The Uniform Commercial
Code is comprised of two main categories: Transactions in Goods, and Payment
Systems. Payment Systems involve:
Negotiable Instruments under Article 3; Bank Deposits and Collections under Article
4; Electronic Funds Transfers under Article 4A, and Letters of Credit under
Article 5. It is important to remember
that even though an underlying transaction may not be governed by the Code, the
payment systems of the UCC will still apply.
For example, if the underlying transaction is a services contract, and
therefore outside the scope of the Code, if payment for the services was made
by a check, the payment portion would be governed by Article 3 since a check is
a negotiable instrument.
The
importance of negotiable instruments lies in their transferability. If a
writing is a negotiable instrument, and it is transferred under certain
commercial circumstances, the transferee may have superior rights on the
instrument than the transferor had. By way
of illustration:
George sells his
clothing business to Stephen and Alan. An $800,000.00 note is executed by
Stephen and Alan to the order of George, calling for monthly payments of $4,400
for twenty years. The note has the following clause:
It is further
understood that the seller has warranted to the buyers that the schedule of
debts attached hereto is a full and complete disclosure of all outstanding
liabilities, exclusive of taxes owed to the State of Florida.
George sells the
note to First National Bank. After taking over the business, Stephen and Alan
discover major discrepancies between the schedule of debts listed and the
actual debts owed and refuse to make further payments on the note to the bank
claiming the discrepancies between the schedule on the note and the reality of
the debts owed.
If the bank
purchased the note under certain commercial circumstances [resulting in the
legal status of a ‘holder in due course’], it will not be subject to the
defenses to payment being asserted by Stephen and Alan. If however, the writing
was not negotiable in form, the bank would be subject to those defenses
regardless of the commercial circumstances under which it was purchased. The
law producing this result will be discussed in subsequent posts. The main point for now is that the form of
the note—whether it is negotiable or not—is the critical question. If negotiable—superior rights can be
transferred if the instrument is purchased under certain commercial circumstances. If the note is not negotiable, these superior
rights cannot be transferred.
The elements of
a negotiable instrument are contained in Section 3-104:
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.
Section 3-104(a)(1)(2)(3)
Below, I have reproduced an excerpt from The Uniform Commercial Code Made Easy in
which Stephen Seller, the main character in the book, and his attorney Alan
Lawyer, discuss the concept of negotiability.
I have permission from the author to use this material.
Excerpt
from: The Uniform Commercial Code Made
Easy
“And you said that
this whole question is simply a matter of form, right?” asked Stephen.
“Yes,” said Alan.
“Here, let me show you. You start out with Section 3-104(a). As you can see, in order to be a
negotiable instrument, all of the conditions in subsection
(a), (1), (2) and (3) must be met.
The first condition
under Section 3-104(a), that the writing must contain an unconditional
promise or order to pay a fixed
amount of money. The ‘unconditional promise’ is not
made conditional by the fact that the note mentions the underlying sales
agreement, for as noted under Section 3-106, a promise or order is not made
conditional by the fact that it refers to another writing.[1] Nor is the writing
made non-negotiable by the fact that the note refers to the Security Agreement
and various rights contained therein with respect to the collateral. Section
3-106[2] Notice, though, if the agreement stated that it was subject
to the terms of the sales agreement, it would not be negotiable under
Section 3-106(a)(ii).”[3]
Stephen nodded, waiting for Alan to
continue.
Alan then turned
the page back to Section 3-104(a) and said, “As we’ve already discussed, this
unconditional order or promise must be to pay a certain amount of money. I know
what you are thinking,” said Alan. “The fact that there is a possibility of
other charges such as court costs and attorney’s fees being awarded obviously
would make the sum uncertain inasmuch as you will never know exactly what
attorney’s fees or court costs would be in a given matter. However, as you can
see,” Alan continued, “under Section 3-104(a), this poses no problem.”[4]
“Next the instrument must be payable
on demand or at a definite time.”
Section 3-104(a)(2). “This is not a demand instrument
inasmuch as it is not payable ‘on demand
[of the holder] or at sight’ or
otherwise within Section 3-108(a);[5] rather it is payable at a definite time.[6]
That is, it is payable in full on
April 1, 2026. The fact that it is subject to acceleration does not affect this.[7]
“Does this simply mean that if he wants to
he can force us to pay ahead of time?”
“No,” said Alan. “First
of all, Section 1-309 requires that the accelerating party must in good faith[8] believe ‘that the prospect of payment or performance is impaired’. That is,
George must act ‘honestly in fact’ and with the ‘observance of reasonable
commercial standards’ in accelerating.[9] In this case, we negotiated out what
insecurity would be.[10] If we miss two monthly payments and the
profitability schedule has been met during those two months, George has the
right to accelerate. Other than that, the terms of the
agreement still bar him from doing so.”
Stephen nodded.
“Finally,”
continued Alan, “in order to be negotiable, the instrument must be payable
to order or to bearer. As you can see, the note is payable
to the order of George, and is therefore order paper within Section 3-109.”[11]
The
next several posts will focus on Article 3.
Before closing however, I wanted to point out that the although the
volume of checks continues to decline as the use of electronic payment systems
continues to rise, the volume of checks is still significant. In 2012, the last year data was available,
18.3 billion checks were written at a value of 26 trillion dollars.
For more information on the author and book, please visit ucc-madeeasy.com.
[1] ... A reference to another writing does not of itself
make the promise or order conditional. Section 3-106(a).
[2] A promise or order is not made conditional
(i) by a reference to another writing for a statement of rights with respect to
collateral, prepayment, or acceleration. Section 3-106(b).
[3] Except as provided in this section, for the
purposes of Section 3-104(a), a
promise or order is unconditional unless
it states:... (ii) that the promise or order is subject to or governed by writing... Section 3-106(a)(ii). [Emphasis added].
Anyone purchasing paper which states that it is “subject to”
another writing, is on notice that the piece of commercial paper involved is in
effect, subrogated to the terms of the other writing. The promise on the
commercial paper, in that situation, is clearly conditional on the terms and
conditions in the other writing.
[4] It may
seem that these allowances of provisions and references to other agreements,
attorneys fees and the like would make it impossible to ever have a sum certain
or unconditional promise. However, the realities of commercial practice balance
the precise language of the statute and those realities. These references and
various contingencies are to be distinguished from a situation where the note
was ‘subject to’ another agreement as discussed above.
[5] A promise or order is “payable on demand” if it (i) states that it is payable on
demand or at sight, or otherwise indicates that it is payable at the will of
the holder, or (ii) does not state any time of payment. Section 3-108(a).
[6] A promise or order is “payable at a definite
time” if it is payable on elapse of
a definite time period after sight or acceptance or at a fixed date or dates…. Section
3-108(b).
[7] [An instrument can be “payable at a definite
time’ even if] subject to rights of (i) prepayment, (ii) acceleration, (iii)
extension at the option of the holder, or (iv) extension of a further definite
time at the option of the maker or acceptor or automatically upon or after a
specified act or event. Section 3-108(b).
[8] A term providing that one party or his
successor in interest may accelerate payment or performance or require
collateral or additional collateral “at will” or “when he deems himself
insecure’ or in words of similar import shall be construed to mean that he
shall have the power to do so only if he in good faith believes that the
prospect of payment or performance is impaired.... Section 1-309.
[9] “Good faith” means honesty in fact and the
observance of reasonable commercial standards of fair dealing. Section
3-103(a)(4).
[10] By so
doing, the parties removed the definitional aspect of insecurity from the trier
of fact. Section 1-302(b) permits the parties to set standards as to
what constitutes good faith in their agreement as long as such standards are
not manifestly unreasonable. Section 1-302(b) is discussed later in this book.
[11] A promise or order this is not payable to
bearer [Section 3-109(a)] is payable to order if it is payable (i) to the order of an
identified person or (ii) to an identified person or order. A promise or order
that is payable to order is payable to the identified person. Section
3-109(b).
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