Negotiable Instruments: An Introduction

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).

Putting the Framework in Place

We began our journey into the Uniform Commercial Code on March 4, 2015.  The initial goal was to establish a methodology for approaching Uniform Commercial Code transactions.  Part of this process required an understanding of the basic reasons the UCC was drafted, and the policies in the Code which are designed to guide the interpretation and application of the Code. We know that the overriding purpose of the Code was to facilitate commercial transactions, and hence there are core policies in the Code which are designed to achieve that overall purpose.

            The Uniform Commercial Code is not stagnant.  Modernization of commercial transactions is a fundamental purpose and policy of the Uniform Commercial Code. We know that the Code pays great deference to freedom of contract, particularly between merchants. The Code also gives great weight to the customs and practices of any given industry to which the Code applies.  These too are affirmatively stated at the outset in specific language in Section 1-103.  Uniformity of law was a critical goal of the drafting of the UCC and this is recognized as well. The drafters of the Code direct users of the Code to ‘liberally construe and apply the Code to achieve its underlying purposes and policies.’ All of this should be part of the mental framework in place when approaching UCC transactions. 

In drafting contracts involving multistate transactions it was noted that there are differences among the states on a meaningful number of provisions.  The wise draftsperson will always check the law of both states to insure his or her client’s best interests.  Section 1-301 allows the parties to a UCC transaction to choose the law of any state as long as the transaction bears a reasonable relation to the state chosen. In litigation, the uniformity provision has been consistently held to stand for the proposition that cases decided under the UCC in one jurisdiction have relevance in others as well.

            As a draftsperson, the responsibility is to analyze the transaction from start to finish. Activate all Code sections in play. This will provide you with drafting insights which will enable you to draft in the best interests of your client.   As you recall, language is one of several elements to the agreement between the parties.  In fact, there are five elements to the legal definition of ‘agreement’ under the Uniform Commercial Code: language; inferences from other circumstances including course of performance; course of dealing; usage of trade.  Remember, these are illustrative of ‘other circumstances’ not exclusive. The most important in the hierarchy is the written language of the parties.  Under Article 9 you would almost always have a written, executed security agreement due to the nature of Article 9.  Under Article 2 you may simply have a purchase order, an email or just a phone call with some miscellaneous documents and emails.  The latter situation is where you see 2-207 cases.

            One thing to always keep an eye on is the trade involved.  As stated in an earlier post, there are over 83,000 professional and trade associations.  Most of these associations have rules and standards which pertain to their industry.  The meaning given to words in the industry is very important under the Uniform Commercial Code:  The comments to section 2-202 are emphatic on this point:
             
                                     This section definitely rejects: 

                

(b) The premise that the language used has the meaning attributable to such language by rules of construction existing in law rather than the meaning which arises out of the commercial context in which they were used.

Trade usages and any written rules governing a trade should be accessed whenever possible.  It only takes a few minutes and periodicals and articles are extremely helpful. Industry rules supplement and explain the meaning of words used as they relate to their industry.  The differences among the industries are vast. It was noted that the elements of course of performance may not be present, and there may not be a course of dealing, but there will almost always be a trade with attendant customs. 

            So at this point in any preliminary analysis, you almost certainly have language and trade usage, and perhaps conduct which indicates that a contract exists.  Whether or not a contract does in fact exist will be determined by the totality of the agreement; the impact of the Uniform Commercial Code on that agreement; and any applicable supplemental rules of law as stated in the UCC definition of contract in Section 1-201(b)(12).

            For purposes of Sales the starting point is going to be whether or not the agreement is enforceable.  The major hurdle here is the statute of frauds, which requires contracts in the amount of $500 or more to be in writing and signed by the party against whom enforcement is sought.  Contracts exist throughout the Uniform Commercial Code and all have their attendant formalities, legal rights and responsibilities. In each situation, once you get past enforceability issues, the general contract analysis applies with full force to all of these contracts.  

            At this point, ‘Say Hello to My Little Friend; Section 1-103(b).  This provision stands for the proposition that all laws not specifically displaced by the Uniform Commercial Code shall supplement its provisions.  This section is one of the most powerful in the Uniform Commercial Code and opens up a universe of possibilities, particularly in litigation. Does the result being advocated by the other side violate laws of equity?  Is there an estoppel of some kind that your client can use?  Was there fraud or misrepresentation involved? Is there anything under the general law of contracts that might be useful? What about agency?  The list goes on, but only those with trained eyes and a thorough understanding of the facts will see the possibilities.

            Regardless of what might apply under Section 1-103, ‘every contract or duty within the Uniform Commercial Code imposes an obligation of good faith in its performance or enforcement’  Section 1-304.  In most cases, this means ‘honesty in fact and the observance of reasonable commercial standards of fair dealing in the trade’ Section 1-201(b)(20).  According to the comments, there is no independent cause of action for the failure to act in good faith.  Most courts agree.  However, some courts have determined that the failure to act in good faith as required by Section 1-304 can give rise to punitive damages.   Properly pleading such a cause of action, and getting it past the motion stage, will change the dynamics of almost any litigation.

            With this solid basic background in place, we begin our foray into other articles of the Code. As this is the first time I have employed this type of teaching model [linear explanations], I can’t be certain of the direction other than to say it will start with Article 3.  Most readers are familiar with Articles 2 or 9, and Article 3 fits nicely with both as a payment mechanism and an integral part of most Article 9 transactions.  It is my expectation that I will move around the Code to try to deliver the best overview possible by the end of February 2016. 

            In addition to discussing the Uniform Commercial Code, there will be some discussion of certain brain and learning theories that I have developed over the course of the past 47 plus years which are integral to my teaching of the UCC and learning in general.  The level and volume which is ultimately presented will depend on the response the posts.  

For more information on the author and book, please visit ucc-madeeasy.com. 

Going Forward

As of this point, there have been nineteen posts to the UCC Made Easy blog.  The process has been a great learning experience for me as it has required me to fashion a new way to communicate UCC content.  The problem with the manner in which the material is being delivered is the linear plane on which it must, of necessity, be presented. This is not true of the short story format used in the book which delivers content in a multidimensional manner. By way of illustration, total word count for the nineteen blog posts is about 15,000.  The total word count for the book, counting several long indexes is 135,000.  At the current pace it would take millions of words and decades to deliver the same amount of content.

            Up to this point, a solid basic foundation for approaching all UCC transactions is in place. Following these simple steps consistently will, over time, create literal tracks in your brain that will be activated every time you have a Uniform Commercial Code related problem.  If you have this format in place, you will have a good idea of where to go to find your answer and how to support it.

            The next step in this process will be a review of where we are up to this point in time, and the direction coming.  That is a good process for me and will be a good one for those following along.  That post will be on Thursday.  There will be one upcoming change and that is in frequency of the posts as I must go from two to one post per week.

            The time which will not be utilized for the second post will be utilized to write other things. For example, the problems in the inner cities are something of great concern to me.  I have worked at the front line with many of those currently rising up in the inner cities.  There are solutions to those problems and I feel a responsibility to speak out about them.  When I worked at Los Angeles County Central Juvenile Hall, the kids used to speak about what was coming.  I told them I had been around for the riots in Detroit and in Los Angeles when Rodney King happened.  Their response was…’Rob, no more riots. Next time it will be a revolution’. So, what I see now does not surprise me.  I simply need to do something about it.

            With that stated, I look forward to putting together a comprehensive review on where we are in our Uniform Commercial Code journey for the next post.  The will also serve as a solid foundation for going forward as I envision forays into the various articles of the Code with the constant connection to Article 1.

For more information on the author and book, please visit ucc-madeeasy.com.

Free The Mikey By Michael McCurtis

Good Faith On Demand?

          As discussed in an earlier post, one of the cornerstone principles of the Uniform Commercial Code is ‘good faith’:

Every contract or duty within the Uniform Commercial Code imposes an obligation of good faith in its performance and enforcement. [Emphasis added] Section 1-304

In the majority of jurisdictions this requires ‘honesty in fact and the observance of reasonable commercial standards of fair dealing’ to everyone involved in commercial transactions under the UCC per section 1-201(b)(20).  In addition, for those jurisdictions that have not enacted the amended version of Section 1-203, the expanded definition is contained in the various Articles, for example Section 2-103(1)(b) for merchants under Article 2 and Section 3-103 for transactions under Article 3.

            The question examined in this post is whether or not the obligation of good faith exists in the calling of a demand note.  For those of you unfamiliar with negotiable instruments, a demand note, as implied in its name, means that it is payable upon the demand of the holder of the note:

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)

 

Does this mean that the holder can demand payment for any reason or no reason? That is the position taken by most cases that have examined the issue, as well as the comments to Section 1-309, dealing with acceleration of payment under a note.

            I certainly understand the need to protect lenders who have extended funds under a demand note.  Their reasonable expectation as a matter of contract law is that they will be entitled to demand payment whenever they decide to do so.  On the other hand, honesty in fact and the observance of reasonable standards of fair dealing are of paramount importance under the UCC.  Do we really want a rule under which arbitrary and sometimes retaliatory behavior is condoned? 

Consider the following: Let us assume that John has signed a promissory note payable to the order of the Bank in the amount of $140,000.00 calling for payments of $3,500/ month for five years.  The loan officer was Alfred, who had known John for many years. The loan was given to enable John to open a new restaurant. John has made timely payments for three years, and recently purchased expensive new equipment for the restaurant which has been reasonably profitable.

            On the first month of year four, Alfred decides to demand full payment immediately.  The reason Alfred decided to demand full payment is because he did not like the way that John acted toward him at a recent fundraiser.  Alfred felt that John should have shown him more respect.  He thought ‘I’ll show him’ and demanded full payment of the note.  Obviously, Alfred’s action is not within the standard of the ‘observance of reasonable commercial standards of fair dealing in the trade’.  Quite the contrary.  Therefore, Albert has violated the good faith requirement of Section 1-304 or Section 3-103.  If it applies.

            The language of Section 1-304 makes it clear that Albert’s demand on the note should be subject to the obligation of good faith. After all, that section states that the obligation of ‘good faith’ applies to ‘[e]very contract or duty within the Uniform Commercial Code’. Most courts have held that there is no good faith requirement imposed on a holder of a demand note in making a demand for payment. At the very best, this leaves us with a clear conflict between the overriding obligation to act in good faith contained in Section 1-304 and the seeming ability of a holder of a demand note to operate outside of this requirement.

            The first indication of the Code’s position on this can be found in the comments to Section 1-309 which deals with acceleration clauses.  The comments address the ‘good faith’ requirement that is attendant with an option to accelerate at will in comparison to a demand instrument stating:

Obviously, this section has no application to demand instruments or obligations whose very nature permits call at any time with or without reason.

In following this basic policy, courts have, with rare exception, found no obligation of good faith in the calling of a demand note.  The rationale generally given is that the imposition of good faith in the calling of a demand instrument would add new terms to the contract between the lender and the borrower:

‘The imposition of a good faith defense to the call for payment of a demand note transcends the performance or enforcement of a contract and in fact adds a term to the agreement which the parties had not included….The parties by the demand note did not agree that payment would be made only when demand was made in good faith but agreed that payment would be made whenever demand was made.’  Solar Motors, Inc. v. First National Bank of Chadron, 249 Neb 758, 545 N.W.2d 714 (1996).

Is this a good result?  Should a holder of a demand note be exempt from the duty to act in good faith in so doing?  Should Alfred by able to demand payment from Fred because he did not like something Fred did to him personally?

            At least one court has found that there is a duty to act in good faith in the calling of a demand note. K.M.C. Co., Inc., v. Irving Trust Company, 757 Fed.2d 752 (6^th Cir.1985).  In K.M.C., a financing arrangement existed between Irving and K.M.C. which, among other things, contained a provision which allowed for K.M.C. to draw up to $3.5 million, as well as an ongoing note with a demand clause. On March 1, 1982, Irving refused to advance $800,000 requested by K.M.C.  The verdict below was for K.M.C. and Irving appealed.  In affirming the ruling below, the court addressed the issues pertaining to good faith.

            First, the court found that a duty of good faith existed with Irving in the termination of the line of credit.  Given the reality that the refusing further funding was tantamount to a decision to put it out of business, the court determined that the duty of good faith required notice prior to the refusal so that K.M.C. would be able to seek alternative financing. The court also noted that there was adequate inventory at all times to cover the outstanding balance on the note.

The court also addressed appellants’ contention on the demand provision contained in the note:

We agree with the Magistrate that just as Irving’s discretion whether or not to advance funds is limited by an obligation of good faith performance, so too would be its power to demand repayment.  The demand provision is a kind of acceleration clause, upon which the Uniform Commercial Code and the courts have imposed limitations of reasonableness and fairness.  K.M.C. Co., at 760

Again, this is the minority position, and is not consistent with the language contained in the comments to Section 1-309.

            I certainly understand the strong policy arguments which support the right of a holder of a demand note to enforce accordingly.  However, I would not hesitate to argue for a good faith requirement in a demand note regardless of the comment in Section 1-309 and the cases which hold otherwise.  First, the comments are not law.  Second, Section 1-304 requires good faith in all contracts and duties under the Code.  Third, Section 1-302 states that the parties to an agreement cannot disclaim the obligation of good faith showing how important the concept is under the UCC.

            Suggestion: If you represent a client on whom a demand has been made, with no commercial grounds for making the demand, I would suggest going back to Section 1-103(b) and finding a supplemental principal of law which will create a favorable result. For example, a bad faith demand on a note may be acceptable under Article 3, but the result itself might be inequitable.  Equity is a supplemental principle of law which applies and as we saw in In re Invenux, the provisions of Article 1 can be used to override certain substantive provisions of other Articles.

For more information on the author and book, please visit ucc-madeeasy.com.