By way of
review, some of the most critical, if not the
most critical provisions of Article 3, are those which address the question of
whether a particular writing is negotiable. If the answer to that question is
‘no’, the transaction, except in extremely rare circumstances, will not be
governed by Article 3. If the writing
complies with Section 3-104, and subsequent related sections, it is a
negotiable instrument. At this point,
the writing becomes ‘magical’ in the sense that a transferee of that paper may
obtain superior rights than his or her transferor had. This is a result of the holder in due course status
that is conferred on a party who takes the instrument under the circumstances
stated in Section 3-302.
Before
looking at Section 3-302, I thought it would be useful to create a loose
historical context in which to view and understand the concept of
negotiability, and why it was, and is, so very important. It was my experience as a law student and as
a law professor, that by understanding something about the evolution and
importance of negotiable instruments, one has a much better grasp of the concept
and its continued importance today.
To understand
this history, one has to detach from 2015—a large city America where there are
nearly 7,000 banks represented by nearly 94,000 branch offices. Imagine instead, going back two hundred years
to a time when a town with 20,000 residents was a’ big city’. By way of illustration, the population of
Chicago in 1800 was 4,470; New York City had a population of 60,000.
The banking system as we know it
today did not exist. In order for
commerce to grow, payment systems needed to be created which would facilitate
payments and create credit. Enter the
negotiable instrument, already in wide use in England. Historically, the backbone of the American
economy has been created and sustained by the manufacture, sale and
distribution of goods and the various types of commercial paper generated as a
result of those processes. The following
example is illustrative of how things may have worked two hundred years ago.
Bob Blacksmith
from Wheaton needs to buy 1,000 horseshoes to get him through the winter/spring
season of 1832-1833. William Welder has
a horseshoe production facility in Chicago.
Bob wants to buy the 1,000 shoes from William, but Bob does not have the
cash to cover it until the end of the first quarter of 1832. William asks Bob if would be acceptable to
give Bob a ‘draft’, a type of negotiable instrument, payable at the end of the
first quarter, for $1221.94, the full amount owed for the shoes. Bob does not
want to wait until the end of the first quarter to get paid, so he agrees to
accept the draft with the idea of selling it to his bank or some investor. Due to the imminent sale and inevitable
discount on the note, William raised the amount owed to $1250.00 so that he
would be able to realize his full profit on the shoes.
Before further discussing the specifics of the
transaction, let’s take a quick look at Section 3-104 to review the elements
required to make a writing a negotiable instrument:
… "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….
There are a number of options to choose from when creating a
negotiable instrument. In the Outlet
deal a promissory note was used. In the
facts above, the approval of a ‘draft’ is being requested. Section 3-104(e) tells us that an instrument is a
note if it is a ‘promise’ and a ‘draft’ if it is an order. The promise and order being referred to is a
promise or order to pay. The proposed
draft might read as follows:
Pay to the order of William
Welder, on April 1, 1832
One
thousand two hundred and fifty dollars…….$1250.00
Drawn
on: Bob Blacksmith, Inc; Wheaton Illinois
As
you can see, the writing reads very much like a check, with one major
exception, the drawee, the entity upon whom the draft is drawn. In a check situation, the drawee is the bank.
In a non check situation such as the one described above, the drawee would most
likely be the business or individual who was asking for credit, in our case Bob
Blacksmith. With banking services
extremely limited, a commercial draft had unique importance.
It
is clear from the terms above, that the writing is a negotiable
instrument. The writing contains an
obligation to pay a fixed amount, is payable to order and at a definite time
with no other undertaking or obligation.
The reason this is so critical is that in order for William to sell the
note to a bank or other investor, the purchaser will insist that the note be in
negotiable form. If the instrument is
negotiable in form, the purchaser of the instrument knows that if the draft is
purchased under certain commercial circumstances [stated in Section 3-302] personal defenses on the instrument that the
obligor [here, Bob Blacksmith as drawer] has incurred will be cut off. For example, assume that the horseshoes were
defective. Against a presentment to Bob
for payment by William, Bob could assert a defense on the draft of failure of
consideration. If however, the bank or
investor purchased the note under the circumstances set forth in Section 3-302,
the personal defense of failure of consideration would be cut off.
This
result would not be possible if the writing were not negotiable in form. This is critical when you think about the
importance of William’s being able to sell the draft to generate capital for
his business. Someone purchasing the
paper must be certain that there is no concern about the underlying transaction
which gave rise to the paper. The bank or
purchaser is interested in three things: the form of the note, the credit of
William; and finally, the credit of Bob.
William,
who will indorse the draft to the bank, will be liable on his contract of
indorsement if Bob fails to pay when the draft is presented to him. The
investor or the bank is likely to do some type of search on Bob—limited as that
might be—but it will primarily be looking to William for the ultimate assurance
that it will be paid. The bank knows William
and he is local. However, unless the writing is ‘negotiable’ in form, the bank
or investor will not be interested in the deal, due to the exposure on the
underlying contract. The profit of the
latter two depends on how much ‘discount’ they get when purchasing the
note.
In
order to better understand the significance of the concept of negotiability,
bear in mind that as America grew, more and more financing was done via
documentary drafts [which will be discussed in a future post] and promissory
notes. The volume of this type of
commercial paper is massive in today’s economy, and is generated at virtually
every level of the manufacture, distribution and sale of goods. The rules of Article 3 are designed to
facilitate the movement of this paper in commerce. There was no electronic search to flush out relevant data
about whom you were dealing with. Parties were concerned with their immediate
transferees, the form of the note and the credit worthiness of the obligor. If
the note was in proper form, they were confident in their transferee, and the
price was right, they did the deal.
The
volume of promissory notes in America today is in the hundreds of billions of
dollars. As America grew from a
population of slightly over 5,300,000 in 1800 to over 320,000,000 today, the
volume of commercial paper increased exponentially. It must be remembered that this paper is more
than someone’s debt; it has served, and continues to serve, as a core component
of American finance and commerce.
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