Negotiable Instruments and Secondary Obligors

Among the most significant changes in the 2002 amendments to Article 3 are those found in Section 3-605 which deals with Discharge of Secondary Obligors.  As noted in the comments to Section 3-605, these changes have particular significance to loan workouts, many of which involve secondary obligors, which are defined as follows:

"Secondary obligor," with respect to an instrument, means (a) an indorser or an accommodation party, (b) a drawer having the obligation described in Section 3-414(d), or (c) any other party to the instrument that has recourse against another party to the instrument pursuant to Section 3-116(b).  Section 3-103(a)(17)

As discussed in the last post, an accommodation party ‘signs the instrument for the purpose of incurring liability on the instrument without being a direct beneficiary of the value given for the instrument’ per Section 3-419(a). Secondary obligors are often required by lenders as back up security in the event that the primary obligor defaults. Section 3-605 addresses the impact on the secondary obligor when changes are made in the contract between the primary obligor and a person entitled to enforce the instrument.

There are four situations contemplated by Section 3-605:

    

1. Release of principal obligor by the person entitled to enforce—Section 3-605(a);

2.    Extension of time of payment for principal obligor by person entitled to enforce—Section 3-605(b);

3.    Modification of obligation of principal obligor by person entitled to

enforce—Section 3-605(c);

4.    Impairment of collateral by the person entitled to enforce—Section 3-

605(d);

Given the unique importance in workouts, the statutory content of Section 3-605 will be analyzed in detail.  This post will discuss Sections 3-605(a)(b); the next post Section 3-605(c)(d).

            Before discussing Section 3-605, it is important to remember two very important facts.  First, the rules contained in that section apply only with respect to an instrument.  Typically, there will be a separate contract of guaranty.  The law of suretyship and guaranty can be brought into any UCC transaction by Section 1-103, and to the extent such law has not been displaced by specific provisions of the Code, it will supplement Code law.

            Second, as stated in comment 4 to Section 3-605: 

[S]ubsection (a) will not apply to any transaction that includes a provision waiving suretyship defenses (a provision that is almost universally included in commercial loan documentation) or to any transaction in which the creditor obtains the consent of the secondary obligor at the time of the release.

With that background in place, attention can be focused on the text of Section 3-605.

1.    Release of principal obligor by the person entitled to enforce—Section 3-605(a);

            Section 3-605(a) states as follows:

(a) If a person entitled to enforce an instrument releases the obligation of a principal obligor in whole or in part, and another party to the instrument is a secondary obligor with respect to the obligation of that principal obligor, the following rules apply:

(1) Any obligations of the principal obligor to the secondary obligor with respect to any previous payment by the secondary obligor are not affected. Unless the terms of the release preserve the secondary obligor's recourse, the principal obligor is discharged, to the extent of the release, from any other duties to the secondary obligor under this article.

            Application:

SP loans   D $10,000;

                                G signs as an accommodation maker on the note;

            Release entered into between SP & D;

                                    D still owes G for all payments made by G;

  If release does not preserve G’s rights against D, the latter—to the       extent of the release—owes no further duties to G.

As seen in the text, Section 3-605(a) is activated when an instrument has a primary and secondary obligor and the primary obligor receives a complete or partial release (or extension) by a person entitled to enforce.  While the release may impact on the obligation of the primary obligor to the secondary obligor for future payments, nothing in the release relieves the primary obligor for payments which the secondary obligor has already made.  Further, unless the terms of the release ‘preserve the secondary obligor’s recourse’ the principal obligor will be discharged from any further obligations to the secondary obligor.  

Section 3-605(g)(1)(2). states when the release ‘preserve[s] the secondary obligor’s recourse’:

 A release or extension preserves a secondary obligor's recourse if the terms of the release or extension provide that

(1)   the person entitled to enforce the instrument retains the right to enforce the instrument against the secondary obligor; and

(2)   the recourse of the secondary obligor continues as though the release or extension had not been granted.       Section 3-605(g)

In the example above, this would mean that:

·      SP has given D a release on some or all of the debt;

·      The release retains the right to enforce the note against G;

·      The release provides that G maintains full recourse against D.

Section 3-605(a)(2) continues:

(2) Unless the terms of the release provide that the person entitled to enforce the instrument retains the right to enforce the instrument against the secondary obligor, the secondary obligor is discharged to the same extent as the principal obligor from any unperformed portion of its obligation on the instrument. If the instrument is a check and the obligation of the secondary obligor is based on an indorsement of the check, the secondary obligor is discharged without regard to the language or circumstances of the discharge or other release. 

 Again, we see a very straightforward rule in the first sentence.  If the person entitled to enforce the instrument does not specifically reserve the right to enforce against the secondary obligor in the release, the secondary obligor will also be discharged.  As noted in the second sentence, there is a special rule when the secondary obligation is based on an indorsement of a check. In that situation, the indorser will be released automatically upon release of the primary obligor without regard to any language in the release.

            The final rule dealing with a full or partial release of a primary obligor is stated in Section 3-605(a)(3):

 

(3) If the secondary obligor is not discharged under paragraph (2), the secondary obligor is discharged to the extent of the value of the consideration for the release, and to the extent that the release would otherwise cause the secondary obligor a loss.

Therefore, to the extent that the primary obligor gave consideration for the release to the person entitled to enforce, the secondary obligor is discharged ‘to the extent of the value of the consideration’ given.  Further, the secondary obligor is discharged to the extent the release ‘would otherwise cause the secondary obligor a loss.’

1.    Extension of time of payment for principal obligor by person entitled to enforce—Section 3-605(b)

.     (b) If a person entitled to enforce an instrument grants a principal obligor an extension of the time at which one or more payments are due on the instrument and another party to the instrument is a secondary obligor with respect to the obligation of that principal obligor, the following rules apply:

(1)  Any obligations of the principal obligor to the secondary obligor with respect to any previous payment by the secondary obligor are not affected. Unless the terms of the extension preserve the secondary obligor's recourse, the extension correspondingly extends the time for performance of any other duties owed to the secondary obligor by the principal obligor under this article.

As with a release, an extension of time to the primary obligor by a person entitled to enforce does not impact the obligation of the primary obligor to the secondary obligor for any payments previously made. Unless the primary obligor ‘preserved the secondary obligor’s recourse’, the extension will also apply to duties owed to the secondary obligor by the primary obligor.

            If the extension to the primary obligor results in a loss to the secondary obligor, a discharge to the extent of the loss will occur:

(1)  The secondary obligor is discharged to the extent that the extension would otherwise cause the secondary obligor a loss.

Finally, Section 3-605(b)(3) states:

(3) To the extent that the secondary obligor is not discharged under paragraph (2), the secondary obligor may perform its obligations to a person entitled to enforce the instrument as if the time for payment had not been extended or, unless the terms of the extension provide that the person entitled to enforce the instrument retains the right to enforce the instrument against the secondary obligor as if the time for payment had not been extended, treat the time for performance of its obligations as having been extended correspondingly.

This provision gives the secondary obligor the option to disregard the extension and pay according to the original instrument or treat its obligations as having been extended as well unless the person entitled to enforce retains the right to enforce the instrument against the secondary obligor as if the extension had not been granted.

            Section 3-605 is a revision and renumbering of former Section 3-606.  I call this to your attention in connection with the post which included information on the current law in the State of New York for Article 3.  Remember, New York has not enacted the amendments to Article 3; hence, Section 3-606 exists in its original form.  The difference between current Section 3-605 and Section 3-606 of the New York UCC are significant.  If you are planning on executing notes with a New York party, or are in New York contracting with someone from another state, you might consider utilizing the choice of law provisions of Section 1-305 which was discussed in an earlier post.