorser*

[1]

Definition of an Indorsement

[a]
Elements Necessary to Constitute an Indorsement
Indorsement is a formal act in which the indorser signs an instrument, usually for the purpose of negotiating the
instrument to the indorsee.1 An indorsement is only necessary to negotiate an order instrument.2 If the instrument
is payable to bearer or in blank, it may be negotiated by delivery alone.3 Nevertheless, the transferee of the
instrument may wish to have the indorsement of the transferor in order to have the benefit of the indorsers
contract. Any signature that does not unambiguously indicate that it was made for some other purpose is considered
an indorsement. Thus, the default rule for any signature is that it is an indorsement.4 The intent that a signature
serve some other purpose may be indicated by the place of the signature on the instrument, the terms of the
instrument, or words that accompany the signature.
An indorsement does not simply include a signature written by a holder. A signature will be an indorsement if the
signer is not a maker, drawer, or acceptor and the signature is made for the purpose of negotiating the instrument,
restricting payment on the instrument, or incurring indorsers liability on the instrument.5 Nevertheless, negotiation
of an instrument that is payable to an identified person, i.e., an order instrument, can occur only if it is indorsed by
a holder.6 Thus, only the payee or one signing on behalf of the payee can make the first effective indorsement of an
order instrument. The indorsement must appear either on the instrument itself or on a separate papercalled an
allonge7that is so firmly attached to the instrument as to be considered a part of it.8
[b]
Types of Indorsement
[i]
Special Indorsement
Indorsement of an instrument may occur for various purposes. An indorser may want to negotiate the instrument to
another party. Alternatively, the indorser may desire to restrict the payors capacity to pay the instrument properly.
Finally, an indorser may sign the instrument solely to incur liability on it, such as where the indorser signs as an
accommodation to another party to the instrument.9 Depending on the purpose, the indorser may use a different
form of indorsement.
There are two basic types of indorsement: a special indorsement and a blank indorsement. See discussion above,
20.03[2][b].
[ii]
Blank Indorsement
A blank indorsement is an indorsement made by a holder that does not specify the name of any particular
indorsee.10
The indorsers signature alone is the usual form of such an indorsement. An instrument originally payable to order,
indorsed in blank, becomes payable to bearer and may be negotiated by delivery alone unless and until a subsequent
indorser specially indorses the instrument.11
A holder of an instrument bearing a blank indorsement may wish to restrict payment to a particular party. In this
way, the holder may reduce the risk inherent in holding a bearer instrument. The Code permits the holder to
transform the blank indorsement into a special indorsement by writing, above the signature of the indorser, words
identifying the person to whom the instrument is made payable.12 See discussion above, 20.03[2][b].
[iii]
Anomalous Indorsement
An anomalous indorsement constitutes a signature made by a person who is not the holder of the instrument.13 An
indorser who signs to incur liability on the instrument for accommodation purposes will generally sign with an
anomalous indorsement.14 A forger of a payees signature, however, may also technically make an anomalous
indorsement since the forger cannot be a holder of the instrument. Since only a holder can negotiate an order
instrument, the signature of the anomalous indorser will not facilitate negotiation.
[iv]

Restrictive Indorsement
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A special or blank indorsement may also be restrictive. A restrictive indorsement is one which attempts to specify or
limit subsequent actions that can legitimately be taken with the instrument.15 For example, an indorsement that
states For deposit only is restrictive.16 Generally, restrictive indorsements are given effect.17 No restrictive
indorsement, however, will prevent further transfer or negotiation of the instrument.18 Thus, an indorsement Pay
Indorsee only, Indorser would not have such restrictive impact and Indorsee could negotiate the instrument as if
the purported restriction did not exist.
Restrictive indorsements limit what can properly be done with checks in particular situations. Where an
indorsement reads pay any bank, or otherwise indicates an intention to have the instrument collected for the
indorser or for a particular account, a nonbank or depositary bank that purchases or takes the instrument under
conditions inconsistent with the restrictive indorsement commits conversion.19 An intermediary bank (neither
depositary nor collecting) or a payor bank that is not also the depositary bank is not affected by the indorsement.
Where the indorsement restricts payment to an indorsee in his or her fiduciary capacity, a person who purchases or
takes the instrument for collection from the indorsee may make payment or give value to the indorsee, unless there
is notice of breach of fiduciary duty.20 A transferee of an instrument bearing a restrictive indorsement may be a
holder in due course of the instrument unless the holder has notice or knowledge of a breach of fiduciary duty or is
a converter. Under both the prior version and current version of the code, an obligor under an instrument has a
defense against a person not a holder in due course if payment violates a restrictive indorsement.21
[2]

The Indorsers Obligation

[a]
The Indorsers Contract
An indorser is obligated to pay an instrument according to its tenor at the time of his or her indorsement.22 That
obligation, however, is contingent on the timely presentment to and dishonor of the instrument by some other party
who is primarily responsible for its payment. Thus, an indorser is traditionally considered a secondary party.23
The current version of Article 3 does not use that phrase, but retains the prerequisites of dishonor and, in
appropriate cases, notice of dishonor. Protest, however, is no longer required.24 These obligations are owed both to
parties entitled to enforce the instrument and to any subsequent indorser who pays the instrument.
[b]
Conditions Precedent to the Indorsers Obligation
Important differences exist in the holders capacity to impose liability on drawer and indorsers. The most important
distinctions involve the effects of failure to comply with the technical and timing requirements of presentment and
notice of dishonor. The current version of Article 3 significantly relaxes the technicality of these requirements
compared to prior law.25
Examination of the indorsers liability, and the differences from drawers liability, is best made through example.
Assume that D draws and delivers a check on May 1, payable to the order of P in the amount of $500. Payee
indorses the check to H on May 15. H, however, does not deposit the check until July 1. When Depositary Bank
presents the check to the Drawee, the check is dishonored because D has insufficient funds in her account.
At this point, H can bring an action against D on her drawers contract under Section 3-414(b). But H can also bring
an action against P on his indorsers contract under Section 3-415(a), since the check was dishonored.26 Recall that
under Section 3-414(f), H was supposed to present the check for payment or give it to a depositary bank for
collection within 30 days after its date. So, too, Section 3-415(e) provides a 30-day period in which H must present
the check or deposit it for collection in order to bring the action against the indorser, P. But there are two crucial
differences in these 30-day periods. First, while the 30-day period with respect to drawers liability begins with the
date of the instrument,27 the 30-day period with respect to indorsers liability is marked from the day the
indorsement was made.28 Nevertheless, that period is exceeded in this example, since the indorsement was made
on May 15 and the check was not deposited until July 1.
Second, the consequences of failure to comply with the timing requirements are significantly different. Recall that
failure by a person entitled to enforce the instrument to deposit the check within 30 days of its date discharged the
drawer only to the extent that an intervening suspension of payments by the drawee bank deprived the drawer of
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funds.29 Failure of the holder to comply with the 30-day deadline applicable to indorsers will discharge the
indorser.30
Timely presentment of the check is not the only hurdle over which the person entitled to enforce the indorsers
contract must pass. Assume in the previous example that issuance of the check had occurred on May 1 and
indorsement by P to H occurred on May 15, but that H deposited the check in Depositary Bank on May 25.
Depositary Bank receives the dishonored check back from Drawee Bank on May 26 and sends notice of the
dishonor by mailing the notice and the returned check to H on that date. The notice is delivered to Hs home on
May 29. H, however, has left for a vacation and does not return to find the notice and the check until July 1. H
notifies D and P of the dishonor on July 3.
Recall that notice of dishonor was not even required as against D, so that the long period between dishonor and
giving notice to that party does not affect Hs rights. Section 3-503(a), however, provides that the obligation of an
indorser cannot be enforced unless proper notice of dishonor is either given or excused. The Depositary Bank
appears to have acted promptly in notifying H of the dishonor, in that it acted before midnight of the next banking
day following the banking day on which it received notice of dishonor.31 At least, this would be the conclusion if
the giving notice requirement is satisfied as of the time it is sent rather than when it is received. Section 1-201(26)
provides that notice is given by taking such steps as may be reasonably required to inform the other in ordinary
course. That appears to have occurred by sending the notice to Hs place of business or residence.
H, however, may not have given timely notice. As a non-bank, H had to notify P of the dishonor within 30 days
following the day on which H received notice. Section 1-201(26) provides that notice is received by a person
when it either comes to his or her attention or it is duly delivered at the place held out by the person as the place for
receipt of such communications. Here, delivery occurred more than 30 days before H gave notice to P, even though
the notice did not come to Hs attention until July 1. Since the second alternative of the receives notice definition
was satisfied on May 29, it appears that H gave late notice to P.
H has one other possible source of recovery, however. Under Section 3-504, a late notice of dishonor can be
excused if the delay was caused by circumstances beyond the control of the person giving the notice and that person
exercisedreasonable diligence after the cause of the delay ceased to operate. Although going on vacation may be
considered to be within Hs control, H is unlikely to be considered negligent for doing so or for having its mail held
until its return. If the circumstances beyond his control test essentially means non-negligent, as it probably
should, then H should be excused for the late notice to P, as long as the delay between July 1 and July 3 (the period
between return from vacation and giving notice) is not considered to violate the requirement of reasonable
diligence. P will not ultimately suffer the loss, since P has an action against D. Thus, in the absence of negligence
by H, there is little reason to impose on it the loss resulting from delay. Of course, if delay is not excused, H still
has an action against D. P, who dealt directly with D, however, may be in a better position to bring that action.
[c]
Varying the Indorsers Contractual Obligation
[i]
Disclaiming the Indorsers Contractual Obligation
An indorser may disclaim the terms of the statutory contract by appropriate language in connection with the
indorsement.32 The disclaimer must be specified in the indorsement itself. Since the disclaimer necessarily varies
the written contract of indorsement, it may not be proved by parol evidence.33 One court, however, has allowed the
introduction of parol evidence where the indorser claimed he was fraudulently induced to omit a disclaimer.34 The
customary way of disclaiming liability, and the way suggested by the Code, is to include in the indorsement the
words without recourse.35 This means simply that the indorser makes no promise to pay by virtue of the
indorsement. Although the indorsement will be effective to negotiate the instrument, it will not create any
contractual liability on the part of the indorser. Signing without recourse, however, negates neither the warranty
liability of the indorser, nor any other liability of the indorser based upon obligations arising apart from the
instrument.36 An indorsement without recourse is merely a transfer of the indorsers rights in the instrument to
the indorsee. Thus, an indorser who believes that it has avoided all liability by invoking the without recourse term
is likely to receive a rude awakening when faced with a claim under Section 3-417.
[ii]

Modifying the Indorsers Contractual Obligation

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An indorser may include any terms modifying the indorsement contract. For example, an indorser may voluntarily
accept the obligation of a surety by adding the words payment guaranteed37 or collection guaranteed38 to the
indorsement. In either case, the usual conditions precedent of presentment, dishonor, notice and protest are no
longer necessary.39 Payment guaranteed creates a contract that if the instrument is not paid when due, the
indorser will pay it according to its tenor without resort by the holder to any other party,40 while collection
guaranteed requires the holder to obtain judgment against the maker or acceptor and pursue enforcement by
execution of that judgment until it is apparent that payment cannot be obtained from the primary obligor.41
The 2002 Revision clarifies the effect of language of payment or guarantee. New Section 3-419(e) provides that if a
signature of a party is accompanied by words that indicate guarantee of payment, or an accommodation party does
not unambiguously indicate an intention to guarantee collection rather than payment, the signer is obliged to pay
the amount due on the instrument to a person entitled to enforce the instrument in the same circumstances as the
accommodated party would be obliged, without any need for the person entitled to enforce to resort first to the
accommodated party.
[iii]
Admissibility of Parol Evidence to Establish Indorsers Contract
Pursuant to the parol evidence rule, a written contract, such as an indorsement, does not exclude proof of an outside
collateral agreement varying the terms of the contract where the contract is not intended to embody the whole
agreement of the parties and does not on its face purport to cover completely the subject matter of the alleged
collateral agreement. Where the indorsement is merely ambiguous, parol evidence may be admissible to establish
the indorsers intent in signing the instrument.42
Two New York cases illustrate how these rules operate. Central State Bank v. Baccara Restaurant, Inc.43 involved
an action by a bank to recover the balance due on a corporations promissory note against the president of the
corporation who had signed the note as an indorser. The defendants signature appeared immediately below the
following statement:
Each indorser hereby waives protest and consents to the release of any collateral applicable thereto, (the note) all
without notice, and without affecting or releasing the liability of any indorsee.
The defendant attempted to avoid its obligation as an indorser by claiming that prior to its indorsement, the banks
loan officer had informed defendant that the note was fully secured by collateral and that the bank would proceed
first against the collateral and not look to the defendant in the event of default. The court held, however, that the
alleged outside agreement was completely contrary to the writing above the defendants signature and that since the
indorsement was clear on its face as to all terms and conditions and embodied the entire agreement, parol evidence
was inadmissible to vary the defendants contract of indorsement.
In Jamaica Tobacco & Sales Corp. v. Ortner,44 on the other hand, the meaning of the indorsement itself was not
made clear. On each of six notes, a legend typed above the indorsers signature stated that in the event of
nonpayment the total amount due of all notes shall become due and payable. The indorser argued that such
language did not legally constitute an indorsement or a promise to pay the amount of the notes. To the court,
however, it was not clear whether the statement bound the defendant to do anything, or was applicable to it, or
whether the defendant was an accommodation indorser or a guarantor. Thus, parol evidence was admissible to
explain the meaning of the ambiguous language.
[d]
To Whom Does the Indorsers Obligation Run?
An indorser is liable to any person entitled to enforce the instrument.45 This will include a holder, a person in
possession of the instrument with the rights of a holder, or a person not in possession who can satisfy the
requirements for enforcing a lost or stolen instrument.46 The indorser is also liable to a subsequent indorser who
pays the instrument in accordance with its indorsers contract.47 In Cincinnati Cent. Credit Union v. Goss,48 the
court held that a person who indorses a check in blank is liable to the person to whom the check is delivered. This
conclusion follows from the rule that if a holder of a negotiable instrument payable to order transfers it for value
without having indorsed it, the transferee has an enforceable right to have the unqualified indorsement of the
holder-transferor.Pre-Revision UCC 3-201(3). UCC 3-203(c).49 Based upon this provision, the prior transferor
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is an indorser and therefore liable to a transferee-holder, since the transferee could compel the indorsement and the
result would be the same.
[e]
In What Order Are Indorsers Liable?
Unless they otherwise agree, indorsers are liable to one another in the order in which they indorse. Presumably, this
is the order in which their signatures appear on the instrument.50 Determining the appropriate order of liability is
important because an indorser is liable only to subsequent indorsers.51 Thus, parol evidence is admissible to show
that they have indorsed in another order, or that they have otherwise agreed as to their liability to one another. Parol
evidence is also admissible to show that the indorsers signed as a part of the same transaction and are thus jointly
and severally liable. This will often occur in the case of accommodation indorsers who sign at the same time and in
the same capacity.52

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Rene Tierney

20.16 Liability of the Surety*

[1]

The Nature of a Suretyship Relationship

[a]
In General
Suretyship is a three-party relationship involving a creditor, the principal debtor, and the surety. Typically, the
relationship arises because the obligee under a contract (who becomes the creditor in the surety relationship) is
unwilling to assume the risk that the obligor (the subsequent principal debtor) will be able to pay or perform as
called for by the contract. Thus, in addition to, or in lieu of, taking an interest in the obligors property to secure that
payment or performance,1 the obligee may require that a third personthe suretywho is deemed more
financially responsible and reliable also undertake the same obligation as the principal obligor.2 Thus, the surety
contract is basically one by which an obligee obtains additional security for the performance of a promise.
[b]
Suretyship and Negotiable Instruments
In analyzing the duties of a surety, it is important to distinguish between liability on an instrument and liability
based on the underlying obligation which the instrument may also represent. Thus, a surety need not be a party to
the underlying contract giving rise to the issuance of an instrument. The surety may instead sign an independent
agreement with the creditor. But if the surety is not a party to the instrument itself, the surety, though liable on the
contract, will incur no obligation on the instrument.3 The Code makes this distinction clear, by its use of the term
accommodation party to describe a surety who is made a party to a negotiable instrument. The liability of
accommodation parties and guarantors is specifically defined by the Code and it should not be assumed that
otherwise valid principles of suretyship law are applicable when a negotiable instrument is involved.4 Rather,
general state law, including the law of suretyship, may be applied to supplement Article 3 only if that law does not
conflict with a provision of the Code.
[2]

Accommodation Parties

[a]
Definition of Accommodation Party
Section 3-419 defines an accommodation party as one who signs the instrument for the purpose of incurring
liability on the instrument without being a direct beneficiary of the value given for the instrument.5 The current
version of Article 3 does not substantively change the prior version. Section 3-419 combines Pre-Revision sections
3-415 and 3-416 to eliminate confusion as to a guarantors obligation.6 The prior version, Section 3-415(1), defined
an accommodation party as one who signed in any capacity to lend his name to another party; the current version
defines the intent of an accommodation party with respect to whether the person is a direct beneficiary of the value
given.7 A surety whose obligation is undertaken by executing a separate document to which the debtor is not a
party does not fall within the coverage of this section, since that party would not be signing the instrument.8
Thus, if the parent guaranteed the childs debt by executing a separate agreement with the bank, the parent would
still be a surety under common law, but would not be an accommodation party under the Code.9
[b]
Establishing Accommodation Status
[i]
Admissibility of Parol Evidence
Although accommodation parties are often thought of as co-makers on notes, there is no need for a signature to
appear in a particular place in order to qualify as an accommodation.10 An accommodation party may sign the
instrument in any capacity maker, drawer, acceptor, or indorser and is liable in the same capacity as any other
party who signs in that capacity.11 The fact that the person seeking to enforce the instrument knows of the
accommodation is irrelevant to the existence of liability.12 The accommodation party, however, receives the benefit
of certain defenses and will not be liable to the person accommodated.13 Thus, while the taker has no immediate
interest in establishing a partys accommodation status as the takers recovery will be predicated on the
accommodation partys signature as maker, drawer, or indorser the surety may seek to demonstrate that it did
sign as an accommodation.
Subsection (e) is revised in the 2002 Revision by adding a sentence (between the two sentences in the subsection)
that provides that In proper circumstances, an accommodation party may obtain relief that requires the
accommodated party to perform its obligations on the instrument.
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Practical Hint:
There are no proposed comments to assist in explaining this change. This author envisions that this provision will
support an action or proceeding by the accommodation party, who under a guaranty of payment has received a
demand to pay an instrument from the person entitled to enforce the instrument, against the party accommodated, to
pay the person entitled to enforce the instrument.
Parol evidence will be unnecessary if the accommodation party has been fortunate enough to have indorsed the
instrument. In such a case, the indorsement is likely to be an anomalous indorsement. Section 3-205 defines an
anomalous indorsement as an indorsement made by a person who is not a holder of the instrument. Such an
indorsement itself provides notice of its accommodation character.14 Thus, any defense available to such party
against a holder with notice of accommodation status will be available to this particular surety. One who signs an
instrument with an anomalous indorsement is presumed to be an accommodation party.15 Presumably, the reason a
nonholder would sign the instrument in this manner is to incur an indorsers liability on it.
In other cases, the accommodation party may have a more difficult road to proving its status. Pre-Revision Section
3-415(3) provided:
As against a holder in due course and without notice of the accommodation oral proof of the accommodation is not
admissible to give the accommodation party the benefit of discharges dependent on his character as such. In other
cases the accommodation character may be shown by oral proof.
Presumably, the phrase oral proof was synonymous with parol evidence, even where that evidence is not
oral.16 Thus, parol evidence would be admissible to prove accommodation status against any person except a
holder in due course who takes the instrument without notice of the accommodation. For example, where the payee
of a promissory note was not a holder in due course, parol evidence was admissible to determine the validity of a
claim by the maker of the note that the maker signed as an accommodation party under pre-Revision Section 3415(3).17 In addition, the accommodation party would be entitled to introduce parol evidence of its status in
asserting a claim against the accommodated party.18 Of course, if the accommodation party had signed as an
indorser and its indorsement appeared outside the chain of title, even a holder in due course could not avoid the
introduction of parol evidence, as the indorsement would constitute notice of accommodation character.19
The current version of Article 3 omits any similar provision. Under certain circumstances, an accommodation party
will be considered discharged if the person entitled to enforce the instrument knew of the accommodation or had
notice of the accommodation character of the partys signature.20 The introduction of extrinsic evidence by the
accommodation party to prove that the person seeking enforcement had the requisite knowledge therefore seems
appropriate, whether or not that person is a holder in due course. Notice sufficient to create a presumption of
accommodation will exist if the signature of the alleged accommodation party is an anomalous indorsement or
otherwise is accompanied by words that indicate the guarantor relationship of the signer.21
[ii]
Receipt of Benefit
An accommodation party cannot be the direct beneficiary of the value given for the instrument.22 (Of course, one
can be the beneficiary of value given for becoming an accommodation party, but that benefit would presumably
flow from the accommodated party rather than from the creditor.) The issue of benefit can become difficult where
the accommodation party has a relationship with the principal obligor that makes it appear that the accommodation
party will be able to take advantage of the value given for the instrument. It will rarely be the case that the
accommodation party gets absolutely no benefit from that value. For instance, a parent who co-signs a note that
permits the child to obtain an automobile loan apparently gets some benefit from the childs purchase. This
vicarious benefit, or parental pride, however, is not the type of benefit that would deprive the parent of
accommodation status.23 If the child was going to allow the parent to use the car, a closer case would exist. At the
other extreme, a co-maker on a corporate promissory note was not an accommodation party where the comaker
owned 99 percent of the corporate stock.24 In Wilmington Trust Co. v. Gesullo,,25 the seller of a truck co-signed a
note to enable the buyer to receive a bank loan. Although the seller was a 50 percent shareholder of the buyer
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corporation, the court held that it was an accommodation party because it received no direct benefit of the proceeds
of the loan and the bank required its signature.
The receipt of benefits also becomes an issue where one spouse purports to sign as an accommodation to the other.
If the loan appears to be for business purposes and only one spouse is active in the underlying business, a court is
more likely to find that the uninvolved signer is an accommodation party.26 In McCarthy v. Sessions,27 however,
the court held that a wife was not an accommodation party for her husband where she signed a note for farm
equipment sold solely to her husband for use on a farm that she helped to operate.
In Sack Lumber Co. v. Goosic,28 the court observed that Official Comment 1 to Section 3-419 recognizes that this
section distinguishes between direct and indirect benefits. When a person receives only an indirect benefit, that
person can qualify as an accommodation party. Under the facts, the wife, who signed a note together with her
husband, payable to the plaintiff for an outstanding balance owed by a business run by the husband, was found to
be an accommodation party because she received only an indirect benefit. The wife was not involved in the
business (it was solely the husbands business), she had her own job, and she never used the business checking
account.
In Baker v. Veneman,29 the court recited the rule that a determination as to the status of whether a person is an
accommodation party is a question of the intention of the putative accommodation party, of the accommodated
party, and of the holder of the paper at the time of the signatures. The court found under the facts that the
defendant was not an accommodation maker. The defendants signature on the note was not followed by any
indication that she signed as a surety, guarantee, or accommodation party; the language of the note showed she
signed as borrower. The court also found that she was a direct beneficiary of the value given for the note. The
note was given to obtain funds to refinance delinquent debts on certain farm property, owned by the maker and
defendant as tenants by the entirety. As such, defendant received a benefit from the loan and note, in that it
prevented the foreclosure of the property, in which she had an ownership interest. The fact the defendant did not
participate in the farming operations did not affect this conclusion that she received a direct benefit.
In Cranfill v. Union Planters Bank, N.A.,30 the court stated that a party can receive a direct benefit from a loan
even if the party does not receive any of the proceeds of the loan, and a party can receive a direct benefit from a
loan when the party obtains a release from a personal obligation. Under the facts of this case, the court found that a
person (physician) who signed a guaranty of a loan received a direct benefit from the loan. The loan was made to an
entity that had repurchased the assets of a clinic (in which the physician was a shareholder) that had previously
been sold. As part of the total transaction, the physician was released of certain obligations, under certain
agreements, to the purchaser of the assets. This release was a direct and substantial benefit to [the physician] ... so
that he was not an accommodation party.
[c]
To Whom Does the Accommodation Partys Obligation Run?
An accommodation partys obligation, regardless of whether incurred as accommodation drawer, maker, or
indorser, runs to the same persons as the obligation of a similarly situated party to a negotiable instrument who is
not a surety.31 For instance, an accommodation indorser would have indorsers liability to all subsequent indorsers
or holders.
There is, however, one exception to this principle of the accommodation partys liability. Section 3-419(e) provides
that an accommodation party is not liable to the party accommodated. See above 20.16[2][b][i]. Thus, even if comakers would otherwise have an action against each other for contribution, an accommodation maker would bear
no liability for contribution to a co-maker on behalf of whom it signed the instrument.32 This exception makes it
important to know the identity of the party accommodated in any given case. This seemingly simple inquiry may
prove quite protracted.
In T.W. Sommer Co. v. Modern Door & Lumber Co.,33 for instance, an officer of a corporation signed notes,
payable to the order of certain other companies, as an officer of its corporation in the capacity of maker, and as an
individual in the capacity of indorser. This last signature constituted an accommodation indorsement. The payee
companies indorsed the notes to a bank as security for a loan. When the corporation dishonored the notes, the payee
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companies paid the note and sued the officer in its capacity as an individual indorser. The officer contended that it
had signed as an accommodation to the payees, and thus was not liable to them under Section 3-415(5). They
contended that the officer had signed as an accommodation to the corporation of which it was an officer. If they had
prevailed, they would have been able to impose liability on it as an indorser. The court, however, found that the
officer had indorsed solely to assist the payees in obtaining a loan, and thus had liability to them. The court
reasoned that since the officer knew its company was in precarious financial condition at the time the notes were
made, it was unlikely that the officer personally would have guaranteed a corporate obligation.
[d]
The Accommodation Partys Obligation Under the New York State Variation
As noted above, the accommodation party can sign as maker, drawer, acceptor, or indorser and generally has the
liability of a person signing in that capacity.34 In New York an accommodation party additionally incurs certain
warranty liability.35 As enacted in New York, Section 3-415 includes a subsection (6) which reads as follows:
(6) An accommodation party warrants to any subsequent holder who is not the party accommodated and who takes
the instrument in good faith that:
(a) all signatures are genuine or authorized; and
(b) the instrument has not been materially altered; and
(c) all prior parties had capacity to contract; and
(d) he has no knowledge of any insolvency proceeding instituted with respect to the maker or acceptor or the
drawer of an unaccepted instrument.
The reason for the imposition of warranty liability is to afford additional protection to the holder of the instrument.
Ordinarily, an accommodation partys liability on an instrument does not become enforceable until the instrument
reaches maturity. Especially where a long-term instrument is involved, however, by the time the instrument
becomes due and payable, recourse against the accommodation party may be either difficult or impossible.36 Since
a cause of action for breach of warranty accrues at the time of breach, not necessarily when the instrument reaches
maturity,37 this provision allows the holder to secure the liability of the accommodation party immediately upon
the breach.
[e]
Defenses Available to Accommodation Parties
An accommodation party who is asked to make payment may seek to assert defenses that would be available to the
accommodated party. The argument of the accommodation party would be that its liability should not be greater
than the liability of the principal obligor. Section 3-305(d) does permit the accommodation party to assert those
defenses as a general matter. The defenses available to the accommodation party under this subsection (d) are the
defenses enumerated in subsection (a). These defenses are discussed, generally, above in 20.10. Nevertheless,
there are some cases in which allowing those defenses would undermine the function of the accommodation
contract. For instance, the primary reason why a creditor would seek the guarantee of an accommodation party is
the risk that the principal obligor is insufficiently creditworthy. Thus, it would be anomalous to allow the
accommodation party to take advantage of the principal obligors financial distress to avoid the accommodation
contract. Section 3-305(d), therefore, excepts the defense of discharge in insolvency proceedings from the defenses
of the principal obligor that the accommodation party can assert. For similar reasons, the accommodation party
cannot assert the principal obligors defenses of infancy or lack of legal capacity.
[i]
Failure of Consideration Not a Defense
Under prior law, there was some question about the extent to which an accommodation party could avoid liability to
the person entitled to enforce the instrument by claiming that it (the accommodation party) had received no
consideration for agreeing to serve as surety.38 Pre-Revision Section 3-408 provided that lack of consideration was
a defense against any person not having the rights of a holder in due course. Thus, some accommodation parties
attempted to resist a creditors efforts at recovery on the accommodation contract by claiming that they received no
consideration for the accommodation. Although this argument was accepted by some courts,39 it seems
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inconsistent with the intent, if not the words, of the drafters of the Code. Indeed, Official Comment 3 to preRevision Section3-415, which governed the accommodation contract, provided that the accommodation partys
obligation was supported by whatever consideration ran between the principal obligor and the creditor. If a party to
a note receives consideration on the instrument, he is not an accommodation party, but rather an original obligor.40
By definition, an accommodation party is one who executed an instrument without receiving value for the
instrument.41 Accodingly, the majority of courts acknowledged that the consideration running to or from the
original party to the instrument will support the obligation of the accommodation party without any further or
additional consideration. An accommodation party cannot assert lack of consideration for the accommodation, since
the value received by the party accommodated is the consideration.42
The current version of Article 3 eliminates any doubt on the need for consideration. Section 3-419(b) explicitly
provides that the obligation of an accommodation party may be enforced notwithstanding any statute of frauds and
whether or not the accommodation party receives consideration for the accommodation.43 Of course, it is in the
very nature of an accommodation party that no consideration will have been received from the obligee on the
instrument, as an accommodation party is one who has received no direct benefit of the value given for the
instrument. The current version of the Code clarifies that an accommodation party is liable even if the
accommodation party has signed after the holder has given value.44
In one situation, even the earlier version of Section 3-408 suggested that there was no need for consideration.
Assume that D becomes obligated to C and subsequently delivers to C a note evidencing the debt. If A signs the
note as accommodation party, A cannot later contend that no consideration existed for the note, even as between D
and C. Section 3-408 provides an exception to the consideration requirement for an instrument or obligation
thereon given in payment of or as security for an antecedent obligation of any kind.
[ii]
Discharge or Release of Accommodated Party
Assume that the holder of a $10,000 note made by M and on which A serves as an accommodation party decides to
release M of all liability on the note in return for a payment of $5,000. Can the holder now proceed against A for the
additional $5,000? Section 3-605(b) provides that the holders discharge of the principal obligor in this situation
does not discharge the accommodation party.45 This is true even though the accommodation party has not agreed to
the cancellation of the principal obligors liability, and unlike earlier versions of Article 346 even though the
holder or the original payee did not reserve rights against the accommodation party in the note or otherwise.47 The
underlying assumption is that the holder would only agree to a release in return for a partial payment if M were
truly in financial distress. In that event, A is not adversely affected by the discharge, since A would presumably
have been required to satisfy the obligation in any event. Indeed, A should be pleased that at least partial payment
was extracted from the principal obligor. Of course, the accommodated party retains the right of reimbursement
against the discharged principal obligor. If M was truly in financial distress, however, this is likely to be an empty
right, except insofar as it deters collusive conduct between the holder and the principal obligor.
[iii]
Extension of Time of Payment
Assume that the P obtains a loan for $10,000 from C and that A signs Ps note as a co-maker, but receives no direct
benefit from the loan. Assume further that the note is issued on January 1 and is due December 31 of the same year.
On November 30, P informs C that it is experiencing cash flow problems and will be unable to pay the note until
the following March 31. C agrees to permit the extension of the maturity date. Can A be discharged on the theory
that it now has financial exposure on the note for a longer period of time than was required under its original
bargain?
Section 3-605(c) creates a presumption that the accommodation party has suffered no loss as a result of the
extension of time, and therefore is not discharged. Unlike prior law, the current version of Article 3 generates this
result even though the accommodation party did not consent to the extension of time and the person entitled to
enforce the instrument did not reserve rights against the accommodation party.48 It is possible, however, that
during the period of extension assets of the principal obligor will depreciate or the principal obligors financial
position will worsen. In either of these situations, the extension of time will work to the detriment of the principal
obligor, since the value of his right of reimbursement will be reduced. Thus, Section 3-605(c) provides that to the
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extent the accommodation party can demonstrate that the extension of time caused loss with respect to his right of
recourse against the principal obligor, the extension will operate to discharge the accommodation party.49
[iv]
Modification of Accommodated Partys Agreement
Article 3 currently governs the modification of terms of the instrument other than extensions and releases. No
parallel provision existed in pre-Revision Article 3. Assume that, in the prior example, under the terms of the initial
agreement between P and C, P was precluded from incurring any additional indebtedness. Prior to the maturity of
the note, P obtains Cs permission to borrow additional funds from X for a new venture. In this situation, Section 3605(d) reverses the presumption that applies to extensions: if the modification is material, it will discharge A in
an amount equal to As right of recourse against P, except to the extent that C, the person entitled to enforce the
instrument, can demonstrate that the modification did not cause a loss to A.50 The rationale for this presumption is
that modifications are likely to be detrimental to the accommodation party.51 In this example, for instance, the
additional borrowing for a new venture is likely to increase the level of risk to which P is exposed. A default on the
loan from X could jeopardize Ps assets on which A is relying to secure his right of reimbursement should A be
required to make payment to C.
[v]
Impairment of Collateral
A creditor may desire security from the debtor in addition to obtaining the contract of an accommodation party. The
creditor, for instance, may require that the principal obligor provide collateral for the extension of credit. Should the
creditor obtain payment from the accommodation party after the principal obligors default, however, that same
collateral may serve to secure the accommodation partys right of reimbursement. That right, therefore, is obviously
placed at risk should the creditor fail to take proper care of the collateral. Assume, for instance, that in the above
example, P grants C a possessory security interest in Ps stamp collection as collateral for the loan on which A
serves as accommodation party. C, however, keeps the stamp collection in a damp basement, and it is destroyed by
mildew. Section 3-605(e) provides that the obligation of A is discharged to the extent that C has impaired the value
of the interest in the collateral.52 This provision dovetails with Section 9-207, which places on creditors who obtain
possessory security interests the obligation to take reasonable care of collateral.53 Note, however, that Section 3605(e) is even stricter, in that it effects a discharge even if the impairment did not result from a failure to use
ordinary care. The justification for the rule is that the accommodation party may have relied on the principal
debtors assets in agreeing to act as surety.
In Hawaii Broadcasting Co. v. Hawaii Radio, Inc.,54 the court observed that under the current version of Article 3
the impairment no longer is required to be unjustifiable.
Practical Hint:
The provisions dealing with impairment of collateral are separated with respect to whether the situation involves a
true surety, which is covered in Section 3-605(e), or a comaker having joint and several liability on the instrument,
which is covered in Section 3-605(f).
Under subsection (e) where a principal obligor-debtor has given collateral to the creditor to secure the obligation,
the surety (indorser or accommodation party) who has right of recourse against the debtor (accommodated party) is
discharged to the extent of the value of any impairment of the collateral by the creditor. This rule is the same rule as
under the prior version.55 However, the current version specifically describes how the value of the impairment is
determined, clarifying how the case law would have evaluated the impairment.
The value of an interest in collateral is impaired to the extent (i) the value of the interest is reduced to an amount
less than the amount of the right of recourse of the party asserting discharge, or (ii) the reduction in value of the
interest causes an increase in the amount by which the amount of the right of recourse exceeds the value of the
interest.56
The case law under the Pre-Revision described situations which were construed to be impairments of collateral. The
current version of Article 3 has a separate subsection (which was not in the prior version) which specifically sets
forth certain types of situations which would be deemed to be impairments.57 Two notable situations that are
specifically described are that the creditor fails to perform a duty to preserve the value of collateral owed, under
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Article 9 or other law or to obtain or maintain perfection or recordation of the interest in collateral.58 The
revised Code is essentially a codification of the case law, and by using the word includes, courts will be permitted
to find impairments in other, nonenumerated situations, allowing a degree of flexibility.59
The 2002 Revision would make significant changes to the rules concerning discharge of accommodation parties
and other secondary obligors. These proposals would bring Article 3 into conformity with the provisions of the
Restatement of Suretyship and Guaranty.60 The proposals would include new definitions of principal obligor and
secondary obligor. The former would include an accommodated party or any other party against whom a
secondary party has recourse under Article 3.61 The latter would include an indorser or accommodation party, a
drawer who has the obligation stated in Section 3-414(d), or any other party to the instrument who has recourse
against another party who has joint and several liability on the instrument due to payment under Section 3-116.62
The proposals clarify, and in some cases alter, the consequences for the secondary obligor if a person entitled to
enforce an instrument grants a full or partial release to the primary obligor.
Obligations of the principal obligor to the secondary obligor with respect to any prior payment are not affected by
the release. But unless the terms of the release explicitly preserve the secondary obligors recourse, the principal
obligor is discharged, to the extent of the release, from any duties to the secondary obligor that are created by
Article 3. Similarly, unless the terms of the release preserve the recourse rights of the person entitled to enforce the
instrument against the secondary obligor, that party is discharged from any unperformed obligation on the
instrument. In the case of a check, and the obligation of the secondary party is based on an indorsement, the
secondary obligor is discharged without regard to the language or circumstances of the discharge.
If the person entitled to enforce has preserved rights against the secondary obligor, the secondary obligor is still
released to the extent of the value of consideration that party received for the release and to the extent that the
release would otherwise cause the secondary obligor a loss. A loss may occur, for instance, where the release of the
principal obligor is effected without preserving the secondary obligors recourse rights.
The 2002 Revision also creates a series of rules for the effect of an extension of time for payment on secondary
parties. Unless the time for extension preserves the secondary obligors right of recourse, the extension
correspondingly extends the time for performance of duties arising under Article 3 and owed by the secondary
obligor to the primary obligor with respect to payments made subsequent to the extension. The secondary obligor is
discharged to the extent that the extension would cause that party a loss. The secondary party retains the right to
make payments to the person entitled to enforce the instrument as if no extension had been granted.63
If a person entitled to enforce the instrument agrees, with or without consideration, to modify the terms of an
instrument in some way other than a release or extension of time for payment, the modification correspondingly
modifies any other duties owed to the secondary obligor by the principal obligor. The secondary obligor is again
discharged from any unperformed part of its obligation to the extent that the modification would cause that party a
loss. As in the case of an extension of time, a secondary obligor who has not been discharged may satisfy its
obligation on the instrument by performing as if the modification had not occurred.64
The 2002 Revision would retain the rule that a secondary party is discharged to the extent that collateral securing
the principal obligors obligation is impaired by the person entitled to enforce the instrument. It also retains the
current rules for defining impairment and measuring the extent of any impairment. The notice rules of current
Section 3-605(h) would also continue to apply. Similarly, the current rules concerning consent and waiver of
discharge continue, with the addition of a provision that states that, unless circumstances otherwise indicate,
consent by the principal obligor to an act that would lead to a discharge under this section constitutes consent to
that act by the secondary obligor if the secondary obligor controls the principal obligor or deals with the person
entitled to enforce the instrument on behalf of the principal obligor.65
A release or extension will automatically preserve a secondary obligors right of recourse if the terms of the release
or extension provide that the person entitled to enforce the instrument retains the right to enforce the instrument
against the secondary obligor.66
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A secondary obligor who asserts discharge has the burden of persuasion with respect to both the occurrence of acts
alleged to harm the secondary obligor and the loss or prejudice caused by the acts. If, however, the secondary
obligor demonstrates prejudice as a result of impairment of the right of recourse and the circumstances make
measurement of the amount of loss not reasonably susceptible of calculation or require proof that is not
ascertainable, it will be presumed that the act impairing recourse caused a loss equal to the secondary obligors
liability on the instrument. The person entitled to enforce the instrument will bear the burden of persuasion on any
lesser amount.67
[f]
Consent to, and Waiver of Discharge
It is provided under the Pre-Revision, current version of Article 3, and under the 2002 Revision, that all suretyship
defenses can be waived.68 The Official Comment recognizes that such waivers are common in notes delivered to
financial institutions. Therefore, the importance of surteyship defenses is greatly diminished.69 An express
statement of consent that is incorporated in the instrument itself is binding on a surety.70 The surety (secondary
obligor, as defined in the 2002 Revision) who consents to the event or the conduct that otherwise would be the basis
of the discharge is not discharged; accordingly, the parties can opt out of the rule that would otherwise effect a
release.
[g]
The Accommodation Partys Right of Subrogation
The Code provides that an accommodation party who pays an instrument is entitled to reimbursement from the
accommodated party and is a person who is entitled to enforce the instrument against the accommodated party.71 In
effect, an accommodation party who pays is subrogated to the rights of the holder who has received such payment.
Under this provision, the accommodation party has all of the procedural advantages of bringing suit on a negotiable
instrument.72 Further, the appropriate statute of limitations is that applicable to negotiable instruments rather than
to other kinds of contracts.73 In some instances, however, the accommodation party may prefer to proceed directly
against the accommodated party on the accommodation contract. In this way, the accommodation party is not
subject to defenses that could be asserted against the creditor on the instrument.
Subrogation means that the accommodation party inherits the rights that the holder had, no more and no less.74
Thus, if a holder discharged the principal debtor by failing to fulfill essential conditions precedent such as
presentment and notice, an accommodation party who paid could not recover on the instrument from the principal
debtor.
An accommodation party who pays an instrument need not institute a separate action for recovery on the instrument
pursuant to the Code, however, in order to shift liability to the accommodated party. Anna National Bank v.
Wingate,75 for example, involved a note on which the defendant was maker and the defendants uncle was
accommodation maker. The payee brought suit on the note and recovered a judgment by confession pursuant to the
terms of the note against both the defendant and the defendants uncle. The uncle executed a renewal note to the
payee in satisfaction of the judgment taking back an assignment of that judgment. He then assigned the judgment to
the plaintiff who brought suit against the defendant to execute on the judgment.
The defendant argued first that under the provision governing accommodation parties, the plaintiffs only remedy
was to bring a separate action on the note. The court rejected the argument, stating:
[I]t is clear that the drafters considered an accommodation maker to be a surety for the person accommodated.
Thus, even apart from the remedy of [pre-Revision] Section 3-415, a surety may, after payment of the underlying
debt, take an assignment of the judgment against himself and the party assured, and enforce that judgment against
the latter, thereby satisfying the obligation created by the payment of the debt. The surety does not have to rely on
his right of subrogation; he may choose an alternate remedy.76
The court also was not persuaded by the defendants claim that once the note had been discharged by payment by
any person, all liability on the instrument, including the defendants, came to an end. The court reasoned that such
an interpretation would render the accommodation partys right to reimbursement on the instrument a nullity.77

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In Word Invs., Inc. v. Bruinsma (In re TML, Inc.),78 the court stated that an accommodation party who pays the
holder is entitled to reimbursement or indemnification, in that the payment by the accommodation party does not
discharge the note. The court also stated that the accommodation party, as a surety, has a right to recover under two
theories: subrogation (the suretys equitable right to assert against the debtor accommodated party the rights
of the creditor holder of the note) and reimbursement (that does not depend upon the creditors rights, but upon
the debtors accommodated partys express or implied promise to indemnify the surety).
Article 3 extends the right of subrogation to parties other than accommodation parties who are obligated and who
are disadvantaged by acts of the creditor. Assume, for instance, that A and B become co-makers on a $10,000 note
payable to the order of X and that the proceeds of the note are to be used in a joint business venture of A and B.
Thus, neither signs without receiving direct benefit from the instrument and neither is an accommodation party. In
addition, A delivers to X collateral valued at $10,000. While the debt is outstanding, X destroys the collateral.
Subsequently A becomes bankrupt and is discharged of all liabilityon the note. Had X not destroyed the collateral
and proceeded against B on its makers liability, B would have been able to pay the note, but been subrogated to
Xs rights in the collateral.79 Section 3-605(f) discharges B, but only in an amount beyond what it would have been
obligated to pay, taking into account its right of contribution. Thus, Y is discharged in the amount of $5,000, as it
had a $5,000 contribution claim against X, which now cannot be satisfied in bankruptcy.80 An accommodation
party who cannot obtain discharge when collateral is impaired because the party seeking to enforce the obligation
did not know of the accommodation may still use the defense of Section 3-606(f) if the accommodation party is
jointly or severally liable on the obligation. Again, the burden of proving impairment will be on the party seeking
discharge.
[3]

Guarantors

[a]
In General
A guarantor,81 like an accommodation party, is a surety. A guarantor, who signs the instrument, moreover, does not
create a form of liability different from the obligation incurred by virtue of becoming an accommodation party
under Section 3-419. Thus, Article 3 eliminates any linguistic distinction between guarantors and accommodation
parties.82 The Code does, however, permit a party to indicate unambiguously that is only guaranteeing collection
and not payment.83 A signer who so indicates is not liable unless the party seeking to enforce the instrument
against the guarantor demonstrates that execution of judgment against the accommodated signer has been returned
unsatisfied, or that the accommodated party is insolvent or in an insolvency proceeding, or that the accommodated
party cannot be served with process, or it is otherwise apparent that payment cannot be obtained from the
accommodated party.84
[b]
To Whom Does a Guarantors Obligation Run?
Under prior provisions of Article 3, the law seemed to provide that a guarantors obligation ran to the holder of the
instrument. That result, however, was inconsistent with pre-Revision Section 3-415 which provided that the
obligation of an accommodation party runs to any taker for value. The general liability of accommodation
parties85 should control the more specific liability of guarantors if the Code is successfully to clarify and liberalize
the law of suretyship and negotiable instruments.86 This principle seems to be incorporated into the current version
of Article 3, which discusses liability to the person enforcing the instrument rather than a holder.87
An accommodation party incurs no obligation to the party accommodated.88 Thus, an accommodation party who
defaults incurs no liability to the accommodated party, although he or she remains liable to the party seeking to
enforce the instrument. Of course, an accommodation party who satisfies the obligation is entitled to enforce the
instrument against the accommodated party.
[c]
A Guaranty Is Not Rendered Unenforceable Because It Violates a Statute of Frauds
A guaranty written on an instrument is enforceable notwithstanding any statute of frauds.89 Thus, a guaranty that
does not indicate the consideration for which it is given is not rendered unenforceable by a statute of frauds
provision that no promise to answer for the debt, default or miscarriage of another is enforceable unless it is
evidenced by a writing which states the consideration for the promise.90
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[d]
Guarantees in Consumer Transactions
The Federal Trade Commission has promulgated rules intended to inform consumers of the liabilities they incur
when they co-sign instruments as guarantors. The Commission was concerned that individuals signing for
accommodation, in particular relatives who signed instruments gratuitously, would not be aware that they could be
required to pay the obligation, even before payment was sought from the principal debtor. In 1980, the Commission
created a trade regulation rule that requires creditors to provide cosigners with a document that contains the
following notice.
Notice to Cosigner
You are being asked to guarantee this debt. Think carefully before you do. If the borrower doesnt pay the debt, you
will have to. Be sure you can afford to pay if you have to, and that you want to accept this responsibility.
You may have to pay up to the full amount of the debt if the borrower does not pay. You may also have to pay late
fees or collection costs, which increase this amount.
The creditor can collect this debt from you without first trying to collect from the borrower. The creditor can use the
same collection methods against you that can be used against the borrower, such as suing you, garnishing your
wages, etc. If this debt is ever in default, that fact may become a part of your credit record.
This notice is not the contract that makes you liable for the debt.91
Note that this provision does not affect any of the substantive terms of the contract between the creditor and the
accommodation party. It serves only to provide notice about the consequences of those terms. Failure to provide the
notice may constitute an unfair or deceptive practice by the creditor.

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20.17 Warranty Liability*

[1]

In General

[a]
Contractual and Warranty Liability Distinguished
To this point, the discussion of liability of parties to an instrument has focused on the promises they make by
signing the instrument in a particular capacity. This volitional undertaking is generally described as contractual,
since the terms of the signatorys promise is a matter for negotiation in each transaction.1 Individuals who obtain
payment or acceptance of an instrument or who transfer an instrument for consideration, however, are also deemed
by law to provide certain warranties to the payor, acceptor, or transferee. These warranties, found in Sections 3-416
(transfer warranties) and 3-417 (presentment warranties),2 are in addition to any contractual obligations that a
signatory to the instrument might incur. There may, therefore, be important reasons to select one theory over
another in order to recover money paid for an instrument. Assume, for instance, that H purchases a note bearing a
forgery of Ms signature and discovers the forgery shortly after purchase, but a year before maturity. Even if able to
find the forger or a prior indorser, H would have no claim on a contract theory until the time of maturity, as there
could be no appropriate presentment and dishonor to trigger contract liability until that time. H, however, would be
entitled to bring an immediate action for breach of warranty and rescind the purchase of the document. In addition,
a party discharged under contractual liability, e.g., an indorser discharged because of an untimely presentment, may
remain liable under its warranty, for which timely presentment is not a prerequisite.3
[b]
The Nature of Warranty Liability
The apparent function of warranty liability is to place the loss that occurs as a result of a warranty breach on the
party who was in the best position to avoid it. For instance, Official Comment 3 to pre-Revision Section 3-417
distinguished between warranties made by drawees concerning drawers signatures and indorsements because the
drawee is in a position to verify the drawers signature by comparison with one in his hands, but has ordinarily no
opportunity to verify an indorsement. The distinction continues under current law.4 Warranty liability, therefore,
induces a party so situated to take advantage of its superior ability to detect or deter any fraud or other wrongdoing
relating to the instrument.
[i]
Varying Warranty LiabilityModifications and Disclaimers
Prior versions of the Code omitted any provision with respect to the modification or disclaimer of warranty liability
on negotiable instruments.5 A curious pre-Revision Official Comment to Section 3-417 stated only:
Like other warranties, those stated in this section may be disclaimed by agreement between the immediate parties.
In the case of an indorsee, disclaimer of his liability as a transferor, to be effective, must appear in the form of the
indorsement, and no parol proof of agreement otherwise is admissible.6
The Codes failure to include a more detailed provision with respect to the subject of varying warranty liability
raised a number of troublesome questions. First, did the provision for disclaiming warranty liability preclude the
possibility that the warranties may be supplemented or modified? Second, did the phrase between the immediate
parties prevent a disclaimer from having effect beyond those parties?7 Third, why is parol evidence admissible to
show a disclaimer when the transfer is by delivery alone but not when the transfer is by indorsement?
The Codes ambiguity in this area suggested the need to refer to prior law, to the extent it was not inconsistent with
specific Code provisions.8 In response to the first question, pre-Code cases recognized the ability of parties to
supplement or modify their warranties.9 This should be the approach under the Code as well. It would make little
sense to allow parties to commercial paper to disclaim their liability but not to supplement or modify it. Indeed, preRevision Section 3-417(3) implicitly recognized that a transferor may limit its warranty liability by transferring
without recourse.
With respect to the second and third questions, the Official Comment to pre-Revision Section 3-417 implied that an
indorsee who desired to disclaim warranties to a subsequent transferee had to do so through a written indorsement.
Apparently, the theory underlying this distinction was that when an instrument is transferred by delivery only, the
transaction rests in parol and the lack of a signature on the instrument allows the admission of parol evidence to
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prove the disclaimer. On the other hand, when the warranty has become part of a written contract, i.e., the
indorsement, it cannot be modified by parol evidence.10
A different explanation of the distinction rests on a more functional approach to the law of commercial paper. As
noted below, when the transfer is by delivery without indorsement the transfer warranties run only to the immediate
transferee.11 Thus, if a dispute were to arise over an alleged disclaimer of warranty, only the immediate parties to
the transaction would be involved. In such a case, parol evidence should be admissible since there is no reason to
deny the admissibility of all relevant evidence as between the original parties to the transfer.
On the other hand, when the transfer is by indorsement, the transfer warranties also run to subsequent holders who
take in good faith.12 Where the dispute is between the transferor-warrantor and a distant transferee, it makes sense
to preclude the admission of parol evidence to show a disclaimer. Such a rule promotes certainty and encourages
the free transferability of commercial paper because a purchaser can safely rely on the warranties unless they are
expressly disclaimed on the instrument. This assumes, however, that a disclaimer may have an effect beyond the
original parties. If the disclaimer does not run to a remote transferee in the first place, the issue of the admissibility
of parol evidence to prove the disclaimer becomes irrelevant. Thus, it seems reasonable to suggest that the drafters
intended that a disclaimer of warranty have an effect beyond those parties who originally agreed to the disclaimer.
If this is the rationale, however, it is unclear why it should apply only to indorsees who subsequently transfer, as
the words of pre-Revision Official Comment 1 indicated. The same rationale would permit disclaimers by payees as
well, as long as the disclaimer is written along with their indorsement to a subsequent transferee.
Even accepting this analysis, however, one further problem remains. When the transfer is by indorsement, the Code
would seem to preclude the use of parol evidence even if the plaintiff is the immediate transferee of the instrument.
As suggested earlier, parol evidence should always be admissible between immediate parties. Such evidence cannot
affect the negotiability of the paper nor can it injure the transferee who, being unaware of the disclaimer,
detrimentally relied on the warranty.
The current version of Article 3 addresses the issue of disclaimers directly, though it fails to answer many of the
above questions. It does provide explicitly that warranties made on transfer and presentment cannot be disclaimed
on checks.13 This limitation is based on the concern that banks rely on warranties of transfer and presentment, and
automated procedures render individual inspection for disclaimers inefficient. The negative implication
(affirmatively stated in the Official Comment)14 is that disclaimers are permitted on other instruments. Any such
disclaimer, however, must appear in the indorsement with words such as without warranties.15
An indorsement without recourse that under Section 3-415(b) has the effect of negating the endorsers secondary
liability to pay the instrument if it is dishonored does not effect a disclaimer of the various presentment and transfer
warranties.16
The effect of this provision, that with respect to checks the warranty cannot be disclaimed, is illustrated by the facts
in Talbert v. U.S. Bank, N.A.17 The payee deposited a check that was subsequently returned by the drawee bank
based upon a claim of material alteration (altered payee). At the time of the deposit, the payee expressed concern
about the validity of the check and was told that the bank had a special collections procedure service that she
could use for her protection, which she opted to use and for which she was charged a fee of $75. When the
depositary bank debited her account for the returned check based upon the alteration and sought payment of its loss
against her for breach of warranty, she asserted that she and the bank entered into an agreement to waive her
warranty obligations and to impose the risk of loss on the bank, based upon this special service. The court held that
the payee (as depositor) could not assert this defense because of the provision that the warranties (in this case, that
the check had not been altered) cannot be disclaimed. The court concluded that the agreement to waive all
obligations, asserted by the depositor, would also be a disclaimer of those obligations, which is prohibited.
[c]
Accrual of Cause of Action
[i]
A Cause of Action for Breach of Warranty Accrues When the Instrument Is Transferred or Presented
Pre-Revision law suggested that a cause of action for breach of warranty accrues when the instrument was
transferred in the case of transfer warranties, or presented for payment or acceptance in the case of the presentment
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warranties. From the perspective of a victim of a breach, this provided at least two distinct advantages over liability
based on contract.18 First, the cause of action accrued at the time of breach, and second, the liability could be
imposed without the transferee first fulfilling the requirements of diligent presentment and notice of dishonor. A
transfer warranty is breached at the time of transfer and suit may be brought on the instrument without awaiting its
maturity. This is because the warranty applies to the condition of the instrument when it leaves the transferors
possession. Thus, the warranty is broken when the transfer is made and the transferor-warrantor may be sued
immediately without reference to when the instrument itself becomes due and payable.19 Both of these rules help
to streamline recovery on an instrument and thus encourage the purchase of commercial paper. Additionally,
allowing an immediate suit for breach of warranty prevents increased damages that could result while waiting for
the instrument to mature.
Current law provides an even more expansive period for victims of a breach of warranty to seek redress. A cause of
action on both transfer and presentment warranties now accrues only when the claimant has reason to know of
the breach.20 The claimant must inform the warrantor of the alleged breach within 30 days after having reason to
know of its existence and the identity of the warrantor.21 Assume, for instance, that an indorsement has been forged
in violation of both transfer and presentment warranties. Until liability is sought against the person whose signature
was forged, transferors and drawees may have no reason to know of the forgery, even though the transfers (and
hence making of the transfer warranties) occurred long before.
A federal district court22 emphasized that the notice requirement does not act as a statute of limitations to bring suit
on a breach of warranty claim. Under the notice provision, the liability of the warrantor is not affected; the question
of timely notice affects only the amount of damages that may be awarded, in that there is a discharge of the
warrantors liability to the extent of any loss caused by the delay in giving notice of the claim.
[ii]
Statute of Limitations
Recall that until promulgation of the current version of Article 3, the Code did not include a statute of limitations
provision governing an action brought for breach of warranty. Arguably, the applicable statute of limitations would
be the one governing written contracts generally.23 One court has argued that a breach of warranty action based on
both Sections 3-417 and 4-207, which governs warranties in bank collections, will be subject to the one-year statute
of limitations provided in Section 4-406(4).24
Since the breach of warranty occurs at the time of transfer or presentment, pre-Code cases generally held that the
statute of limitations began to run from that time.25 However, a few cases held that the statute began to run at the
time the defect was discovered.26
Article 3 now clarifies these issues. It adds a three-year statute of limitations period for actions stated in breach of
warranty and defines the point at which the cause of action accrues.27
[d]
Damages for Breach of Warranty
The current version of Article 3 also clarifies a previously open question concerning the measure of damages for
breach of warranty. In the absence of any provision, one could defend any of the following measures:
(1)
the amount the aggrieved party paid for the instrument;
(2)
the difference between the value the instrument would have had if the warranty had not been breached and
the value it had when transferred or presented with the breach; and
(3)
the face amount of the instrument.
The first rule, though easy to apply, would fail to give the transferee the benefit of the bargain where the instrument
was purchased at a discount or would have appreciated in value but for the breach. The second method would
compensate for the amount of loss actually occasioned by the breach and would be consistent with the measure of
damages for breach of a sales warranty.28 It would also be consistent with the Code policy of interpreting damage
provisions in a manner that will place aggrieved parties in the position they would have occupied without any
breach.29 The third rule would be the simplest to apply but would also afford the transferee a windfall through a
recovery in excess of the amount of loss caused by the breach.
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In the majority of cases involving checks, courts need not choose among these seemingly disparate rules, because
each provides an equivalent measure of damages. The face amount of the check (rule 3) equals the amount paid for
the check (rule 1), which equals the difference between the value the instrument would have had if the warranty had
not been breached (face amount) and the value it had when transferred or presented (arguably zero) (rule 2). In
those cases in which courts have had to make a choice, however, such as when there has been an alteration of the
face amount of the instrument, or when the instrument is a promissory note bought at a value below the face
amount, courts have regularly attempted to apply the second rule of calculation.30
The cases did not take a consistent approach with respect to allowing attorneys fees as appropriate damages; some
cases permitted recovery while others denied recovery.31
Current law explicitly recognizes these elements of damages.
A beneficiary of a transfer warranty may recover as damages an amount equal to the loss suffered as a result of the
breach, but not more than the amount of the instrument.32 Assume, for instance, that a transferee of an instrument
claims that the immediate transferor breached a warranty of no alteration. If the transferee can still enforce the
instrument against the drawer for its original amount, damages would be limited to the difference between that
amount and the increased figure. Since Section 3-416(b) also permits for recovery of expenses incurred as a result
of the breach, attorneys fees may be awarded where state law permits them.33
Damages for breach of a presentment warranty where the claim for damage is made by a drawee are equal to the
amount paid by the drawee, less any sum the drawee received or is entitled to receive from the drawer, plus
compensation for expenses and loss of interest.34 Where the claim is made by a drawer, indorser, or any other party
(other than a drawee), damages are equal to the amount paid plus expenses and loss of interest.35
[2]

Transfer Warranties

[a]
Against Whom Are the Warranties Imposed?
[i]
There Must Be a Transfer of the Instrument
A person who transfers an instrument for consideration gives certain transfer warranties to the transferee.36 An
instrument is transferred when it is delivered by a person other than its issuer for the purpose of giving to the person
receiving the instrument the right to enforce it.37 Presentment of an instrument for payment or acceptance is not a
transfer. Thus, a presenter does not give the warranties of a transferor, but the warranties of a presenting party as
specified in Section 3-417. Similarly, one who indorses an instrument as a surety does not give the warranties of a
transferor because the surety does not transfer the instrument.38
[ii]
The Transfer Must Be for Consideration
Transfer warranties are only given by a person who transfers an instrument for consideration.39 This requirement
can sometimes work to the serious disadvantage of holders who have relied on the warranties of prior transferors. In
particular, it often is not possible for a remote transferee to know whether a prior indorsee on whom the transferee
relies received consideration for the transfer of the instrument. Nevertheless, if the indorsement was made without
consideration, the remote transferee will not be entitled to rely on the indorsers warranties. A transfer without
consideration carries no warranty liability. Consideration is defined as any consideration sufficient to support a
simple contract.40
[b]
To Whom Do the Warranties Run?
[i]
Transfers With and Without Indorsements
Where the transfer is effected without indorsement, the transfer warranties run only to the transferors immediate
transferee.41 For example, if X transfers a bearer instrument to Y by delivery alone and Y then indorses the
instrument to Z, X undertakes the warranties of a transferor to Y, but not to Z. Where the transfer is by indorsement,
however, the warranties run with the instrument to any subsequent transferee.42 In this way, the remote holder
may sue the indorser-warrantor directly and thus avoid a multiplicity of suits which might be interrupted by the
insolvency of an intermediate transferor.43
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Arguably, the shelter provision of Section 3-201 broadens the application of the transfer warranties when the
transfer is without indorsement. Return to the example above where X transferred a bearer instrument to Y by
delivery alone and Y then indorsed the instrument to Z. As we saw, the warranties run only to Y pursuant to Section
3-416(a). But according to Section 3-203(b), Ys transfer of the instrument to Z vests in Z any rights that Y had to
enforce the instrument. Arguably, those rights include the rights to bring an action against X for the breach of any
transfer warranty, as well as rights to enforce the contract liability of any party to the instrument. On this theory, Z
has Ys warranty rights against X as well. This logic has the effect of negating the distinction drawn by Section 3416(a) between transfers with and without indorsement in any case in which the indorser has warranty rights
against a prior party.
[c]
The Specific Transfer Warranties
Section 3-416(2) lists five warranties made by a transferor of a negotiable instrument: (1) the warrantor is a person
entitled to enforce the instrument, (2) all signatures are authentic and authorized, (3) no alteration, (4) no valid
defenses or claims in recoupment, and (5) no knowledge of insolvency.
[i]
Person Entitled to Enforce
The essential warranty that there are no unauthorized or missing indorsements on the instrument is made through an
implied warranty that the transferor is a person entitled to enforce the instrument.44 Recall that persons in this
category include holders, a nonholder in possession with the rights of a holder, or a personwho has the rights to
enforce a lost or stolen instrument or one paid by mistake for which restitution has been obtained.45 Since the vast
majority of persons in this category will be holders or transferees from holders, breach of this warranty will
typically occur because a particular transferor was not a holder by virtue of taking an instrument in a chain that
included a forged indorsement.
Pre-Revision Section 3-417(2)(a) effected the same result by providing that a transferor warrants that it has good
title to the instrument or is authorized to obtain payment or acceptance on behalf of one who has a good title and
the transfer is otherwise rightful.46 The scope of this warranty could be confusing because the meaning of title
varies in effect from its meaning in the property context. The effect of the warranty can be analyzed by examining
three fact situations. In the first, M issues a note payable to the order of P. T steals the note, forges Ps indorsement,
and transfers the note to X. X subsequently transfers the note to H for consideration. X has breached the warranty
of title. This is a classic situation of breach of warranty of title by transferring an instrument that bears a forged
indorsement. Ts forgery breaks the chain of title so that no subsequent transferee can be a holder or be a person
entitled to enforce the instrument.47 There was, however, one drafting anomaly in this provision in the preRevision version. The introductory language to pre-Revision Section 3-417(2) provided that warranties, when made
by indorsement, ran to any subsequent holder. Of course, where the indorser-warrantor takes an instrument that
bears a forged indorsement, there can be no subsequent holder. Nevertheless, the intent of the provision seems to
be that persons in the position of H in the example above were the beneficiaries of the warranties, and thus
constituted holders as that term was used in Section 3-417(2). Current law omits this unfortunate usage and refers
only to a subsequent transferee.
In the second situation, assume that T steals a blank note, forges Ms signature as maker and issues the note payable
to the order of X. X indorses the note and transfers it to H for consideration. X has not broken any warranty. Even
though the form of note has been stolen and H will be unable to recover,48 the note serves as an instrument issued
by T.49 Since transfer of the note now a note of which T is the maker under Section 3-403(a) was
consistently rightful, and no forged indorsements appear on the note, each subsequent transferee retains the right
to enforce it. Thus, no breach of that warranty has occurred.50
In the third situation, T finds a bearer note issued by M. T transfers the note to X who transfers it to H for
consideration. The warranty of good title has been broken. As noted above, any transferee of a bearer instrument
can become a holder and thus H has rights against the maker of the note.51 Nevertheless, the transfer from T was
not otherwise rightful as against the original owner of the note, and thus there is a technical breach of the
warranty of good title. Since H could be a holder or holder in due course, however, no damages would exist.
[ii]

All Signatures Are Authentic and Authorized

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Under Section 3-416(a)(2), a transferor warrants that all signatures appearing on the instrument, not just
indorsements, are genuine (or authentic) or authorized. Thus, although the forgery of an indorsement not necessary
for negotiation will not preclude good title, it will be a breach of the warranty of genuineness of signature. Where
an indorsement is forged, of course, the subsequent transferee will have claims for breach of both the warranty of
genuineness and the warranty of good title.
A signature can be considered authorized when signed by a proper party rather than issued pursuant to a
legitimate transaction. Thus, one cannot claim breach of this warranty simply because one authorized to issue a
check was fraudulently induced to do so.52 It is not clear why both terms, authentic and authorized, are used.
Section 1-201(43) defines unauthorized signatures to include forged signatures.
[iii]
No Alteration
A transferor under Section 3416(a)(3) warrants that the instrument being transferred has not been altered. Section
3-407 defines alteration.53 Negligence that contributes to the material alteration of an instrument may, in some
instances, preclude recovery for breach of the warranty of no material alteration. In one case,54 for example, a
drawee bank had paid a check after it had been altered to increase its face amount by $37,000. The drawer
subsequently recredited the amount to its drawers account and then brought an action against the payee, the
depository bank and an intermediary bank which had accepted the check from the depository bank and in turn
presented the check to the drawee for payment. The drawee moved for summary judgment contending that the
depository and intermediary banks were liable to the drawer for breach of the transfer and presentment warranties
of no material alteration.55 The defendant banks argued, however, that there was at least a triable issue as to
whether the drawers negligence had contributed to the alteration of the check. The court denied the drawees
motion for summary judgment, holding that if it could be shown that the negligence of the draweecontributed to the
alteration of the check, the drawer would have a valid defense against the drawees claim.56 Further, if the drawer
maintained that defense or failed to assert it on request, the court held that the drawee would be estopped under
Article 4 from asserting any claim against the other banks.57
[iv]
No Defense Good Against Transferor
Section 3-416(a)(4) provides that a transferor warrants that the instrument is not subject to a defense or claim in
recoupment of any party that can be asserted against the warrantor.58 The pre-Revision transfer warranty permitted
a transferor to limit this warranty to one that he or she has no knowledge of such a defense by transferring without
recourse.59 The current version of Article 3, however, omits this opportunity on the grounds that a without
recourse indorsement does not clearly indicate an intent to disclaim warranties.60
The warranty of no defense resolves a conflict in decisions under the Negotiable Instruments Law which did not
specifically provide for a warranty that no defense was good against the transferor of an instrument. The Official
Comments explain the rationale for the Codes position:
The rationale of subsection (a)(4) is that the transferee does not undertake to buy an instrument that is not
enforceable in whole or in part, unless there is a contrary agreement. Even if the transferee takes from a holder in
due course who takes free of the defense or claim in recoupment, the warranty gives the transferee the option of
proceeding against the transferor rather than litigating with the obligor on the instrument the issue of the holder-indue-course status of the transferee.61
The warranty is against all defenses, real and personal, and the warranty is breached as long as the particular
defense is good against the transferor. It does not matter that the defense would not be good against the subsequent
holder who is a holder in due course.62 The defenses available to liability on an instrument are discussed in detail
with reference to Sections 3-305 and 3-306.63
[v]
No Knowledge of Any Insolvency Proceeding
A transferor warrants that it has no knowledge of any insolvency proceeding commenced with respect to the maker
or acceptor or, in the case of an unaccepted draft, the drawer.64 The current version of Article 3 limits the warranty
of drawers to those who are liable on unaccepted drafts. Acceptance of the draft by a bank, of course, would have
discharged the drawer.65 This is not a warranty of the obligors solvency, nor is the section intended to warrant
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against difficulties of collection.66 Rather, the provision is intended to prevent a fraud by a transferor who knows
that insolvency proceedings have been instituted against the party who is expected to pay and conceals such fact
from the buyer.67 An insolvency proceeding is not limited to formal bankruptcy hearings, but includes any
assignment for the benefit of creditors or other proceeding intended to liquidate or rehabilitate the estate of the
person involved.68
[vi]
Warranty as to Remotely-Created Consumer Item under 2002 Revision
The 2002 Revision adds a warranty intended to address unauthorized telephonically authorized checks. When
authorized, these checks are authorized by a drawer, but actually completed by a distant creditor to whom the check
is made payable in an amount stated by the nominal drawer. Someone in possession of the drawers account
information, however, could issue such a check in an unauthorized amount or could issue an unauthorized check.69
The amendment to Section 3-416 creates a warranty made by a transferor to the effect that, with respect to a
remotely-created consumer item, the person on whose account the item is drawn authorized the issuance of the
item in the amount for which the item is drawn. Thus, the warranty does not exist with respect to items purportedly
issued by commercial entities, but only by consumers. A remotely-created consumer item is defined as an item
drawn on a consumer account, which is not created by the payor bank and does not bear a handwritten signature
purporting to be the signature of the drawer.70 A consumer account is an account established for personal,
family, or household purposes.71
[3]

Presentment Warranties

[a]
Against Whom Are the Warranties Imposed?
Warranties made on presentment are, most obviously, made by the person who obtains payment or acceptance of
the instrument. Since a presentment does notconstitute a transfer, the presenter of an instrument will only be
making the warranties provided by Section 3-417, and not those provided by Section 3-416. Prior transferors,
however, also make the warranties on presentment to persons who pay or accept the instrument, even though these
transferors never dealt with the payor or acceptor. Thus, transferors make two warranties transfer warranties to
their immediate transferees and, if the transfer is by indorsement, to subsequent transferees, and presentment
warranties to the party who ultimately pays or accepts the instrument.
Section 3-417(a) governs presentment warranties made to drawees of uncertified checks or other unaccepted drafts.
These warranties vary somewhat from those made under prior law. Section 3-417(d) covers presentment warranties
to payors of all other instruments. Parties covered by these warranties basically represent only that they are entitled
to enforce the instrument as that phrase is defined in Section 3-301.
[b]
To Whom Do the Warranties Run?
Unlike the transfer warranties, which run in favor of any subsequent good-faith transferee when transfer is made by
indorsement, presentment warranties run only to the person who pays or accepts the instrument. There is no
requirement of privity between the person making the warranty and the payor or acceptor. It is necessary, however,
that the beneficiary of the warranty pay or accept the instrument in good faith.72 If the payor or acceptor, at the
time of payment or acceptance would, given reasonable commercial standards, be aware of the circumstances that
underlie the breach of warranty, the payor or acceptor cannot claim the benefit of the warranty.
In the controversial case of Sun N Sand, Inc. v. United California Bank,73 the Supreme Court of California held
that the drawer of a check was the beneficiary of the presentment warranties. The court argued that even though the
drawee bank was the party to whom the check was presented, the drawee debited the drawers account or looked to
the drawer for reimbursement for the payment on the check. The current version of Article 3 rejects this result.74
Warranties of presentment with respect to unaccepted drafts are made only to drawees. A drawer may be the
beneficiary of a presentment warranty only when it is also the drawee or when the drawer is presented with a
dishonored draft.75
[c]
The Specific Presentment Warranties
Section 3-417(a) lists three warranties made by a presenter or transferor of a negotiable instrument to the payor or
acceptor of an unaccepted draft: (1) that the warrantor was a person entitled to enforce the draft or was authorized
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to act on behalf of a person entitled to accept the draft; (2) that the draft bears no alteration; and (3) that the
warrantor has no knowledge that the signature of the drawer is unauthorized. Although these warranties appear
similar to those given on transfer, there are subtle but important differences between them.
[i]
The Presentment Warranties Operate in Conjunction With the Finality of Payment Rule of Section 3-418
To understand the distinctions between transfer and presentment warranties, it is necessary to step back from the
warranty provisions and examine Section 3-418, which concerns the finality of payment or acceptance.76 In a
purported attempt to bring some finality to commercial transactions, the drafters of the Code adopted the rule of
Price v. Neal.77 That case imposed liability on a drawee who paid or accepted an instrument bearing a forged
drawers signature. The drafters determined that once that act had occurred, the defrauded payor ought not to be
able to upset a series of completed commercial transactions. Thus, no absolute presentment warranty exists with
respect to the genuineness of the maker or drawers signature.
The rationale for choosing this particular point to close the transaction, as opposed to imposing finality after the
defrauded payor brought a warranty action, is the belief that the payor or acceptor is in a superior position to detect
the fraud. Presumably, the payor or acceptor, typically a drawee bank, is in the best position to know its customers
signature. Drawee banks usually have signature cards of the maker or drawer that can be compared with the
signature on the instrument as presented. The finality rule, therefore, induces these parties to take advantage of their
opportunity to detect and deter any fraudulent use of their customers checks.
The Code drafters, however, dismissed this rationale as fictional.78 This judgment appears predicated on a belief
that banks the typical acceptors do not make comparisons of signatures and signature cards. Even if this is
true, it does not contravene the general point that drawees may be in the best position to decide whether to make the
comparison. Presumably, even if comparisons of signatures on each item would be inefficient, the rule of Price v.
Neal may still induce them to make the comparisons in certain cases, i.e., with respect to items over a minimum
amount, or instruments that are particularly susceptible to fraud. As long as the bank bears the risk of forged
drawers signatures, it is likely to decide to review signatures when the costs of doing so are less than the expected
losses they will suffer from failing to inspect.
In fact, banks do adopt policies and procedures to verify the signatures on certain checks that meet stated criteria,
such as minimum amounts and the nature of the customer/depositor and volume of deposited checks. Banks also
employ sophisticated computer models and programs to identify checks for sight review.
Section 3-418 is discussed further in connection with the warranty of no knowledge of forged signature, 20.17[3]
[c][iii] below; it is in connection with this warranty that there is the connection between the finality of payment rule
and the warranty provision.
The finality rule of Section 3-418, however, is not ironclad in all cases. If one of the presentment warranties has
been breached, the payor or acceptor is authorized to bring a warranty action and recover the payment. In addition,
the finality rule runs only in favor of a holder in due course or a person who has in good faith changed position in
reliance on the payment. Any other party is relegated to general rules of restitution, which may require the
surrender of benefits obtained as a result of a material mistake, e.g., the mistaken belief that the drawers signature
was authorized.79
The 2002 Revision adds a presentment warranty applicable to remotely-created consumer items similar to the
transfer warranty for such items discussed above.80 This warranty creates a limited exception to the rule of Price v.
Neal in that it permits a drawee bank that had paid an unauthorized telephonic check to bring a presentment
warranty action, and prior banks could bring transfer warranty actions up the line until the loss came to lie on the
depositary bank.
[ii]
Person Entitled to Enforce
[A]
In General
Section 3-417(a)(1) provides that a presenter or prior transferor warrants to a good-faith payor or acceptor of the
instrument that the warrantor is a person entitled to enforce the draft or is acting on behalf of a person entitled to
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enforce the draft. Essentially, this is a warranty that there are no forged or missing indorsements on the instrument.
This language, which replaces the warranty of good title under prior law,81 essentially requires that the warrantor
be a holder, or be sheltered to the rights of a holder, or be entitled to enforce a lost or stolen instrument under
Section 3-309.82 The drawee, therefore, does not admit the authenticity of indorsements by paying the draft.83
[B]
Title to Bearer Instruments and Order Instruments
Pre-Revision presentment warranties, which spoke of good title, raised questions about the effect on the warranty
of forged indorsements that were irrelevant to negotiation of the instrument. The warranty was deemed to be
breached only if the indorsement was necessary to negotiation. This limitation on the warranty of good title meant
that presentors warranty liability could vary between order and bearer instruments. In this respect, the discussion as
to transfer warranties, above in 20.17[2][c][i], also applies to presentment warranties in that both Sections 3416(a)(1) and 3-417(a)(1) provide for a warranty that the warrantor is or was a person entitled to enforce the draft
or instrument. Accordingly, the illustrative situations to follow are similar to those set forth under the discussion of
the transfer warranties, and the authorites cited for the latter also would apply to the examples for the presentment
warranties. Assume a thief steals a bearer instrument, negotiates it to X who presents it to the payor, and payment is
made. The negotiation of the bearer instrument by the thief to X constitutes the latter as a holder,84 and, assuming
X otherwise satisfies the requirements of Section 3-302, a holder in due course. X has a right to payment of the
instrument, and, notwithstanding that Xs ownership of the instrument is traced back to a thief, has good title within
the meaning of pre-Revision Section 3-417(1)(a). No warranty of good title, therefore, has been broken in this
situation.
Assume, however, that the thief stole an instrument payable to the order of Y, forged Ys signature, and negotiated
the instrument to X for value. When X presented the instrument for payment, X did not do so as a holder, as the
forged payees signature does not constitute an indorsement necessary to give X that status.85 Even if the
instrument was paid, the payor could bring a subsequent action against X for breach of warranty. As Official
Comment 3 to pre-Revision Section 3-417 stated, the party who accepts or pays does not admit the genuineness
of indorsements, and may recover from the person presenting the instrument when they turn out to be forged.
A warranty of good title may be breached even where no forgery exists. A depositary bank that presents a check
bearing fewer than all necessaryindorsements has breached its warranty of good title, just as if the check bore a
forged or unauthorized signature.86
[iii]
Authorized Signatures
[A]
The Basic Warranty
Presentors and prior transferors of unaccepted drafts warrant to the payor or acceptor that they (the presentors and
transferors) have no knowledge that the signature of the drawer is unauthorized.87 No such warranty, however, is
made with respect to instruments other than unaccepted drafts presented to drawees. Presentment made on such
other drafts carries only the warranty that the presenter and prior transferors were entitled to enforce the
instrument.88
The basic warranty of no knowledge stems from the general principle that one who presents an instrument
knowing that the signature of the maker or drawer is forged or unauthorized commits an obvious fraud upon the
party to whom presentment is made.89 Note that the effect of this warranty is to place on the drawee the risk that
the drawers signature is unauthorized, except in the rare case where the warrantor has knowledge of the lack of
authority. Hence, it is this part of the presentment warranty that embodies the rule of Price v. Neal, discussed
above.90
Knowledge under the Code is defined subjectively; a person must have actual knowledge of a fact in order to
know of it.91 Knowledge, therefore, differs from notice of a forgery, which can be attributed to a person who,
from all the facts and circumstances known at the time in question, has reason to know that it exists.92 The
existence of notice, however, would be insufficient to constitute a breach of warranty.
[B]

Exceptions to the Basic Warranty

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Prior to the current version of Article 3, the presentment warranty of no knowledge of an unauthorized drawers
signature was inapplicable in cases involving a person with the status or rights of a holder in due course acting in
good faith.93 These exceptions are currently omitted or incorporated into the general warranty provision rather than
separately stated.
Holder in due course status is created at the time the holder takes the instrument and one of the basic requirements
that must be satisfied is that the holder take the instrument in good faith.94 Thus, the addition of the good-faith
requirement in the exceptions, if not redundant, must be read to require that the holder in due course also be acting
in good faith at the time of presentment.95 If, for instance, the holder took the instrument in ignorance of a forgery,
but learned of the forgery prior to presentment, the holder, although retaining due course status, would not be
entitled to the benefit of the exception.
The prior Article 3 provision identified four exceptions to the basic warranty.96
The provisions of Pre-Revision UCC 3-417(1)(b) and 3-418 are contained in and renumbered under the current
version as UCC 3-417(a)(3) and 3-418 without any change in substance. As explained previously, the
presentment warranties operate in conjunction with the rule on finality of payment (see 20.17[3][c][i] above).
Under the prior version payment or acceptance was final in favor of a holder in due course or person who changed
position in reliance on the payment or acceptance.97 The current version is structured to correspond to the general
laws of mistake and restitution, so that while a drawee bank has a right to recover payment or revoke acceptance for
mistaken payments, this right is limited in that it may not be asserted against a person who acted in good faith and
either gave value or changed position in reliance on the payment or acceptance.98
Based upon the foregoing, the current version contains a more expansive explanation of the rule. A drawee may
recover a payment made upon the mistaken belief that the signature of the drawer was authorized, from the person
to whom or for whose benefit payment was made, except a person who took the instrument in good faith and for
value or who in good faith changed position relying on the payment. This is a significant change that needs to be
emphasized. For a payee to avoid payment to a payor under a mistaken payment, it must only have taken the
instrument in good faith and for value or have changed position in reliance on the payment; the payee does not have
to prove it is a holder in due course, which would then require, additionally, proof that the payee took the
instrument without notice of defenses.
[iv]
No Alterations
[A]
The Basic Warranty
Section 3-417(a)(2) states only that the presenter and prior transferors warrant to a drawee on an unaccepted draft
that there has been no alteration. Exceptions that existed under prior law (see 20.17[3][IV][B], below) are
omitted, as they refer primarily to a holder in due course and to situations not involving unaccepted drafts. As noted
above, presentors and prior transferors of such instruments make no warranty other than entitlement to enforce the
draft.
The basic warranty of no alteration is in accord with decisions at common law and under the Negotiable
Instruments Law, which generally held that a payorcould recover money paid to the presenter of a materially altered
instrument.99 Alteration is defined in Section 3-407.100
[B]
Exceptions to the Basic Warranty
As in the case of pre-Revision Section 3-417(1)(b), the pre-Revision warranty of no material alteration was not
imposed against a holder in due course acting in good faith. Although knowledge is an important element in the
warranty dealing with unauthorized signatures, it did not appear in the warranty of no alterationwhich was
previously stated as a warranty of no material alterationand thus, may be considered in assessing the holders
good faith.
There were four exceptions to the basic warranty under pre-Revision law.101 As noted above, these exceptions are
omitted in Section 3-417.102
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[v]
Right to Assert Drawees Defenses
Warranty liability is typically used by a drawee bank that has paid over a forged drawers signature or forged
indorsement and cannot charge its customers account the amount of the draft, since the customers authorized
signature does not appear on it or the forged indorsement renders the draft not properly payable.103 In some cases,
however, the drawee would be entitled to charge its customers account, either because the customer was precluded
from denying the signature or because the signature was effective under the imposter, padded payroll, or fictitious
payee doctrines. When that occurs, the drawee bank may still prefer to proceed against its presenter or a prior
transferor on warranty liability rather than against its customer.104 If the customer was negligent, however, or
otherwise occupied a superior position to detect or deter the fraud, a shift in the risk of loss to the warrantor would
defeat the Code objective of allocating losses efficiently. Article 3, therefore, provides the warrantor with certain
rights that place the drawers conduct in issue. Section 3-417(c) permits a warrantor who has presented a draft
bearing an unauthorized indorsement or an alteration to defend by proving that the indorsement is effective under
the imposter, fictitious, or employersresponsibility doctrines, or that the drawer is precluded from asserting the
forgery or alteration against the drawee. That preclusion would occur if the drawer had substantially contributed to
the making of the signature through negligence or had exceeded the time limits of Section 4-406 in bringing the
forgery or alteration to the drawees attention. The statement in the official comment emphasizes the importance of
this provision in subsection (c) by explaining that It gives to the warrantor the benefit of rights that the drawee has
against the drawer under Sections 3-404, 3-405, 3-406, or 4-406. If the drawers conduct contributed to a loss from
forgery or alteration, the drawee should not be allowed to shift the loss from the drawer to the warrantor.105 The
warrantor, however, is not given the right, similar to pre-Revision Section 4-406(5), to require the drawee to
proceed first against the drawer.106 Instead, the warrantor must bear the costs of the suit, but may defend using the
rights otherwise available to the drawee against the drawer.
[d]
Third Party Actions and Vouching-In
A person against whom a claim is made or a lawsuit is brought alleging breach of an obligation under either Article
3 or 4 can enforce the warranty obligation of another party by commencing a third-party action against such
party107 or by using the vouching in provision of the Code. Under the pre-Revision section and Code section,
written notice of the litigation is given to the person alleged to be liable stating that the person may come in and
defend and that failure to do so will result in that person, in a later action against him, being bound by fact
determinations common to the two litigations. If the person receiving notice fails to come in and defend, he will be
so bound.108

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20.18 Conversion Liability and Forged Indorsements*

[1]

In General

In addition to liability that parties may incur as a matter of contract or warranty, the Code provides in certain cases
for liability based on a theory of conversion. The current version of Article 3 clarifies the law of conversion of
instruments in a number of respects, so that understanding of the pre-Revision law is necessary to appreciate some
of the changes made in the law. Pre-Revision Section 3-419 defined conversion as a failure to return or pay an
instrument delivered for payment or, most importantly, payment of an instrument on a forged indorsement. Courts
have also expanded forged to include a banks acceptance of unauthorized deposits and disbursements.1 These
situations, however, do not exhaust the possibilities for conversion. Most obviously, it does not impose conversion
liability on the thief of an instrument. Rather, the Code provision is limited to conversion among the parties to the
instrument; other acts of conversion are incorporated through Section 1-103, which supplements the Codes
provisions with common-law principles. Article 3 explicitly incorporates common-law acts of conversion into the
law of negotiable instruments. Section 3-420(a), the new section dealing with conversion, provides that [t]he law
applicable to conversion of personal property applies to instruments. The provision then adds particular instances
of conversion that are distinctive to the law of commercial paper.
Pre-Revision Section 3-419 provided that the measure of liability for conversion was presumed2 to be the face
amount of the instrument.3 Face amount is now clarified as the amount payable on the instrument. The same
measure of damages applies regardless of the identity of the converter. Under prior law, there was a conclusive
presumption that damages are equal to the face amount of the instrument where the drawee is the convertor and a
nonconclusive presumption in other cases. Evidence was admissible to show that for any reason,such as insolvency
or the existence of a defense, the damage incurred was more or less than the instruments face amount,4 except in a
conversion action against a drawee. In the latter case, the Code, in an obvious attempt to protect collecting banks,
asserted conclusively that the drawees liability is the face amount of the instrument.5
The Code, similarly, states that the measure of liability is presumed to be the face amount of the instrument, but
then adds language that states that recovery may not exceed the amount of the plaintiffs interest in the
instrument.6
[2]

Incorporation of Common Law

Pre-Revision law specified a number of ways in which conversion could occur. Statements that conversion occurred
when a holder or transferee of an instrument could not obtain its return after delivering it for payment or
acceptance7 were deemed by the revisers to be inappropriate for certain noncash items.8 Appropriate cases were
instead considered to be subsumed within the common law of conversion that is incorporated into the first sentence
of Section 3-420.9
Nevertheless, some prerequisites previously stated in the Code can be considered inherent in the common law of
conversion. To trigger conversion liability, the instrument must be delivered to the acceptor or payor.10
Delivery is defined by the Code as a voluntary transfer of possession.11 Second, there must be a demand for
return of the instrument.12 The demand may be made expressly at a particular time or it may be understood by
custom as implied under the circumstances.13 Third, there must be an intentional failure to return the instrument.14
If the instrument is not returned because of its negligent loss or destruction, the acceptor or payor may be liable in
tort for any resulting damages, but is not liable for conversion of the instrument.15
[3]

Conversion by Payment on a Forged Indorsement

[a]
Introduction
The most complex situation in which the issue of conversion arises involves payment by the drawee of a check
bearing a forged indorsement. The situation is complicated by Code provisions that purport to define which parties
are liable on the instrument, which parties may bring actions as a result of the forgery, and the causes of action that
properly run among the parties. While the Codes jigsaw-puzzle approach to the forged-indorsement issue appears
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to have some supporting logic, courts have substantially disagreed on the interpretation of the governing Code
provisions. It is useful, therefore, to begin with a basic transaction and to examine the liabilities that may ensue
when an instrument is paid on a forged indorsement. The following discussion will assume, with stated
modifications as we proceed, that a completed check has been stolen from Drawer or Payee and that the thief or
some subsequent person forges the indorsement of Payee. The thief then cashes or deposits the check, and the
Depositary Bank sends the check through the collection process to the Drawee Bank. Drawee Bank pays the check,
not noticing the forged indorsement. Prior to discovery of the forgery, the thief absconds after withdrawing all
funds from the account at Depositary Bank. Since revisions in the law governing this scenario grew out of
dissatisfaction with pre-Revision law, that prior law will be explained first where differences between pre-Revision
and current versions of Article 3 are relevant.
[i]
Payee vs. Drawer
At this point, Payee has presumably provided goods or services to Drawer in return for which Drawer issued the
original check. If the check was received by Payee prior to the theft, Payee may now request a replacement check.
The Drawer may initially refuse, alleging that under Section 3-310, the original check was taken for the underlying
obligation, thus suspending the obligation, and payment of the check discharged Drawer on both the instrument and
the underlying obligation.
Payee has a series of responses to this argument and should succeed. First, payment over a forged indorsement does
not constitute a discharge, since payment was not made to a person entitled to enforce the instrument.16 Second,
Section 3-309 permits Payee to enforce the terms of a check that has been lost or stolen. Drawer, however, may
have a concern that Payee indorsed the check in blank prior to the theft. If that were the case, Drawer would end up
paying twice: The original check will have become bearer paper, properly payable to any party in possession of it;
the replacement check will be properly payable to Payee. To prevent this double liability, Section 3-309(b) permits
the court to require adequate protection from the Payee, e.g., by indemnifying Drawer for any loss by reason of
further claims on the original instrument.17
If the completed check is stolen from Drawer prior to delivery to Payee, Payee may obtain another check or bring
an action on the underlying obligation. Since the check was never taken by Payee, that underlying obligation has
not yetbeen suspended under Section 3-310. Under the current version of Article 3, an underlying obligation for
which an uncertified check is given is discharged only when the instrument is taken by the obligee.18 A payee or
indorsee who does not receive an instrument is considered to be an obligee with a right to payment, but not a holder
or a person entitled to enforce the undelivered instrument under Section 3-301.
White v. Hartford Life Ins. Co. Pac. Ins. Co.,19 addressed the factual situation where a check is stolen from the
payee (as opposed to the situation discussed above where the check is stolen prior to delivery to the payee). Under
these circumstances, where the payees signature is then forged, and the forger obtains payment, the court explained
that because the suspension of the underlying obligation continues, the payee could sue the depositary or payor
bank in conversion (Section 3-420) or the drawer (under Section 3-309), but could not sue on the underlying
contract. Similarly, in Bank of Am. Natl Trust & Sav. Assoc. v. Allstate Ins. Co.,20 the court held that the payee
has the conversion action or action against the drawer and that these are the only causes of action possessed by the
payee.
[ii]
Drawer vs. Drawee Bank
A bank may charge the account of its customer for any item that is properly payable from the account.21
Although the Code does not define the quoted phrase, the unauthorized signature by the thief clearly renders the
check not properly payable.22 Drawee Bank, therefore, is not entitled to charge Drawers account and, if it has paid
the check and debited Drawers account, must recredit it.23 As discussed below, however, Drawee Bank will be
able to resist Drawers claim for credit if Drawee Bank can establish that Drawers own negligence substantially
contributed to the forged indorsement.24
Cases have also recognized the intended payee defense where the proceeds of the check can be proven to have
reached the intended payee. This rule is a common law exception, and defense, to a banks liability for payment on
a forged indorsement when the proceeds of an instrument have reached the intended beneficiary of that
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instrument.25 The cases have also acknowledged that the drawee bank is only liable where its payment caused the
drawers loss. Once the customer has established an improper payment based upon payment of an instrument
containing a forged endorsement, the customer has the burden of showing the amount of loss resulting from the
improper paymentthe customer cannot recover an amount in excess of its actual loss.26
[iii]
Drawee Bank vs. Collecting Banks
Although Drawee Bank must recredit Drawers account, under the scenario described above Drawee Bank will not
bear the ultimate loss of the forged indorsement. Instead, Drawee Bank is entitled to maintain an action against its
predecessors in the collection chain for breach of the warranty that they were persons entitled to enforce the
instrument.27 As described above,28 that warranty basically promises that the instrument bears no forged
indorsements.
If Drawee Bank chooses to maintain its warranty action against its immediate predecessor, the presenting bank,
under Section 3-417(1) or Section 4-207(1), may subsequently bring similar warranty actions against its own
transferor under Section 3-417(2) or Section 4-207(2). This process should continue back through the collection
chain until the loss finally comes to rest on Depositary Bank, which took the check from the thief. In Olympic Title
Ins. Co. v. Fifth Third Bank,29 the court recognized that the drawee banks remedy where there has been a forged
endorsement is a breach of warranty claim against the depositary bank. This statutory remedy is consistent with the
delicately balanced statutory scheme of the Code whereby the loss from a forged endorsement is shifted, ideally,
to the thief, who is accountable, but in reality, in many circumstances, it is shifted to the depositary bank, whose
conduct or relationship with the forger most facilitated the risk of loss.
[iv]
Payee vs. Drawee Bank
The discussion thus far suggests that if Payee obtains a replacement check from Drawer after a theft, Drawer will
proceed against Drawee Bank. Payee may attempt to shorten this process, however, by bringing a conversion action
directly against Drawee Bank. Section 3-420(a) authorizes this action by defining conversion to include payment
with respect to an instrument for a person who was not entitled to enforce it or to receive payment.30 Drawee Bank,
as the payor, is thus directly liable to Payee. Of course, Drawee Bank would retain its warranty rights against prior
transferors, and thus would not bear the ultimate loss of the forgery.
Payees action under Section 3-420(a) is effectively one of strict liability. Neither good faith nor due care on
Drawee Banks part will absolve it.31 Nevertheless, as discussed below,32 Drawee Bank could avoid liability by
demonstrating that payees own negligence substantially contributed to the forgery.
The statement in Section 3-420(a) that [t]he law applicable to conversion of personal property applies to
instruments makes it clear that the thief who steals a check from a payee and forges the payees indorsement has
converted the instrument. This scenario was missing from the explicit definition of conversionunder prior law. The
provision also defines conversion as taking an instrument by transfer, other than a negotiation, from a person not
entitled to enforce the instrument or, in the case of a bank, making or obtaining payment for a person not entitled
to it. Thus, it is clear that both payor and drawee banks can convert an instrument.33 Conversion also occurs when
a bank as transferee takes a check made payable to two persons, only one of whom has indorsed, if the check
requires both indorsements.
Prior to bringing a successful conversion action, however, a payee must be able to demonstrate that the check was
stolen after delivery. Article 3 rejects prior cases that allowed a payee to state an action for conversion when the
check, made payable to payee, was stolen from the drawer. A payee to whom an instrument is not delivered has no
interest in the check and has no conversion action.34 Constructive delivery through an agent or co-payee, however,
will satisfy the requirement.35
The conversion remedy set forth in Section 3-420 displaces any common law claims such as negligence and
common law conversion; where the facts underlying the claim involves an unauthorized payment of an instrument,
the statutory remedy is the exclusive remedy regardless of the legal theory that may be advanced.36

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Section 3-420(b) provides that the measure of liability is presumed to be the amount payable... whereas the PreRevision Section 3-419(2) provided it was the face amount of the instrument. This language change makes it
clear that the amount which can be recovered is the full amount due on the instrument which would include interest
and any other amounts provided for in the instrument (e.g., penalties, prepayment fees, etc.), not only the face
amount which may only be the principal of the note.37 The current version removed the absolute liability
language of the prior version; the rule under both versions remains the same to the extent that the drawee banks
liability is not absolute, but can be mitigated by proof the payee-person entitled to enforce the instrument whose
indorsement is forged, received the proceed of the instrument. This is explicitly stated in the Code and was so
construed by the majority of courts that had considered the issue under the prior version.38
[v]
Drawer vs. Depositary Bank
If an action by Drawer against Drawee Bank will only result in a series of warranty suits until liability finally
comes to rest on Depositary Bank, why not simply permit Drawer to bring an action directly against Depositary
Bank?39 Pre-Revision Section 3-419(3) would appear to have a bearing on this issue, as it suggests that a
depositary bank is not liable in conversion to the true owner of an instrument beyond the amount of proceeds
remaining in its hands. The negative implication of this statement would appear to be that a drawer from whom a
check was stolen would have an action against a depositary bank that retained proceeds of the check.
The early case of Stone & Webster Engineer Corp. v. First National Bank & Trust Co.,40 however, rejected this
interpretation. In that case, the plaintiff-drawer drew three checks in the payees name, but before the checks could
be delivered to the payee, the drawers employee secured possession of the checks and cashed them at the
defendant-collecting bank. The collecting bank indorsed the checks and obtained payment from the drawee which,
in turn, debited the drawers account. The drawers demand on the drawee to recredit the account was refused and
the drawer brought an action directly against the collecting bank seeking recovery on the alternative grounds of
money had and received and conversion.
The Supreme Judicial Court of Massachusetts held that the drawer had no cause of action against the collecting
bank. The court reasoned first that the drawer was not a holder to whom the checks were valuable property and to
whom the drawee could make payment. Moreover, the court found that the collecting bank had never possessed
money that belonged to the drawer because the money received from the drawee belonged to that party.
The court rejected a conversion theory under pre-Revision Section 3-419(1)(c) since the depositary bank, not being
the drawee, could not have paid the checks as required in that provision. The court noted, however, that a
conversion action would lie under Section 3-419(3). Yet the court reasoned that this action was limited to a proper
party. That category, in the courts opinion, excluded the drawer as it had no valuable rights in checks made out
to someone else.
The New York Court of Appeals has held that a drawer may not sue a depositary or collecting bank for conversion
in the absence of a contractual relationship, unless the forgery on the check it issued was effective under preRevision Section 3-405 and the check was paid over a restrictive indorsement.41 But the Stone & Webster rationale
has not met with universal acclaim. In Sun N Sand, Inc v. United California Bank,42 the Supreme Court of
California permitted a drawer to bring an action for the amount of stolen, altered checks against a depositary bank.
The court, avoiding Section 3-419(3), reasoned that the drawer, as ultimately responsible for checks it issued, was
entitled to the benefit of warranties made by a depositary bank to a payor. An Indiana appellate court reached a
similar result in Insurance Co. of North America v. Perdue National Bank.43
Nevertheless, the current version of Article 3 adopts the reasoning, or at least the result, of Stone & Webster.
Section 3-420(a)(i) denies an action for conversion of an instrument to the issuer or acceptor of the instrument.44
The Official Comment notes that the check represents an obligation of the drawer rather than the property of the
drawer, so the drawer has an adequate remedy when it requires the drawee to recredit his or her account for
payment of an unauthorized item.45 Therefore, under Section 3-420(a) a drawer does not have a direct action in
conversion against a depository bank.46
[vi]

Payee vs. Collecting Bank

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[A]
The Scope of Pre-Revision Section 3-419(3)
The implication of pre-Revision Section 3-419(3) was that some party had an action in conversion against
Depositary Bank. If Drawer is not the appropriate party, then presumably Payee is. Such an action would permit a
payee who suffers the theft of several checks, potentially drawn on various drawees but deposited in a single bank,
to recover all lost funds in a single action. Nevertheless, the Code appeared to place numerous obstacles in the path
of a payee seeking recovery directly against a depositary bank. The relevant Section provided:
(3) Subject to the provisions of this Act concerning restrictive indorsements a representative, including a depositary
or collecting bank, who has in good faith and in accordance with the reasonable commercial standards applicable to
the business of such representative dealt with an instrument or its proceeds on behalf of one who was not the true
owner is not liable in conversion or otherwise to the true owner beyond the amount of any proceeds remaining in
his hands.
Thus, the provision presumably applied to a direct action only insofar as the depositary or collecting bank is a
representative, defined as any person empowered to act for another.47 Even if Depositary Bank fits the
description of a representative, Payee will be able to recover only the proceeds remaining in Depositary Banks
hands, as long as Depositary Bank acted in good faith and in accordance with reasonable commercial standards.
The common-sense interpretation of the proceeds requirement of the provision would suggest that if the thief has
withdrawn the funds or cashed the check at Depositary Bank, the depositary is immune and Payee must find
recovery elsewhere. Thus, at first glance, Section 3-419(3) appeared to confer only a limited liability on depositary
and collecting banks for conversion of checks bearing forgeries.
The courts, however, demonstrated remarkable ingenuity in circumventing the apparent restrictions on actions by
payees against depositary banks. Courts found failures to comply with reasonable commercial standards,
narrowly interpreted the concept of representative, and discovered proceeds in the bank, even where the thief
has absconded with funds from the forged check. It is to the justification and propriety of these decisions that we
now turn. It should be noted, however, that the current version of Article 3, Section 3-420(a), eliminates the need
for some of the judicial creativity by granting a conversion action to the payee against a depositary bank that has
collected a check with a forged indorsement and paid the proceeds to one not entitled to them.48 Section 3-420(c)
continues to provide immunity from conversion liability to a representative who has dealt with an instrument in
good faith, beyond the amount of any proceeds remaining in the representatives hands. The provision, however,
explicitly excludes depositary banks.49 The Official Comment to the provision states that there is no reason to bar
the action since the depositary will ultimately be liable on breach of warranty theory where it transferred or
presented a check bearing a forged indorsement.
In order to maintain a conversion action against a collecting bank, the payee must have received delivery of the
check, directly or through an agent.50 This is the same rule discussed above in connection with the payees
conversion action against the drawee.
[B]
Reasonable Commercial Standards
The approach that is perhaps most consistent with a literal reading of the pre-Revision provision on conversion by
depositaries, but often the least compatible with the facts of the case is to find that the collecting bank failed to
observe reasonable commercial standards and is thus liable to the payee.51 This is not to say that banks never act
unreasonably. A collecting bank may well have a duty of inquiry of the depositor, especially if the depositors rights
are acquired directly through the forged indorsement. For example, a bank that allows an employee of a corporate
indorser to deposit and then withdraw large sums for obviously other than corporate purposes is hardly exercising
reasonable commercial standards.52 Alternatively, a bank that accepts a check that does not beara necessary
indorsement may not be acting in good faith.53 Generally, the courts, while recognizing the validity of the
limitation of liability provision, hold that a bank that accepts a double indorsed check payable to a corporation for
deposit to an account other than the payee-corporation, or that cashes such a check, has not acted in accordance
with reasonable commercial banking standards, and the bank is not afforded the protection of the section.54 Yet in
the majority of cases where an instrument is paid on a forged indorsement, the depositary and all other collecting
banks will have acted reasonably and in good faith. In view of the large volume of checks that go through the
collection process daily, to require anything more of the depositary than a cursory examination of the indorsement
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in other than an unusual transaction would itself be unreasonable.55 To rely on this exception to the defense of a
collecting bank is often to skirt the real issue of direct liability.56
The defense under Pre-Revision section 3-419 that the depository bank acted in accordance with reasonable
commercial standards in dealing with the instrument is eliminated in the revised Code.57 The section creates strict
liability.58
Section 3-420 continues the Code standard requiring the representative (other than the depository bank) to act in
good faith. Good faith requires the person to observe reasonable commercial standards of fair dealing, and actions
are to be judged in light of reasonable commercial standards.59 By virtue of this new definition, the Pre-Revision
requirement that the bank act in accordance with reasonable commercial standards is continued.
[C]
Representative
The issues of representation and proceeds were thoroughly explored in opinions arising out of Knesz v. Central
Jersey Bank & Trust Co.,60 a case that reads more like a law professors hypothetical than an actual fact situation.
Knesz owned a cooperative apartment in New York and arranged to have a New York attorney (subsequently
disbarred) act as financial agent concerning the property. The attorney sold the apartment without the knowledge of
Knesz and received in return checks made payable or indorsed to the order of Knesz. The attorney forged his
clients indorsement on the checks and, with respect to the checks that became the subject of the litigation, indorsed
them over to a third party in satisfaction of a debt. These checks were deposited by the attorneys creditor in Central
Jersey Bank & Trust and the checks were paid by the various drawees. The depositor subsequently issued checks in
the full amount of the deposited funds.
The Superior Court permitted Knesz to maintain a conversion action directly against Central Jersey concluding,
there is neither commercial nor rational justification for construing (the immunity of pre-Revision Section 3419(3)) as applicable to depositary and collecting banks engaging in the normal check collection business. The
elaborately reasoned opinion gave several rationales for this holding. The common law had permitted the direct
action, and the underlying policies remained the same: the depositary bank that dealt with the forger had the best
opportunity to avoid the loss, and permitting the action would avoid the circuity of a chain of conversion and
warranty litigation that would ultimately produce the same result. The court also considered the historical
acceptance of the direct action so well-established as to preclude the possibility that the legislature intended to
abrogate it through Section 3-419(3).
Nevertheless, the court had to confront the plain language of the provision. It began by reading the term
representative to exclude banks acting simply as the acceptor of a check for collection. Following the lead of an
earlier Pennsylvania case,61 the court concluded that since representative included a broker, it was intended to
apply only when a bank acted as a true agent by dealing with another persons funds. When cashing a check or
permitting a withdrawal from an account, the court concluded, the bank was dealing with its own funds and neither
positive law nor policy entitled it to the immunity provided for agents. In fact, the court concluded, substantial
policy supported its conclusion; immunity for the depositary bank would result in circuitous litigation and impose
substantial burdens on an innocent payee who might have to bring conversion suits against several distant drawee
banks rather than a nearby depositary.
On appeal, the Supreme Court of New Jersey disagreed with the lower courts narrow interpretation of
representative. The court noted that under Section 4-201, a bank handling an item for collection was, in fact, the
agent of the owner of the item. Since the forger cannot be the owner of the item, the broader term
representative was, in the courts mind, carefully chosen to cover the forgery situation. While the court did not
dispute the policy behind a contrary result, and recognized that other jurisdictions had reached a conclusion similar
to that of the lower court,62 it refused to elevate that rationale over the plain meaning of the statute. As noted
above, the current version of Article 3 confirms the position of the Superior Court in Knesz that there is no policy
reason to deny a payee the cause of action against the depositary bank. Thus, the Code now omits depositary banks
from the representatives entitled to immunity from conversion liability.
[D]

Proceeds
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The immunity of Section 3-419(3) existed only insofar as the depositary or collecting bank was not holding
proceeds of the instrument at issue. Thus, if the thief in our example either cashed the check at the depositary bank
or deposited the check but subsequently withdrew an amount that included the fundsrepresented by the check,63
one would imagine that Payees action against Depositary Bank would fail. Nevertheless, courts have demonstrated
remarkable ability to construe the term proceeds in a manner that continues the liability even of banks that
otherwise qualify for the immunity as representatives acting in accordance with reasonable commercial standards.
In Ervin v. Dauphin Deposit Trust Co.,64 the court held that a bank that had cashed checks bearing a forged
indorsement had not parted with proceeds. Rather, the bank had purchased the checks and had done so with its
own funds. As a result, the proceeds of the checks were delivered to the depositary by the drawee bank and those
proceeds remained within the hands of the depositary. Evasion of the proceeds requirement continued in Cooper v.
Union Bank.65 There the depositary bank accepted checks bearing forged indorsements for deposit. The forger
subsequently depleted his entire account. One might believe that in so doing, the forger absconded with the
proceeds of the checks. Not so, concluded the California court. The depositary bank held those proceeds through a
constructive trust for the true owner of the checks. Only by having its total assets depleted to an amount below the
sum of the forged checks could the depositary bank ever be said no longer to be holding their proceeds. As in Ervin,
the Cooper court concluded that proceeds could arise in the first instance only when the depositary received funds
from the drawee in return for the forged checks.
The New Jersey Supreme Court rejected these analyses in Knesz. The court concluded that most of the commentary
had reflected negatively on these decisions and that subsequent decisions had rejected them outright.66 The court
then defined proceeds as the amount, if any, the bank actually has left in its control as a consequence of dealing
with the forged check. Thus, if the depositary bank had given a provisional credit for the amount of the item and
had prevented the customer from withdrawing actual credit for the instrument, the bank would have been liable to
the owner of the check notwithstanding Section 3-419(3). If a withdrawal of the amount had occurred, however, or
the check had been cashed over the counter, the immunity of the Section would be available.
The current version of Article 3 continues to limit the conversion liability of eligible representatives to proceeds,
though it modifies the term by referring to proceeds not paid out rather than those remaining in his hands.
There is no indication that this was intended to choose among the competing definitions of proceeds, and one
would expect courts seeking to permit recoveries to adhere to the broader definitions of that term.

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