Commercial Paper 2010 Holmes

Negotiable instruments, commercial paper
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    December 1969
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Commercial Paper, Bank Deposits, and Collections I. Introduction a. Essence of the course i. About making payments for goods, services, etc. 1. The way payments are made 2. This used to be primarily negotiable instruments law ii. Negotiable Instruments Law b. History i. 1896 America borrowed from English statute ii. The only statutory law involved negotiable instruments 1. NIL – negotiable instruments law. This is old terminology 2. Every state had adopted this old statute iii. Mid-twentieth century 1. Development of the UCC by this time a. Article 3 replaced old NIL b. 1952 Articles 3 and 4 were promulgated c. Article 4 – collection and deposit of checks d. By end of 1960s, all the states had adopted Original Articles 3 and 4, except for Louisiana, which waited until 1973 to adopt them i. The Louisiana version changed a lot of the UCC official text ii. So remember two things about La. law: 1. Any case prior to 1974 is based on NIL, not the UCC 2. After 1974, our statutory law was significantly different from other states iv. 1990 Revision 1. ALI and National Commissioners did completely new version of Articles 3 and 4 – “The Revision” 2. Louisiana was one of the first states to adopt The Revision! a. Louisiana did not tinker with the UCC articles of 1990 nearly as much as originally b. There are minor differences c. No blockbuster cases since the Revision v. 2002 Amendments to Articles 3 and 4 1. Done by ALI and National Commissioners. Not a complete revision. 2. Most states have not adopted these amendments a. Louisiana has not b. Our statute book includes these amendments in the “official text” of the UCC without explaining that most states have not adopted the new amendments II. vi. Revised Version of Article 1 1. By ALI/Commissioners 2. Article 1 – general provisions applicable to the UCC generally a. Definitions, etc. 3. Half the states had adopted Revised Article 1, including Louisiana a. New version as adopted in Louisiana in 2006 is in “the handout.” Old version is in the class supplement. The revised UCC version is in the green statute book. b. Louisiana’s major change was changing the definition of “good faith” in Revised Article 1. c. *Our day to day document is primarily “the supplement” because the Article 1 references in most of the cases are to the old Article 1 vii. Article 4A adopted by all the states addresses wire transfers viii. Federal Law 1. Expedited Funds Availability Act in 1987 c. Recommended Treatises i. White and Summers UCC ii. Miller and Harrell, Modern Payment Systems 1. Payment law d. Exam i. Modified open book 1. Can bring the supplement, the statutory book, and the handout on Article 1 2. Free to write notes in these materials ii. Format – same as prior years 1. Short answer Part I 2. Essay Part II Negotiability and Holders in Due Course a. Generally i. “The big idea” – the assignability of debt 1. The ability to transfer a debt owed to you to a different person, for present value 2. The idea that debts are not personal, but are a form of property that can be bought and sold like other property a. At early common law if you didn’t pay your debt, you went to jail. Debts were personal. b. Later on, at common law, debts became a type of property i. This led to a huge wealth-producing concept in western civilization. Created the groundwork for the modern credit economy. ii. Assuring the fluidity of passing negotiable instruments became a key concern historically iii. After the 18th century, the commercial world became vastly different iv. Framework 1. A owes a debt to B. B assigns the debt to C. 2. This creates 3 relationships a. A-B. The debt. b. B-C. Assignment of debt. c. A-C. Obligor’s relationship to the new obligee. 3. Even where A’s debt is evidenced by a negotiable instrument, as far as A and B are concerned, we are really only concerned with contract law. 4. However, where the debt is evidenced by a negotiable instrument, NIL defines B-C and A-C’s relationships. 5. Issues: a. What is necessary for the transfer from B to C to be effective? b. What rights does C acquire against A, and in particular, what effect does the original A-B contract have on C’s rights? i. NIL differs from contract law here ii. Contract law rule is that the assignee, C, only steps into the shoes of B, the assignor. But NIL says that C as holder in due course may have vastly superior rights against A, more than B would have had against A. v. Terminology 1. All negotiable instruments are either one of two types: promises and orders. Both are to pay money. a. A promise to pay money is a note, or promissory note. b. An order to pay money is a draft, the most common of which is a check. 2. A promissory note a. A two party instrument i. A maker ii. A payee iii. There may also be one or more indorsers, a holder, and/or a person entitled to enforce (PETE) 3. A draft (check) a. A three party instrument i. A drawer 1. Person making the order to pay ii. A drawee 1. Person to whom the order to pay is directed iii. A payee 1. The person to whom payment is to be made by the drawee iv. There may be one or more indorsers, a holder, and/or a PETE vi. History 1. The rules of NIL were originally meant to create a free market. But these rules don’t make as much sense in the 21st Century. 2. Still, the basic rules of NIL have been retained. b. Merger Doctrine i. Defined 1. When a negotiable instrument is given in payment for an underlying debt, the debt is merged into the instrument. The underlying debt and the instrument are no longer separate. 2. 5 key terms a. Issue, UCC 3-105 – the first delivery of an instrument by the maker or drawer, whether to a holder or nonholder, for the purpose of giving someone rights on the instrument. b. Negotiation, 3-201 – a transfer of possession, whether voluntary or involuntary, of an instrument by someone other than the issuer to someone who becomes a holder of the instrument by virtue of the transfer. c. Holder, 1-201(20) – with respect to a negotiable instrument, means the person in possession of the instrument, if the instrument is payable to bearer, or if the instrument is payable to an indentified person, the holder is the identified person who is in possession. i. Instruments payable to bearer and to order are different. ii. To be a holder, you have to have possession of the instrument. d. Transfer of an Instrument, 3-203 – Instrument is transferred when delivered by a person other than the issuer for the purpose of giving the person receiving delivery the right to enforce the instrument. i. Delivery, 1-201(14) – voluntary transfer of possession e. PETE, 3-301 – (i) the holder or alternatively (ii) a nonholder in possession who has the rights of a holder, or (iii) someone without possession but the right to enforce under special rules (lost instruments and instruments that have been dishonored). ii. Negotiation and Transfer 1. Negotiation a. Original Article 3 gave the holder the right of enforcement, which sounded like you had to be a holder to enforce i. The 1990 Revision included 3-301 to show that a nonholder may be able to enforce. ii. The Revision made a distinction: Negotiation that creates a holder vs. other changes of possession that don’t involve negotiation but may still create the right of enforcement in the transferee. b. Case #1, page 5 i. John signs a note and delivers it to Rachel. Payable to bearer of the note. 1. This first delivery means there has been an issue of the note to Rachel. Same in Case #2. 2. It is payable to bearer, so Rachel is a holder. Bearer just means the person in possession. 3. This is not a transfer or negotiation because it was made by the issuer. 4. The instrument is Bearer paper. ii. Rachel loses the note, and Peter finds it and takes possession. 1. There has been negotiation of the note to Peter, because transfer of possession has been made, though involuntary. 2. Peter is a holder because instrument is payable to bearer. He becomes the bearer by possessing, so he is a holder. Same result if Peter had stolen the instrument (involuntary transfer of possession). As a holder, he may enforce the instrument against John. This isn’t the right to keep the instrument; he’s not a holder in due course. Therefore, Peter is vulnerable to adverse claims in possession by Rachel. But until she brings such a claim, Peter is a holder and may enforce. c. Case #2 i. John signs a note and delivers it to Rachel, payable to the order of Rachel. 1. There was issuance. 2. Also, the note is payable to a certain person, and that certain person possesses it, so she is a holder. 3. The instrument is Order paper. ii. Rachel sells the instrument to Peter, but she does not indorse the note. 1. There was a voluntary transfer of possession, but no negotiation because there was no indorsement by the holder, Rachel. The instrument was payable to Rachel, so Rachel would have had to indorse the note to Peter for the note to be negotiated to him. 2. However, since the transaction was voluntary, with Rachel’s intention to make Peter the owner of the instrument, there has been the transfer of an instrument. Because the purpose in giving to Peter was to give him the right of enforcement. 3. Peter is now a PETE, a nonholder in possession who under the “shelter rule” of 3-203(b) has the rights of his transferor, Rachel. Peter is a nonholder in possession with a former holder’s rights, making him a PETE. a. The difference matters because there is only a transfer and not a negotiation, under 3-308(b). If the validity of signatures is admitted or proved, the plaintiff producing the instrument is entitled to payment if he proves that he or she is a PETE, unless the defendant can then prove a defense or claim in recoupment. b. If the plaintiff establishes he is a PETE, he gets a directed verdict, unless the defendant can prove a defense or a claim in recoupment (counterclaim). If the defendant proves the defense, the plaintiff must prove he is a holder in due course. 2. Transfer a. Problem 1, Page 7 i. Mark signs a note and delivers it to Patricia for value; she in turn delivers to Theresa for Value. The note is made payable to the order of Patricia. Theresa wants to enforce the note. She introduces the note and rests. Mark asks for a directed verdict. 1. If Patricia indorses the note to Theresa, Theresa is a holder. Patricia was a PETE because the note was payable to her, she then endorsed it to Theresa, making Theresa a holder and therefore a PETE. SHE actually gets the directed verdict. 2. However, if Patricia delivered the note to Theresa intended to pass ownership to Theresa, but failing to indorse the instrument, then Mark gets the directed verdict. Because Theresa must prove the transaction by which she obtained the instrument from Patricia. There has been no negotiation, so Theresa is only proven to be a PETE if she proves transfer of an instrument. ii. This problem shows that the “magic status” of a holder is superior b. Problem 2, Page 7 i. Pete fraudulently induced Maria to issue a note payable to Pete. Pete indorsed and delivered to Helen who had no notice of any defenses on the instrument. Maria discovered she had been defrauded and notified Helen of the fraud, stating she would refuse payment. Helen gave the note to David, telling him the circumstances. David may recover from Maria free of the defense of fraud because of the shelter rule. ii. When Helen took the note, she became a holder in due course: there was negotiation because the note was indorsed to her by Peter, so she was a holder. iii. However, when Helen gives the note to David, David does not become a holder in due course because he’s not a holder. Not a holder because Helen did not indorse it. (Couldn’t be “in due course” because instrument taken after maturity and not for value, as well as the fact that he had actual knowledge of the defense that Maria has.) BUT, since Helen delivered with the intention of transferring rights in the note, there was a transfer to David. 1. Transfer vests in the transferee any right to enforce the instrument, including any right of a holder in due course. David is not a holder in due course, but has the rights of a holder in due course. This is the shelter doctrine. 2. Most types of fraud would not be an effective defense where there is a transfer. 3. If David sues Maria on the note, he must establish that he’s a PETE (meaning that the note was delivered such that there was a transfer) and establish that Helen was a holder in due course, to prove that David obtained derivative rights from Helen. 4. The justification for shelter doctrine is to ensure the free market in negotiable instruments. a. However, if the transferee engaged in fraud or illegality he cannot receive the rights of a holder in due course. iii. Discharge 1. Generally a. The debt is merged into the instrument b. One of the results of merger is that, traditionally, only payment to the holder of the instrument will discharge the obligation on the instrument and the underlying debt 2. 3-602 a. Payment incurs when made by or on behalf of a party obliged to pay the instrument to a person entitled to enforce the instrument. i. As long as obligor pays a PETE, the obligation is discharged. ii. This is different from the traditional rule. The obligor can pay a PETE (doesn’t have to be a holder), and there will be discharge. iii. The policy is that the obligor does not have to get bogged down in the dispute of who is the owner of the instrument. b. “The dark side” of the rule: real estate i. Example – Debtor borrowed money to buy home and granted Bank a mortgage. Bank negotiated mortgage to Assignee. Neither Bank nor Assignee notified Debtor of Assignment. Bank did not notify Debtor, fraudulently, continuing to collect payments. Assignee then notified Debtor of default. Bank then closes shop. 1. The Assignee is the holder of the note because the Bank no longer has possession of the note. Since the Bank indorsed the note, there was negotiation to Assignee, who is a holder, and therefore by definition a PETE. 2. Debtor’s payments did not discharge the obligation because they were not made to a PETE! ii. ALI through the 3d Restatement of Mortgages created a rule to fix this, but the UCC did not also fix the problem initially. The Restatement provided that if Debtor in mortgage situation paid before notice of the assignment, discharge would still occur. iii. Of course, in 99% of cases there is no problem because payment to the bank is payment to the assignee’s agent. Additionally, the assignee usually gives the debtor notice, so there is no problem with paying a non-PETE. iv. Lambert v. Barker - A sells a house to B. A agrees to finance the transaction: “pay me a note and give me, A, a mortgage over the house.” B pays with note and mortgage on the note to secure the obligation to pay. A then negotiates the note and mortgage as security for loan that C is making to A. 1. C doesn’t feel the need to notify B of the negotiation because C won’t have to collect from B unless A defaults on note to C. 2. Let’s say B’s lawyer contacts A, wanting to pay off the debt. A responds that A has lost the note. B’s lawyer says, no problem, and pays the remainder of the debt to A. Then A absconds (runs off). Therefore, A defaults to C on A’s obligation to C. C contacts B demanding payment because C is the holder. 3. The UCC result was that since B paid a nonholder of the instrument (A), there was no discharge for B. B would have to either pay the instrument the second time, to C, or have the property seized by C. a. Also B’s attorney would be liable for malpractice, because when A said A lost the note, B’s lawyer should have required some security before B paid A. Even if A still did have possession of the note, if B didn’t obtain the note back with a notation that it was paid, then B is vulnerable to A giving the note to a holder in due course and C could still collect from B if C did not have knowledge. i. This means never pay a note unless you can obtain the instrument marked “paid.” To ensure that the note cannot be subsequently negotiated to a holder in due course. ii. Or demand some sort of security. iii. To do otherwise is malpractice, if representing a client debtor. v. The 2002 amendment to UCC 3-602, however, solves this problem. A “broad reversal” of the traditional rule. Not limited to either mortgage notes or even to consumer transactions. 1. Louisiana, as most states, has not adopted this amendment. So it doesn’t help very much in the real world. 2. The New Rule: A notice paid to a person that was formerly entitled to enforce the note discharges the debt only if at the time of payment, the party obliged to pay has not received adequate notice that the note has been transferred and that payment is to be made to the transferee. Upon request, the Transferee must furnish reasonable proof of transfer of the note to the Maker. 3. Hypo: Maker issues a note payable to order of Payee, which Payee indorses and delivers to Transferee. a. Neither Payee nor Transferee notified Maker of the transfer and Maker made payments to Payee before receiving notice of transfer. Therefore, Transferee must credit the Maker for the payments made to Payee. (Statute does not address whether Payee is then liable to Transferee for the payments – but under unjust enrichment, Payee would probably have to pay the Transferee.) This is the operation of the new rule working effectively to protect a consumer debtor. b. However, if Transferee had notified Maker via adequate notification of the transfer of the instrument, the Maker may be an unsophisticated person not familiar with Transferee. Not having heard from Payee of the transfer, Maker calls Payee, who says that Payee is the agent for collection. i. This is the blind spot in the statute: the statute requires for Maker to contact Transferee and for Transferee to furnish proof of the transfer. In this hypo, Maker should have contacted the Transferee, not contact the Payee. ii. So under both the new and old law, a Payee/Transferor can defraud a gullible Maker of a note. c. Indorsements i. Indorsement – 3-204(a) 1. A signature on an instrument that is not a signature of a maker, drawer, or acceptor [drawee that accepts the check] that negotiates the instrument, restricts payment of the instrument, or incurs the indorser’s liability. If you sign on the back, it’s an indorsement (because makers sign on the front). A paper affixed to the instrument is part of the instrument (allonge – an archaic concept). 2. Special v. Blank Indorsements a. If a note is payable to Rachel, who wants to negotiate to Peter. Rachel could turn the check over and sign, putting “pay to the order of Peter.” At this point the instrument has been negotiated to Peter and can be indorsed only by his signature. This is a special indorsement (3-205(a)). b. However, if Rachel merely signs her name on the back, this is a blank indorsement, and the instrument is payable to bearer (3-205(b)). i. Blank indorsements are usually the way that instruments become payable to bearer (“bearer paper”). ii. No additional indorsement is required for negotiation, unless Peter takes the note and writes “pay to Tom” and signs his name. Then the instrument is converted back to order paper through a special indorsement. Peter could also merely write the words “pay to Tom” above Rachel’s signature to specially indorse. This latter approach is preferable because Peter’s name will not appear on the instrument; therefore, he will not become liable on the instrument. d. Holder in Due Course Doctrine i. The single most important part of NIL 1. Defined – someone who is a holder in due course takes the instrument free of any adverse claims of ownership and takes it free of most defenses to pay the instrument a. Defenses that would ordinarily be available to a contract obligor are not able to be used against a holder in due course b. This is different from contract law, where the assignee has no greater right than the assignor. 2. UCC 3-302 Definition a. Must be a holder of the instrument i. Very important and often overlooked ii. See definition of “holder” b. The instrument when negotiated or issued to 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. i. Nothing about the document would excite suspicion about it. c. Holder took the instrument i. For value ii. In good faith iii. Without notice of defenses to the instrument 3. Remarkable doctrine a. Radical departure from ancient rule of contract law, that assignee of contract only steps into shoes of assignor, and assumes assignor’s rights b. Common scenario - LP i. Mark is one of 20 limited partners in which Parker is the general partner. ii. Each partner contributes 100k in cash and gives Parker a note for 50k payable on demand. iii. Parker would hold onto the notes and make a call on the notes in the future when needed. iv. Agreement was that upon receipt of money from each partner, Parker would return the note to the partner. v. Notes were payable to order of LP. vi. Parker indorsed all the notes to the bank and gave to the bank, though Parker had fraudulent intentions, which the bank was not aware of. vii. Parker sold the notes to bank, took the money and ran away. viii. Who bears the loss? 1. Mark bears the loss under the UCC 2. The fraud would be an ordinary defense, and since the bank took the note in good faith and for value, and without notice of the defense, the bank is a holder in due course and can force payment of the note by Mark c. Two parties deal with a crook in this above hypo. Policy question is, who should bear the loss? i. Assignee who pays the assignor takes into account the possibility of the obligor having a defense to payment 1. The assignee is taking the risk of not being paid – a credit risk a. So by paying 85% of face value of the note, the assignee assumes it will make a profit, even though some obligors will be insolvent b. Assignee/bank would also adjust the price if it believed that obligor might have a defense of fraud d. Maker’s concerns i. A maker may not be aware he is dealing with a negotiable instrument ii. May not be aware of the holder in due course doctrine iii. Defenses available against the payee may not be available if payee assigns the instrument to someone else iv. The revisers considered amending the law to require every negotiable instrument to explain the holder in due course doctrine, to protect the makers of notes. 1. Suggested a “legend” describing consumer rights 2. But this suggestion was rejected ii. Rights of the Holder in Due Course 1. Claims of Ownership a. The least significant in the “real world” b. Miller v. Race and Rhodes v. Peacock – seminal 18th century cases by Lord Mansfield i. Miller v. Race 1. Promissory note payable to Finney or bearer. Stolen from Finney and then sold to innkeeper. 2. The innkeeper was a bona fide purchaser and took free of any claims of ownership. ii. Rhodes v. Peacock 1. Bill of exchange (modernly, a draft), indorsed in blank, given to bona fide purchaser 2. Same holding as in Miller v. Race c. UCC 3-306 A person having rights of a holder in due course takes free of a claim to the instrument. i. Claim to the instrument – a property claim (ownership or possessory) d. Basically, if someone is a holder in due course, they get to keep ownership of the instrument if the original possessor of the note sues to receive the instrument “back” from the current holder in due course i. If not a holder in due course, previous possessor can sue to rescind negotiation of the note to the current holder ii. See example, pp. 12-13 e. Hypo – (Draft, not a note) i. Drawer (John) writes $100 check to the order of Payee (Rachel). ii. Peter steals check from Rachel and forges Rachel’s indorsement. iii. Peter then goes to Corner Grocery and gives the Grocery the check as payment for items. Corner Grocery is a bona fide purchaser of the note for value, in this hypo. No notice of any claim Rachel may have to the instrument. iv. Rachel sues the Grocery to obtain ownership of the check. v. Grocery is not a holder because of the forgery of Rachel’s indorsement. 1. 3-201(b) the check could only be negotiated with Rachel’s indorsement. 2. 3-403(a) the forgery by Peter is “ineffective” as her signature. Since her indorsement is necessary for negotiation, no negotiation took place; and therefore, while the Grocery may have been a bona fide purchaser, it is not a holder. 3. 3-203(b) Grocery only received rights of Peter, the transferor (shelter doctrine); Peter had no rights as a thief, therefore as a transferee, the Grocery took the draft subject to Rachel’s claim of ownership. 4. The result would have been different if the check was blankly indorsed by Rachel. Example, Rachel just signs the check, then there would be negotiation to Peter (involuntary transfer) and Grocer could be a holder in due course. 2. Ordinary Defenses a. AKA “personal defenses,” available to drawer or maker. b. 3-305 Right to enforce is subject to: i. (a)(1) A defense of the obligor based on … (real defenses); ii. (a)(2)A defense stated in another section of this chapter… (ordinary defenses) iii. (a)(3) and a claim in recoupment. c. 3-305(b) – However, right of holder in due course not subject to defenses in (a)(2) and (a)(3) d. Types of ordinary defenses i. Error, misrepresentation, fraud in the inducement, failure of consideration. These are ordinary contractual defenses. ii. Those created by Article 3 itself: 1. 3-303(b) Instrument issued without consideration 2. 3-117 Agreements by original parties (issuer and payee) that modify, supplement, or nullify the obligation reflected on the face of the instrument a. Example: Child tells parent needs $5k. Parent gives it; child says it doesn’t know if it will be able to pay back. Parent says fine, but wants child to sign a promissory note payable to order of parent. b. The La. 3-117 is different from UCC. It requires a “separate written agreement” to modify the original instrument. i. Reflects our laws on counterletters. ii. So only written agreements can modify the terms of the instrument. e. Ordinary defenses may not be raised against a holder in due course 3. Real Defenses a. Real defenses may be raised against a holder in due course b. Types listed in 3-305(a)(1) i. Infancy of the obligor to the extent it is a defense to a simple contract ii. Duress, lack of legal capacity, or illegality of the transaction which legally nullifies the obligation of the obligor iii. Fraud that induced the obligor to sign the instrument with neither knowledge nor reasonable opportunity to learn of its character or its essential terms 1. Hypo: Guy going door to door sells you aluminum siding. Says if you agree to pay 10k, you’ll be the model house in the neighborhood and get a 1k credit for every other neighbor that orders aluminum siding. You sign paperwork that does not reflect the oral discussion – it is actually a negotiable promissory note and mortgage on the house. Guy then negotiates the note to a finance company. Aluminum siding is never installed. It’s a complete fraud. But under 3-305, the defense of fraud is not available against the holder in due course, because there was a “reasonable opportunity to learn of its character or its essential terms” through reading the documents. 2. **The fraud that is a “real defense” is fraud in factum, or essential fraud. Some sort of excusable ignorance (which does not include failing to read what you sign). a. Fraud in the factum would be signing a promissory note when you thought you were signing an autograph book. iv. Discharge of the obligor in insolvency proceedings c. Real defenses are very rare d. Historically i. Holmes and I play poker. Holmes wins and I write him a check. He negotiates the check to X. Gambling is an unlawful cause; there is no action to enforce the debt. This would have been a historical “real defense” available against X, a holder in due course. [Illegality of the transaction] ii. Usury – an unlawfully high rate of interest being charged. Small number of states declared usurious debts to be void. 4. Claims in Recoupment a. 3-305(a)(3) [the right to enforce an instrument is subject to] a claim in recoupment of the obligor against the original payee of the instrument if the claim arose from the transaction that gave rise to the instrument; but the claim of the obligor may be asserted against a transferee of the instrument only to reduce the amount owing on the instrument at the time the action is brought. i. See Comment 3 hypo: Buyer and Seller. Buyer pays with promissory notes. Seller delivers the goods. Buyer later discovers the goods were defective, so there is a claim for breach of warranty. The claim in recoupment is the buyer’s claim that can offset the seller’s claim to receive payment for the goods. Like a counterclaim. ii. The Revision tells us that the claim in recoupment is available against holders, but not against holders in due course. b. Merchant sold goods to Plumber, who gave a 10k note to pay for goods. Merchant immediately negotiated note to Finance Co. A month later, Plumber does work for Merchant; Plumber’s bill for the work was 8k. Plumber refused to pay the 10k note because Merchant had not paid its 8k and because some of the goods sold were defective, causing damages of 4k. i. Plumber potentially has a claim for breach of warranty for the 4k loss. This would clearly be a claim of recoupment. ii. The 8k is not a claim in recoupment because it did not arise from the transaction giving rise to the instrument. iii. The 4k claim in recoupment may be asserted as a defense to payment of the 10k to Finance Co.., as a holder. However, if a holder in due course, the claim in recoupment may not be asserted as a defense. c. The claim in recoupment asserted against the transfereeholder may only be asserted as a shield, not a sword. i. Example, if the damages to Plumber were 20k, this would only zero out the 10k note; Finance Co. as a transferee-holder would not owe Plumber any money. ii. However, if there was no negotiation of the note, and the payee—Merchant—still held the note, the claim in recoupment could be used not just to reduce the debt but also to bring suit for the excess damages. e. Formal Requirements of Negotiable Instruments i. Generally 1. The rules are clear cut. There is virtually no litigation over negotiability any more. 2. “Magic words” in the document make an instrument negotiable. And the document has to avoid saying anything that the statute prohibits. 3. But the bar examiners love asking questions about negotiability. See supplement, page 80. 4. 3-102 – Chapter 3 of UCC only applies to negotiable instruments. Not to money, payment orders, or securities. 5. The drafters wanted to broaden the definition of “negotiable instrument,” and others wanted to narrow the definition. ii. Definition – 3-104 1. (a) Aside from special rules in (c) and (d), 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: a. Payable to bearer or to order at the time it is issued or first comes into possession of a holder b. Is payable by demand or at a definite time; and c. Does not state any other undertaking or instruction by person promising or ordering payment to do any act in addition to the payment of money, but the order or promise 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. (b) “Instrument” means a negotiable instrument. 3. (c) An order meeting all the requirements of (a) except for being payable to bearer or to order is a negotiable instrument and a check. A check is a draft made on a bank and payable upon demand. a. This is just so that I can’t erase “payable to order of” on a check to make it nonnegotiable. b. The reason is that bank collections require all checks drawn on banks to be negotiable instruments. 4. (d) Any promise or order other than a check is not negotiable if it conspicuously states that the instrument is not negotiable or is not governed by UCC Chapter 3. a. But this doesn’t work for checks, just as in (c). iii. Taylor v. Roeder 1. Facts a. Involved deeds of trust (mortgages on immovables); given to secure notes. b. Only if Prewitt is a holder in due course, because the notes are negotiable instruments, is he allowed to recover on the note c. The interest rate could not be determined from the face of the document because it was set at the Chase Manhattan Prime Rate 2. Court a. This was not a negotiable instrument because the statute at the time required the instrument to be a promise to pay a “sum certain in money” b. The amount payable must be determinable from the instrument itself without reference to any outside source c. The note saying that the interest rate was 3% above a nonfixed amount does not satisfy the sum certain requirement i. This was in spite of the fact that the Chase Manhattan Prime rate could have been ascertained by a phone call ii. This was the Four Corners rule. The comments insisted that the computation of the sum could only be made by reference to the numbers and figures in the note itself. 3. Many cases at the time followed the position of this case. a. Some read the statute more broadly, like the dissent in this case b. Dissent: The variable instrument rate creates a balance between interest rate of borrower and lender in credit markets where the rate is fluctuating i. The lender does not want to be tied down for a long period of time at a fixed rate. ii. The borrower does not want it to be open ended, so he agrees to some amount of fluctuation, but to have an anchor on how high the rate will go. c. The courts required negotiable instruments to be “couriers without baggage” 4. Before the Revision, Louisiana and several states amended the statute to bring about the dissent result: requiring only a fixed amount of money, with or without interest described in the instrument. 5. 3-112(b) now specifically sanctions variable instrument rate notes. iv. Summary of Requirements 1. Written a. Reduced to tangible form 2. Signed a. By the person ordering or undertaking payment 3. Unconditional promise or order to pay 4. Fixed amount of money 5. Payable to bearer or to order at time of issuance or when first coming into possession of a holder 6. Payable on demand or at a definite time 7. 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 (with three listed exceptions) f. Requirements for Holder in Due Course (HIDC) i. Defined, 3-302 1. The holder of an instrument, if: a. The instrument does not bear apparent evidence of forgery or alteration or is not otherwise so irregular or incomplete as to call into question its authenticity; and b. The holder took instrument: i. For value ii. In good faith iii. Without notice that 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 iv. Without notice that the instrument contains an unauthorized signature or has been altered v. Without notice of any claim to the instrument described in 3-306 (property and possessory claims) vi. And without notice that any party has a defense or claim in recoupment described in 3-305(a). 2. In shorthand, that holder took the instrument without apparent evidence of forgery or alteration and for value, in good faith, and without notice of any claims or defenses. ii. Good Faith and Notice 1. Background a. Used to be defined as subjective honesty under old NIL b. Now good faith and no notice of any defenses to payment are both required c. While separate requirements, they are both clearly linked with one another i. If you have notice of a claim, then you probably cannot take the instrument in good faith ii. However, there are situations where a person may have acted in good faith and be deemed to have notice of a claim or defense 2. Kaw Valley State Bank v. Riddle a. Facts i. Co-Mac sold equipment to Riddle and Riddle gave a note for payment ii. Co-Mac than negotiated the note to Kaw Valley, as it did with all its notes for years iii. Riddle never got the equipment. Consideration for the note was never delivered. iv. A receiver had been appointed to take over CoMac’s business immediately before Kaw Valley notified Riddle that it had the note. 1. The receiver is a state law analog to bankruptcy v. Kaw Valley now sues to collect on the note from Riddle b. Issue i. The fact that Riddle never got the equipment is a defense to payment, but an ordinary defense (failure of consideration). ii. Cannot be asserted against a HIDC. iii. Question is whether Kaw Valley is a HIDC: was the bank in good faith and did it have notice of the defense. c. Good Faith i. Subjective honesty standard; honesty in fact in the transaction concerned or conduct concerned 1. Also described as “pure (white) heart, empty head” 2. In other words, even if you are negligent/not reasonable, if subjectively honest, you met the GF standard under the old law a. This standard has changed since this case ii. Court holds that Kaw Valley was honest and did not have knowledge of the material problem with the transaction iii. 1990 Revision 1. Occurred after this case (1976) 2. Article 3, drafters in 3-103(a)(4) adopted an Article 3 definition of good faith. 3. Previously, there was only one definition, the one in the general rules of Article 1. 4. The Revision changed the standard from mere honesty in fact to “honesty in fact and observance of reasonable commercial standards of fair dealing.” 5. When Louisiana adopted the Revision in 1992, the legislature chose not to adopt the new definition of good faith. The fair dealing component was not added so that, from the standpoint of Louisiana law, the definition continued to be the “honesty in fact” standard of this case. a. However, in 2006, the La. Legislature adopted revised Article 1 of the UCC, 1-201(b)(20). This definition is the same as the UCC: “honesty in fact and the observance of reasonable commercial standards of fair dealing.” d. Notice i. Kaw Valley was aware of the fact that Co-Mac frequently delivered equipment to its customers and at the time of negotiation, the equipment had not been delivered. ii. Also Kaw Valley and Co-Mac had a long-term relationship with each other iii. Co-Mac had been paying the note for a period of time following negotiation of the note. Why didn’t this tip Kaw Valley off to something being amiss with the note? 1. Legal answer: Test the good faith at the time of negotiation, and not thereafter. This is because if things that the holder learns after the holder buys the note could defeat their HIDC status, then that HIDC status wouldn’t mean much at all. 2. Practical answer: Co-Mac was guaranteeing payment of the notes. This practice is called selling notes “with recourse” meaning that if Riddle wasn’t paying the notes that had been negotiated to Kaw Valley, Kaw Valley can require Co-Mac to pay the notes. a. Note, in these kinds of dealings between dealers in heavy equipment, they get in squabbles all the time over things like repairs. iv. Objective standard 1. This is where Kaw Valley lost the case; it had notice of the defense, and therefore not a HIDC a. Had constructive notice 2. Four different circumstances where courts have found that a holder has notice of a defense: a. (1) Holder had information from the transferor or obligor which disclosed existence of a defense. i. Example, at time of negotiation, Riddle told Kaw Valley that it never received the equipment ii. Note that “knows” or “knowledge” in the UCC means actual, subjective knowledge b. (2) Where the defense appears in an accompanying document delivered to the holder with the note c. (3) Information appears in the written instrument indicating existence of a defense i. Example, the note itself bears obvious forgery or something along those lines d. (4) Knowledge of the business practices of the transferor or when so closely aligned with the transferor that the transferor may be considered an agent of the holder and the transferee is charged with the actions and knowledge of the transferor i. This is the hard one ii. May come from having a close relationship between transferor and transferee iii. May also come from simple knowledge of transferor’s business practices e. Holding i. After Riddle proved the defense, the burden shifted to Kaw Valley to prove its HIDC status ii. Kaw Valley did not meet its burden of proof that it did not have notice of the defense. iii. Notice 1. Kaw Valley had notice because they had notice of Co-Mac’s business practice; because Kaw Valley and Co-Mac had so many transactions between them that they must know of the defense. 2. Knowledge of Co-Mac is imputed to the principal, Kaw Valley, assuming that there is an agency relationship. Co-Mac was the agent for collection, in collecting payments from Riddle and sending these to Kaw Valley. 3. Ultimately, the court recognizes a legal fiction based upon policy choices. Simply because they’ve had a series of ongoing business practices doesn’t necessarily mean knowledge on Kaw Valley’s part of any particular practices of Co-Mac. Further, it does not mean there is an actual agency relationship. But the court’s reasoning simply justifies the conclusion that where there is this longstanding relationship, that the doctrine of negotiability should not exist at all. 3. UCC: Good Faith and Notice a. Good Faith, 1-201(19) = honesty in fact in the conduct or transaction concerned (+now, observance of reasonable commercial standards of fair dealing). b. Notice i. (25) A person has notice of a fact when: 1. Actual knowledge of it, 2. Received notice or notification of it, or 3. From all facts and circumstances known to him at the time in question he has reason to know that it exists. ii. (26)-(28) elaborate 1. “Receives notice” is defined as a. Either by being brought to his attention, OR b. It is delivered to the place of business through which the contract was made or at any other place held out by him as the place for receipt of such communications 2. Notice to organizations: look through the eyes of the person acting on behalf of the organization a. Organization must exercise due diligence to not have notice b. Due diligence is then defined here: c. Notice, knowledge, or a notice or notification received by an organization is effective for a particular transaction from the time it is brought to the attention of the individual conducting that transaction and, in any event, from the time it would have been brought to the individual's attention if the organization had exercised due diligence. An organization exercises due diligence if it maintains reasonable routines for communicating significant information to the person conducting the transaction and there is reasonable compliance with the routines. Due diligence does not require an individual acting for the organization to communicate information unless the communication is part of the individual's regular duties or the individual has reason to know of the transaction and that the transaction would be materially affected by the information. 4. Hypos a. Problem 1, Page 32 i. U.S. Treasury Bills stolen from Morgan Bank. Morgan sends notice of lost securities, describing the stolen bills, to bankers throughout the country. Third Bank receives notice and notes this in its lost securities file. Third Bank then makes loans and takes collateral, including two of the stolen bills. The officer of Third Bank who approved the loan was not aware that the bills were stolen, but never checked the file either. ii. Third Bank is not a HIDC because they had notice. This illustrates due diligence – the officer should have known that the bank had a “lost securities” file and should have looked this up. This is why maintenance of reasonable routines is good. b. Problem 2 i. Fazarri was induced by Wade to sign a promissory note payable to Wade. After discovering the fraud, Fazarri notified local banks and even spoke personally to the cashier of Odessa Bank about the fraud. Cashier later on forgot about the conversation with Fazarri and purchased the note. ii. One of the classic problems of NIL prior to the UCC. 1. Odessa Bank would have lost because there was actual notice given. 2. Under the old law, there was no distinction between good faith and notice and both would be subject to the “honesty” standard as opposed to constructive knowledge under the current UCC. 3. If the test is honesty, as opposed to reasonable belief, there is an argument that a holder who honestly has forgotten something that they previously knew could be acting without notice. 4. This doctrine of “forgotten notice” is pretty much gone now. The basic point is that, today, if you are Odessa Bank, you have to prove under 3-308 that you are a HIDC. 5. The New Prong of “Good Faith”: Reasonable Commercial Standards of Fair Dealing--Maine Family Fed. Credit Union v. Sun Life Assurance Co. a. Background i. Expedited Funds Availability 1. Traditional practice is for banks to hold onto money as long as they can and deny paying money to the customer a. If customer deposits check, the bank sends it on to the drawee bank b. If the drawee bank dishonors and the drawer does not have enough money, the bank never gets money on the check. If it allowed the customer to make a withdrawal, the bank would be out of money and have no way to acquire the funds to offset having had to pay the withdrawal to customer. 2. Citizens started complaining that banks were holding onto funds for too long 3. Congress passed a law saying that banks must make the money available to customers on a pre-determined schedule, fine tuned by Regulation CC 4. So under federal law there are strict deadlines; have to let the customer withdraw the deposit even though the bank has not gotten payment from the drawee bank 5. Understand that when you “cash a check,” the depositary bank is actually buying the negotiable instrument with the expectation that the depositary bank will be able to then collect on the note from the drawee bank. b. Facts i. Life insurance policyholder died and the three beneficiary children had checks written to them by Sun Life Insurance Company ii. The checks were all drawn by Sun Life on Chase Manhattan Bank iii. Sun Life gave the checks to its agent, so that agent could give the checks to payee beneficiaries iv. Agent gave to the beneficiaries, but suggested a “deal” for them 1. Instead of depositing the checks in their account, they can deposit them in the agent’s investing account with “HER Inc.” 2. Each beneficiary indorsed in blank and gave to the agent 3. The agent and another life insurance agent took the money and ran! Deposited with Maine Credit Union and the Credit Union paid the agents for the checks (cashed them). v. The payees became disappointed with their decision, notified Sun Life of the fraud and asked to issue a stop payment notice to Chase Manhattan. Sun Life does this. When Credit Union presents the checks, Chase Manhattan denies them. vi. Unusually, the CU is able to get some of the money back from one of the crooks. 1. 4-214(a) says that in these circumstances where depositary bank does not receive payment and it allowed its customer to withdraw the amount, the bank is entitled to a refund 2. However, CU is still out by $40k c. Procedural i. CU sues Sun Life under 3-414(b). Where a check is dishonored, the drawer of the check has made a contract to pay it, and Sun Life as drawer is potentially responsible for paying the check. ii. CU also sued one of the beneficiaries who indorsed the check before giving it to the other agent under 3-415(a). He upon dishonor of the check has made a contract to pay as an indorser. iii. Under 3-306 the beneficiary claims that he can rescind negotiation of the check and make a claim to the instrument or its proceeds. Because the beneficiary has that right, Sun Life can assert that claim as a defense to payment to the CU. (3305(c)). d. Issue: If the CU is a HIDC, then the beneficiary’s claim of ownership is ineffective. i. CU says it gave value for the check, it was in GF when dealing with the agents, and had no notice of any fraud and therefore it’s a HIDC. ii. Trial Court said CU not in GF because did not reasonably observe commercial standards of fair dealing iii. Jury held the CU was not in GF and therefore not a HIDC e. Court i. The jury was justified and could have rationally believed that the CU was not in GF 1. It is permissible under CU’s internal policies and Regulation CC to conclude that CU should have waited longer to give the funds to the agents 2. Allowing immediate withdrawal of the funds was not reasonable/fair dealing because the check was drawn on an out of state bank and was a large amount of money – should have waited several days until honoring ii. This is problematic for depositary banks and has the potential to undercut protections available to HIDC 1. This case diminishes protection available to a HIDC and calls into question whether the drafters of Article 3 really thought through adding the second objective component of GF f. Good Faith Analysis i. Honesty in Fact – disposed of easily. Obviously the CU was acting honestly. There’s no way that the typical depositary would have any knowledge of claims of remote persons. Could not have known what the agents told the beneficiaries to whom the checks were issued. ii. Reasonable Commercial Standards of Fair Dealing 1. The federal regulation says that the bank has to pay the person making a withdrawal and depositing a check by a certain date. So this seems to suggest that it would be okay for the depositary bank to pay the money to the depositor (the life insurance agents) fairly quickly. This suggests that a bank in CU’s position should be able to have HIDC status if it has to pay out its own money immediately. Because the federal regulation requires payment immediately, according to a certain schedule. 2. There were plenty of cases at the time that said that doing what the CU did does not prevent GF, under the honesty in fact standard, though. Not dishonest to allow a customer to draw against uncollected funds. 3. The court legitimately has a gripe with the drafters of the statute. They have given little guidance as to what “fair dealing” means! a. 3-103 cmt. 4 – Fair dealing is not the same as “ordinary care.” Dealing carefully is not what is meant. Dealing fairly is the issue. Fairness of conduct, not care of conduct. b. Commercial standards in each case are directed to different aspects of commercial conduct. But this is not clear to us who don’t know what the drafters had in mind. c. The comments do not define fair dealing or how it relates to being a HIDC. 4. Good faith purchase v. performance in Restatement (Second) of Contracts a. When addressing a good faith purchase, the only relevant issue is honesty b. When addressing a good faith performance, then the component of fair dealing was intended to restate that parties should not be allowed to take unfair advantage of one another i. Something more than mere honesty is required when performing a contract c. However, the drafters of Article 3 apparently did not address the Restatement view in the comments to Article 3. If they had, then this case may have come out differently. 5. The UCC does not state to whom the duty of fairness is owed a. So the court develops a two prong test: i. Whether conduct comported with industry or commercial standards applicable to the transaction. ii. If so, whether those standards were reasonable standards intended to result in fair dealing. b. Standard the CU observed is that someone depositing a check should be allowed immediate access. However, if large amount or drawn on out of state bank, the CU had the discretion to withhold access for up to 9 days. However, neither regulations of Regulation CC nor the CU’s internal policies required the CU to withhold access. Expert testimony showed that the practice in the state was to allow immediate access to funds. c. CU is saying it followed standard procedures and its own procedures, therefore they were engaged in fair dealing. The risk of non-payment of a check like this was virtually zero. This was a one in a million case where the payees of the checks had been defrauded. iii. Court 1. The jury was allowed to take into account the amount of the check, the location of payor bank, and the fact that under federal law the CU would be permitted to place a longer hold on the check 2. The jury was justified in its conclusion; rationally could conclude that fair dealing required a hold on the uncollected funds for a reasonable period of time and that in giving value under these circumstances, the CU did not act according to commercial standards that were reasonably structured to result in fair dealing. g. This case is problematic for banks i. Between a rock and a hard place ii. The Expedited Funds Availability Act was meant to allow banks to make funds available more quickly iii. But this decision actually gives the banks the incentive to hold onto money as long as they can, which bucks the purpose of the federal law! iv. Plus, customers will get very, very angry when they can’t get their money immediately. v. This case shows that drafters did not think it through or should have explained that for HIDC, fair dealing has little to do with purchase; and that honesty is the crucial test. h. Note 1, Page 42 i. Many of these cases have been decided the same way. But some cases make clear that fair dealing means not taking advantage of someone. ii. Remember: 1. La. did not initially adopt 3-103(a)(4) new definition of GF 2. But in 2006, we amended 1-201(b)(20) in Article 1 to include the new definition of GF, so La. law now also adopts this 2 part definition of GF. So the potential for this kind of case exists in Louisiana, as well. iii. Overdue or Irregular Instruments 1. 3-302(a)(1) – “the instrument . . . 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…” 2. Problem, p.43: Irregularity of Instruments a. Maker signed note for 10k to Payee. Should have been payable in 20k. Payee brought this to Maker’s attention. Maker told Payee to change the number. Payee did and the alteration was done crudely. b. Payee sold note to Holder. Holder demanded payment from Maker; Maker refused, claiming that Maker never received goods from Payee. c. Held: No one can become a HIDC of the instrument because the instrument bears “apparent evidence of alteration” that “calls into question its authenticity.” i. Note that in this case, there was no defense of alteration, because Maker told the Payee that the Payee could erase the number and write a new one in. Normally, the alteration would be valid and enforceable against the Maker. ii. Here, however, the Maker has a separate defense, failure of consideration. But the fact that there has been some alteration does not suggest to someone taking the instrument that there is no consideration. 1. This was the problem under the old statute. 2. However, the 1990 Revision resolves the problem against the holder by saying that if an instrument is “irregular,” the irregularity prevents anyone from being a HIDC of the instrument 3. Overdue Instruments a. 3-304 Overdue Instrument i. (a) Instruments payable on demand. Becomes overdue at the earliest of the following: 1. (1) On the day after demand for payment is duly made; 2. (2) If instrument is a check, 90 days after its date; or a. This is one of many rules regarding checks and the passage of time b. If more than 90 days have passed since date of check, no one can thereafter be a HIDC. But this does not mean that the check is no longer valid! 3. (3) If the instrument is not a check, when the instrument (mainly promissory notes) has been outstanding for a period of time after its date which is unreasonably long under the circumstances in light of the nature of the instrument and usage of the trade. ii. (b) Instruments payable at a definite time 1. (1) If principal is payable in installments and due date has not been accelerated, the instrument becomes overdue upon default under the instrument for nonpayment of an installment, and the instrument remains overdue until the default is cured. 2. (2) If principal is not payable in installments and due date has not been accelerated, the instrument becomes overdue on day after due date. 3. (3) If a due date with respect to principal has been accelerated, the instrument becomes overdue on the day after the accelerated due date. iii. (c) Unless the due date of principal has been accelerated, an instrument does not become overdue if there is default in payment of interest but no default in payment of principal. b. Problems, Page 45. Problem 1. i. Buyer is concerned about unrecorded liens on property he is buying from Seller. Buyer is suspicious that Seller may have given lien rights to someone, liens that don’t have to be recorded. Buyer gets promissory note from Seller to protect Buyer. ii. Note was executed by Seller on March 25 and due 75 days later. Note indorsed without recourse to Plaintiff on Sept. 1 for consideration. Seller refused to pay the plaintiff. iii. Plaintiff is not a HIDC, because he took with notice of the fact that the instrument was overdue. iv. This is a 3-117 ordinary defense: agreement that modifies the agreement on face of the instrument. $6500 is face of instrument, but parties made separate agreement that Seller’s liability was limited to those amounts expended by Buyer, which is $4244 in this case. Therefore, plaintiff as holder can only sue to receive $4244. 1. In Louisiana, this separate agreement would have to be in writing to be enforceable at all, along with the primary promissory note. 2. **Note that the $3,067 is not relevant. This is what the Plaintiff paid Buyer for the instrument, meaning that the instrument was taken by Plaintiff for value. But this does not limit the amount Plaintiff as holder can recover. Remember this for exam! c. Problem 2 i. Payee sold house to Maker. Maker did promissory note in payment. Payee had to go off to war, so asked Banker to collect payments on the note. Later, Maker fell in default and Banker, also with financial difficulties, sold the note to Purchaser for value. Purchaser knew that four payments had not been made, but had no knowledge of the circumstances under which Banker had taken the note. Payee gets back and sues to receive ownership of the instrument. ii. Purchaser cannot be a HIDC. He had notice that the instrument was overdue; he knew that several installments had not been paid. 1. 3-304(b)(1) The principal was payable in installments, and the Maker was in default on certain payments and the default was never cured. Therefore, the instrument was overdue. 2. If you have notice that the instrument is overdue, then you cannot become a HIDC. iv. Negotiability in Consumer Transactions 1. Universal C.I.T. Credit Corp. v. Ingel a. Generally i. This case is not the law anywhere anymore ii. It is a historical relic. 1964 case: the most recent state supreme court opinion where a court applied the HIDC doctrine in a consumer transaction. iii. In this case, the sale of aluminum siding was fraudulent. b. Facts i. Common scheme ii. $1,890 paid in installments for aluminum siding. iii. The note was negotiated to a consumer finance company. iv. The siding proved to be junk v. Plaintiff holder is suing the homeowners for payment. c. Evidence i. The plaintiffs want to use evidence from BBB records that the payee aluminum siders had been known to make false representations ii. Wanted to introduce the credit company’s letter written to the plaintiffs. Simply says that the company still requires payment. iii. Wanted to introduce evidence of misrepresentation. iv. The court excluded the evidence, saying that the consumers had the burden of showing that the credit company was not a HIDC. d. This case shows that the old rule was that a credit company’s role was simply financing, that they had nothing to do with the underlying transaction involved. i. Even if the dealer’s conduct was outrageous, the credit company could still require payment on the note. ii. The rationale was that the consumers should have to pay the HIDC, the credit company; and then if the consumers got a bad deal, just sue the dealer. 1. If the dealer is solvent, then this is a fair result. 2. However, in reality, often the dealer is either insolvent or has disappeared. Leaving the consumers with having to pay the note and having no remedy against the fraudulent dealer. (=this case). 2. Change to the Modern Rule a. The self-evident truth was that a credit company is in a much better position to monitor the conduct of companies it deals with. i. The finance company is in a better position to address the risk of a fraudulent dealer by adjusting how much it will pay for an instrument written to the dealer. ii. Dean Rosenthal – the case against applying HIDC doctrine to consumer transactions. 1. The drafters of the UCC “punted” the issue for fear that selling the UCC to the states might become difficult. 2. It fell to courts and legislatures to address the need for consumer protection. b. The legislative response i. UCC took a neutral response, 3-302(g): This Section is subject to any law limiting status as a HIDC in particular classes of transactions. 1. The drafters did not take any specific position, but to acknowledge that the HIDC doctrine has eroded in certain areas and may continue to be eroded in the future. 2. Extrinsic laws in states will be recognized. ii. Most states have some legislation that limits HIDC doctrine in consumer cases. 1. Louisiana used to, but not anymore. 2. E.g. having additional requirements for a note to be negotiable. iii. UCCC (Uniform Consumer Credit Code) prohibited the use of negotiable instruments in consumer credit transactions and stated that even if a negotiable instrument is used in violation of the statute, they take the instrument still subject to obligor’s defenses. Only a handful of states have adopted this. iv. The FTC Rules: Nationwide Approach 1. Provides the “holder rule” 2. Their jurisdiction is over sellers, not lenders a. Define the transaction as one entered into for personal, family, or household use i. Sales of goods or services ii. Leases iii. *NOT business reasons, such as buying a computer for use in home office b. Did not include credit cards 3. Required consumer credit transactions to have a legend that stated that the instrument is taken subject to all claims and defenses 4. 3-106(d) The legend does not affect negotiability, but simply means that the person taking the instrument cannot become HIDC. The legend as required by federal law just means that no one can become a HIDC of the instrument. v. So UCC 3-106(d) clarified that the legend simply meant that the no one could be HIDC. 3. Purchase Money Loans a. Definition i. Two different types of transactions exist: 1. Assigned Paper: Buyer gives note to seller. Seller sells note to finance company (like C.I.T.). 2. Purchase Money Loan: Financer lends money to buyer and gets a promissory note from buyer. Buyer then takes the loaned money and pays the seller. a. To avoid collusion between financer and seller, FTC had to devise a rule. ii. Example is buying car. Technically, getting loan from GMAC and using the proceeds to pay GM for the car. b. FTC rule requires that when (1) the seller refers the buyer to a financer or (2) the financer/seller are affiliated by contract/business arrangement; then the contract between lender and buyer must contain the same legend stating that the note to financer is subject to claims or defenses. i. “Business arrangement” 1. What does it mean? Ambiguous. 2. UCCC is much more explicit: the lender in a purchase money situation is subject to buyer’s claims or defenses against the seller. ii. FTC’s power applies to sellers. Not lenders. 1. Creates an issue. If lender did not include the notice, what should happen if the lender does not include the legend? 2. Gonzales v. Old Kent Mortgage Co. a. An ingenious solution for the problem, though the court had absolutely no authority. b. Court treats a case as if the legend was there. A “virtual legend.” Treat the contract as if it did have the legend. This solves the problem in purchase money loans of the financer not having the legend on the promissory note. c. The UCC thought this case was great, so they added a comment to Article 3… iii. 3-305. UCC Article 3 amendment: If extrinsic law requires a legend, even if the instrument does not have the notice, it is treated as if it did. 1. But this amendment has not been adopted hardly anywhere. La. has not adopted it. 2. This amendment would apply to both assigned paper and purchase money transactions. So if federal law would require the notice, if a state adopted this amendment, in a regular old assigned paper transaction, no financer would be able to take the instrument as a HIDC, if the underlying transaction was a consumer transaction. 3. However, in reality, the financer will usually be aware that the underlying transaction was a consumer transaction. So they probably could not qualify as HIDC, regardless of the existence of the legend. Still, the FTC requirement of the legend has been controversial. v. Payee as Holder in Due Course 1. Generally a. Usually, a payee would not need to be a HIDC because the payee is a party to the underlying transaction with the issuer. b. If the issuer has a claim or defense, the payee will have notice, if not actual knowledge. c. But there are unusual cases in which the payee may be able to assert rights as HIDC; to take free of some claim or defense because the defense arises out of a relationship between the issuer and a third person. d. Example, fraud perpetrated upon issuer by someone other than payee. i. Example, fraud perpetrated by agent of the issuer. A company is the issuer, and its agent acts fraudulently. 2. Recoupment a. In two party cases, where there is no third party, a seller cannot claim he is a HIDC and take free of a claim in recoupment on the basis that the seller did not know that the goods were defective. i. The seller has reason to know of the defects in goods and takes note subject to the claim. b. There can only be HIDC when there are three parties involved. c. Comment 4, 3-302. vi. Transactions with Fiduciaries 1. Smith v. Olympic Bank a. Pre-revision case [Original Article 3] b. Facts i. The minor child is beneficiary of grandpa’s life insurance policy ii. Child’s father is appointed by the court as guardian for purposes of receiving and managing the proceeds of the policy iii. Check made payable to “dad, guardian of child, a minor” iv. Dad was told to open a guardianship account with the bank and deposit the check v. Attorney even talked to bank about the minor child’s funds being deposited vi. Dad deposited the check in a personal account and thereafter spent almost all of the money vii. After all this, a new guardian was appointed, and he sues both dad and the bank c. Court i. Issue: is the bank a HIDC? 1. Takes free of the claim of breach of fiduciary only if HIDC 2. Court says under the old UCC, the bank had notice of the claim of breach of fiduciary duty ii. Analysis 1. When the bank knowingly allowed dad to deposit the check in his personal account, that put the bank on notice of the claim d. Prior to 1990, the law was not uniform i. Many cases came out like this one ii. However, Knox and others reached opposite conclusion iii. Explanation of opposing views: 1. Equities of individual cases are very different a. For example, one similar case involved the dad depositing the money in personal account to pay for his five kids, instead of the one kid for whom the check was supposed to benefit 2. Drafters adopted the Olympic Bank approach 2. UCC 3-307. Notice of Breach of Fiduciary Duty. a. Statute i. (a) Defines fiduciary (agent, trustee, corporate officer/director, etc.) and “represented person” (principal, beneficiary, corporation, etc.) 1. A fiduciary must only use the proceeds or money not for personal benefit but for the beneficial owner of the assets 2. The beneficial owner has a claim against the fiduciary for not acting in the best interests of the rightful owner 3. Once a check is negotiated to a bank, this general fiduciary substantive law becomes relevant 4. This statute defines whether someone taking an instrument has notice of the claim of breach of fiduciary duty, such that he cannot be a HIDC. ii. (b) If (i) an instrument is taken from a fiduciary for payment or collection for value, (ii) the taker has knowledge [actual subjective knowledge] of the fiduciary status of fiduciary, and (iii) the represented person makes a claim to the instrument or its proceeds on basis of breach of fiduciary duty, the following rules apply: 1. (1) Notice of breach of fiduciary duty by the fiduciary is notice of the claim of the represented person. 2. (2) If instrument is payable to represented person or fiduciary as such, the taker has notice of the breach of fiduciary duty if instrument (i) is taken in payment of or as security for a debt known by the taker to be the personal debt of the fiduciary; (ii) is taken in transaction known by the taker to be for the personal benefit of the fiduciary; or (iii) is deposited to an account other than an account of the fiduciary, as such, or an account of the represented person. 3. (3) If an instrument is issued by the represented person, or the fiduciary as such, and made payable to fiduciary personally, the taker does not have notice of breach unless taker knows of the breach. 4. (4) If an instrument is issued by the represented person or the fiduciary as such, to taker as payee, taker has notice of breach if (i) taken in payment of debt known by the taker to be a personal debt of fiduciary, (ii) taken in transaction known by the taker to be for fiduciary’s personal benefit, or (iii) deposited to account other than account of the fiduciary, as such, or an account of the represented person. b. Analysis i. “Knowledge” of fiduciary status 1. Remember that UCC defines knowledge as “actual, subjective knowledge.” 2. Therefore, there’s no notice of the claim if the holder does not actually know that they were dealing with a fiduciary. 3. In Olympic Bank case, not only did the check itself reflect dad’s status as a fiduciary, but also the attorney called the bank and notified the bank that the dad was a fiduciary with regard to the check being deposited in the personal account. ii. (b) (i) through (iii) 1. Olympic Bank took the instrument for payment 2. The taker had knowledge of fiduciary status 3. The represented person (the child, through another attorney) has made a claim to the proceeds on the basis that the transaction [deposit of the check to personal account], was a breach of fiduciary duty iii. NOTICE 1. Generally a. The statute is structured such that deemed notice is based upon (1) who issued the instrument and (2) to whom the instrument was made payable. b. These two questions are the essence of (b)(2)-(4). 2. (b)(2) [Olympic Bank case]. When instrument is payable to represented person (to the kid) or to the fiduciary as such (to dad, on kid’s behalf): a. Payment of a debt that taker knows is personal debt of fiduciary b. Transaction is known to be for fiduciary’s personal benefit c. Deposit to account other than an account of represented person or fiduciary as such i. This is the Olympic Bank case. ii. Bank would have had to require that the check be deposited in a guardianship account or in an account in kid’s name. iii. Controversial. Some states rejected this portion of the statute. In conflict with Uniform Fiduciaries Act (UFA), which La. has adopted. 3. Problem, page 66 a. Guardian deposited check in Bank 1 in personal account, only until he could get guardianship account opened. b. Then opened guardianship account in Bank 2. Put funds in it. Then withdrew from Bank 2 and misappropriated funds. c. Held: Bank 1’s breach was not proximate cause of the loss and therefore not liable. d. Prof.: A good result. e. Problem: if guardianship account opened at Bank 1, Bank 1 would have clearly been a HIDC, even if the fiduciary later withdrew and used for personal benefit. Because bank has no duty to monitor use of funds after the deposit is made. i. Statute only imposes a duty upon the holder/bank at the threshold level: time of deposit. The bank has no way of monitoring what fiduciary later does with the deposited funds. ii. Therefore, in this above mentioned case, there was technically a violation of the statute by Bank 1. BUT no harm because transferred funds to guardianship account at Bank 2, and from the guardianship account, the funds were withdrawn. Ingenious use of proximate cause to give Bank 1 some leeway. 4. Problem, Page 67 a. Person issuing the instrument is the fiduciary himself, in the following situations. b. In each case, Little Corp. is in a small city with checking account in Bank. Agreement between Little and Bank is that Bank may honor checks drawn on the account if signed in name of Little by either President or Treasurer. President was involved in the following transactions. In each case in which President issues the check, she does so in breach of fiduciary duty. Little Corp. brings an action against each taker on basis of breach of fiduciary duty. c. Case #1 i. President’s personal credit card was used to pay for auto rentals, restaurants, hotel rooms. All charges incurred for President’s personal benefit and not related to Little’s business. President wrote check on Little’s checking account and sent to Issuer of credit card to pay credit card charges. ii. This is (b)(4), instrument issued by fiduciary, to taker as payee. iii. Credit card company should not be found to be on notice – this is the right result. iv. Applying the statute (3-307): 1. Little is represented person. President is a fiduciary. 2. Credit Card company is not liable unless it has knowledge of fiduciary status and knowledge that the check is taken in payment of a personal debt known by the taker to be a personal debt. 3. “Knowledge” under Art. 1 is actual knowledge. In the case of an organization, determine this by the person conducting the transaction. a. Credit card company clerk is primarily involved in looking to see amount of check and credits it to appropriate account. That’s all the clerk is concerned with. b. Would have to show that clerk had knowledge of President’s fiduciary status. So if the clerk noticed that the check was written upon Little’s account, signed by President, the clerk may have had knowledge of fiduciary status. c. However, there is nothing indicating to the clerk that would make her have knowledge that these charges were a personal debt. The charges may have been for a business purpose. d. Case #2 i. President buys expensive rug from merchant with check written on Little’s account. ii. Same result. However, the fact that transaction was face to face may cut more in favor of merchant having knowledge of fiduciary status, because they saw President write the check on behalf of the corporation. iii. However, still hard to prove that the merchant knew that this was a personal debt under 3-307(b)(4). iv. If the rug had been delivered to President’s house, that may have been a stronger case. v. Note that the comments to the statute indicate that holder in due course status should be liberally construed in these fiduciary breach cases. e. Case #3 i. President went to clothier’s store and ordered several custom made dresses for herself. Wrote check on Little’s account. Clothier asked why Little’s check was being used. She replied that the dresses were being given by Little, as a grateful employer, for her years of service. ii. Tougher case, but jury might find that Little wins. iii. Knowledge of fiduciary status? Obviously yes. iv. Actual knowledge that this was a personal debt of the President? Maybe not. But could any reasonable person think that this was an actual business transaction? The clothier raised the question to begin with, so perhaps he did have actual knowledge that she was buying these for herself in breach of fiduciary duty. 1. Businesses do not pay bonuses to employees buy handing over the credit card and saying, “Go buy yourself something nice.” f. Case #4 i. President wrote $1,000 check drawn on Little’s account payable to herself. She indorsed, deposited at bank account in her personal account. Gave it to a teller who knew that she was Little’s president. ii. (b)(3) If an instrument is issued by the fiduciary as such and made payable to fiduciary personally, the taker does not have notice of breach unless taker knows of the breach. iii. The teller does not have knowledge of the breach. Therefore, Bank wins. 1. How can this be? 2. In a small LLC, it would be common for a corporate officer to sign his/her own payroll check. This does not necessarily incite suspicion. 3. In the same way, a trustee might sign his own check on a trust account to receive his fee. So there would not necessarily be actual knowledge of fiduciary breach by the taker. 4. (b)(3) transactions are normal; therefore, knowledge of the fact that there is a breach is the standard. vii. Value 1. Introduction a. Holder must have given value for the instrument to be a HIDC b. The justification is that HIDC doctrine gives the person substantial rights against the obligor on the instrument. In order to attain these special rights, you should pay for it. c. Avoid having the person receiving the interest get a windfall. d. Statute: 3-303 Value and Consideration i. (a) An instrument is issued or transferred for value in five cases: 1. (1) Instrument is issued or transferred for promise of performance, to the extent the promise has been performed 2. (2) Transferee acquires a security interest or other lien in the instrument, other than a judgment lien 3. (3) Instrument is issued or transferred as payment of, or as security for, an antecedent claim against any person, whether or not the claim is due 4. (4) Instrument is issued or transferred in exchange for a negotiable instrument 5. (5) Instrument is issued or transferred for the incurring of an irrevocable obligation to a third party by the person taking the instrument. ii. (b) “Consideration” means any consideration sufficient to support a simple contract. If an instrument is issued for value, it is issued for consideration (but not necessarily vice versa). e. Problems, page 68 i. $1,000 from maker to payee. Fraud. Goods never delivered to maker from payee. In each case, payee negotiated to holder who had no notice of fraud or failure of consideration. ii. Problem 1 1. Payee negotiates to holder, in consideration of holder’s agreement to perform services for payee. Before holder is obligated to begin performance, note falls due. Holder demands payment from maker. Maker claims defense of fraud on the instrument. 2. The holder gave consideration, but not value. (a)(1) says that there is no value given unless the promise is performed. a. The rationale is that when holder learns of the defense, he is not out anything; all he has done is make a promise. Whenever maker asserts his defense to payment, then holder is relieved of obligation to perform his promise to payee (because of failure of consideration under contract law). iii. Problem 2 1. Payee negotiates note to holder, who pays $900 in cash. Holder has clearly given value and therefore holder will get the entire $1,000 of the note by maker. 2. Payee negotiates note to holder, who pays $600 cash for the note and promises to pay the payee an additional $300 in 60 days. After paying the $600, holder learned of the fraud and paid no more. Holder has given for value; but only to the extent of performing promise to pay. The $300 has not yet been performed. How much can holder recover from maker? a. $666.67 (2/3 of the $1,000 note). b. This is because of a separate rule, 3302(d): If under 3-303(a)(1), the promised performance that is consideration is partially performed, the holder can assert holder in due course status only as a fraction of the performance it has given. c. The holder is a HIDC only on 2/3 of the $1,000 instrument because holder only has give 2/3 value for the instrument through only performing 2/3 of the promised performance made to the payee. d. “Partial HIDC.” e. HOWEVER, La. law is a little different here: 303(a)(1) – …to the extent promise has been performed, or the holder has in good faith changed his position in reliance on the instrument, in which case he is deemed to have given full value for the instrument. Intended to protect some transferees who have only rendered partial performance. i. This is murky law because what sort of change in reliance is anticipated is unclear. ii. This is inconsistent with 303(d), that says you only become holder on a pro rata amount of that which you have performed. iii. What the La. legislature meant has not yet surfaced. But this language is troublesome. iv. Problem 3 1. Payee was indebted to holder on past due loan. To avoid holder suing payee, payee negotiated the maker’s note to holder as collateral for the payment of the loan holder made to payee. 2. Holder demands payment from maker. 3. Holder did give value under (a)(3): instrument was taken as security for an antecedent debt of the payee. 4. The problem with this result is that arguably holder has not done anything: he was an unpaid creditor before, and he is an unpaid creditor now. Why does he suddenly get to sue maker? However, the statute adopts the NIL common law policy that perhaps through the holder taking the note as security for payee’s debt, this may lead holder to not sue payee on the debt. And this is value under the statute. 2. Rights of Depositary Bank in Deposited Check a. Generally i. Involves Article 4, Bank Deposits and Collections ii. Important because HIDC status most commonly involves the right of depositary banks b. Check Collection under Article 4: How it works i. Drawer issues check to payee (customer), who deposits the check in the depositary bank. ii. Check drawn by drawer is drawn upon the drawee (payor) bank. iii. What happens? 1. Depositary bank gives the payee (customer) a provisional credit for his bank account. This is a book-keeping entry. 2. Depositary bank then forwards to drawee (payor) bank for payment. a. If payor bank pays the check, then the provisional credit becomes final, and payee/customer gets access to the money. b. However, in certain cases, payor bank may dishonor the check because (1) NSF to pay the check or (2) drawer issued stop payment check. i. Check is returned to depositary bank. So it will revoke the provisional credit to payee (customer) and returns the check to the customer. ii. Customer is once again the holder and can assert its rights against the drawer 3. Depositary bank may choose to not revoke the provisional credit, but may charge it back under 4-214a, meaning that depositary bank remains the holder. iv. Depositary bank almost never has any rights against the drawee. So depositary will sue the drawer. If the drawer has a defense, the issue then becomes has the depositary bank given value to payee, so as to become HIDC, not subject to drawer’s defense. c. Giving of Value i. Giving the provisional credit by the depositary bank is not giving value because it is revocable. ii. However, acquiring a security interest in the instrument constitutes giving value: 1. 4-210 explains three ways a security interest may be created: a. When the check is deposited, to the extent that the resulting credit is withdrawn or applied b. Check deposited and depositor given unrestricted right to withdraw the credit c. Bank makes a loan or cash payment based on the check. 2. These special rules only complement the general rules in Article 3 d. Problem, page 70 i. Addresses the problem of how to determine whether value has been given; the order in which credits are given ii. 4-210(b) Credits first given are first withdrawn (FIFO) iii. Hypo 1. Depositor has account at Depositary Bank 2. See chart page 71 a. Nov. 1 - 4k balance b. Nov. 2 - 5k deposit by check c. On what date was the 5k credit withdrawn? d. The Nov. 2 check was not paid because drawer issued a stop payment order on the check. (Claim is failure of consideration.) e. Depositary bank sues the drawer 3. The Nov. 3 4k withdrawal is considered to be withdrawal of the original balance. 4. The Nov. 5 withdrawal of 5k represents the withdrawal based on the Nov. 2 check. 5. So Nov. 5 is when there is a withdrawal of the credit given based on the Nov. 2 check. Because this withdrawal occurred before bank received notice of the dishonor on the check (which occurred on Nov. 6), the Bank is a HIDC. Obtained the check for value. iv. The policy is to protect those who have an out-ofpocket loss. So if a Bank has given out of its pocket, then it has given value. 1. Is this what occurred under these facts? 2. On Nov. 6, the bank still had 6k in this account. The bank had a statutory right to withdraw any credit it had given to depositor based on the check, and therefore could have taken the 5k amount of dishonored check out of the 6k balance – remove the credit, reduce the account down to 1k, making the bank whole. This would mean that the bank would have no out-of-pocket loss. Further, even if the customer’s account balance had been 0k, the bank could have sued depositor for the 5k. But still, the UCC says that the bank has given value. a. However, this is not very likely to happen in the commercial world. Because a Bank does not want to purchase the right to sue the drawer of a check. b. Arguably, in this hypo, this creates a windfall to depositary bank because bank could both sue drawer and revoke the credit from customer. c. The policy is to encourage banks to continue the common practice of allowing customers to write checks on their bank accounts based on funds that have not yet actually been received by the bank. v. **This particular problem is unrealistic: the numbers are all round and match up evenly. In the typical checking account, this would not occur. 1. Banks often only because HIDC for a portion of the check: the portion of the proceeds for which they have allowed withdrawal. 3. Article 9 Security Interest as Value a. UCC 3-303(a)(2) says that when the transferee acquires a security interest or other lien in the instrument (other than judicial lien), the transferee has given value i. Whereas Article 9 of UCC specifically addresses security interests broadly, pertaining to movable property b. Bowling Green, Inc. v. State Street Bank & Trust Co. i. Generally 1. Very influential case 2. Early in development of the law under the UCC 3. Federal First Circuit ii. Facts 1. SBA made a loan by $15,306 check to Bowling Green 2. Bowling Green then negotiated the check to Bowl-Mar to buy bowling equipment a. Conditional sales contract. The $15,306 was a down payment to Bowl-Mar. b. Bowl-Mar then deposited the check in State Street Bank’s account. 3. Immediately after the deposit, there was a $5,024 overdraft. The Bank first reduced the overdraft by this amount. 4. Bank then learned that Bowl-Mar went bankrupt. Bank then applied $10,047 of the check to other loans that Bowl-Mar owed to the Bank. 5. Bowl-Mar never delivered the equipment. 6. Bowling Green sues the Bank: claiming that the Bank was holding the check as trustee for Bowling Green. Asserting a property right in the check under 3-306. If the Bank is HIDC, then there can be no such property claim. iii. Statute, 4-210 1. First Issue a. The $5,024 is not at issue. Parties agree that value was given because bank reduced the customer’s overdraft by this amount. b. Under 4-210, this was an application of the proceeds. i. (a)(1) says that bank acquires a security interest when item is deposited, to extent that item has been withdrawn or applied. ii. In this case, there was no withdrawal, but there has been an application—the bank applied $5,024 to reduce the customer’s overdraft. c. Having this security interest = value, even if the application could subsequently be reversed. This used to be highly controversial. 2. The Post-Bankruptcy Application of $10,047 to Other Loans a. Argument that Bank knew of BowlMor’s bankruptcy, therefore knew that they wouldn’t deliver equipment to Bowling Green. Argument is that the Bank therefore had notice of Bowling Green’s defense… b. Bank must have given full value at the time check was received to be a HIDC. iv. Floating Lien 1. The bank had a floating lien on Bowl-Mor’s chattel paper a. This is a security interest in the chattel paper and proceeds thereof b. Under Article 9 lingo, a conditional sale contract like the one between Bowling Green and Bowl-Mor is chattel paper. The check, therefore, given to Bowl-Mor, constituted proceeds of the chattel paper. This means that the Bank had a security interest in the check, from the moment that it came into BowlMor’s hands. 2. When Bank became holder of the check, it became a HIDC because it had already given value by virtue of the Art. 9 security interest obtained upon receiving the check. 3. The floating lien is an arrangement where the secured party has a continuous security interest in a stream of collateral (e.g. inventory). The Bank had a floating lien over all Bowl-Mor’s chattel paper. 4. This opinion is critical because it read the UCC 3-303 broadly to say that when a bank acquires a security interest under Article 9 or outside the UCC altogether (including setoff or banker’s lien), the bank has given value. v. Banker’s Lien 1. Common law possessory right in a check by virtue of customer giving check to the bank and having pre-existing debts owed to the bank. vi. Set-off 1. Bank and customer have account. Once check is deposited and the bank collects, this represents a debt owed by the bank to its customer. 2. If customer then owes debt to the bank by obtaining a loan from the bank, the bank can set off the amount deposited on the check (which is really the debt owed by bank to the customer) against the customer’s debt to the bank. 3. This is called “compensation under the La. Civ. Code a. The old law was that there was no compensation unless the bank and customer had an express agreement b. Now, La. R.S. 6:316, banks have general right of compensation (set off) and bank also has a security interest by law in any checks that a customer deposits. This statute makes Louisiana have the same common law rule regarding set-off and banker’s lien. c. Bowling Green--how could bank have become a holder without showing that Bowl-Mor indorsed the check? i. Old Article 4-205 stated then when customer deposited, then the bank had the right to supply the indorsement. But here this did not happen. How could the court then say that the bank became holder of the check? This was very controversial. III. ii. The Revision sides with this court by providing under New 4-205 that where the customer is a holder, the depositary bank automatically becomes a holder, even if the customer does not indorse the check to the bank. d. Section 4-205 states that a depositary bank receiving a check for collection becomes a holder when it receives the check if the customer was then a holder, regardless of whether the check is indorsed by the customer. Liability of Parties to Negotiable Instruments a. Liability of Maker i. Liability of Parties in General 1. Several types of liability at issue in NIL a. Liability on the underlying transaction between maker and payee b. Liability of a party on the instrument itself i. This is contract liability assumed by a party by becoming a party to the instrument ii. The only way you can become liable on an instrument is by signing it c. Liability based on implied warranties imposed by statute ii. Liability of Maker 1. Simplest of rules of contract liability under Article 3: 3-412 a. A person signing a promissory note makes a contract to pay the instrument according to its terms at the time it was issued b. This is “primary liability,” in the sense that the person enforcing the instrument does not have to make any attempt to recover from anyone else 2. Hypo a. Movie company rounded up 20 investors for new motion picture. Each agreed to contribute $1 million. Company gets bank financing, and persuades all investors to sign single negotiable promissory note payable to the company for $20 million, which company showed to banks to induce financing. Some of the investors wish to now withdraw from the commitment to invest. To induce them to not back out, the company warns them that any one signer of the note can be sued for the full $20 million. b. Is the movie company correct in saying that one investor can be sued for the entire amount? i. YES. 3-412 and 3-116, the investor is the issuer who is primarily liable. ii. Under 3-116, where multiple parties sign an instrument in the same capacity, they become jointly and severally liable on the instrument. Any one or more of them can be sued for the full amount. (Same as solidary liability in Louisiana.) c. What rights does investor have against the other persons? i. Contribution. $1 million from each person. ii. Under 3-116, the amount of contribution that may be recovered is stated by extrinsic law of the states. But all the states have the rule of contribution. d. Important point is that a solvent co-obligor may have to pay the entire note. This is important to explain to any client who is thinking about co-signing a note. b. Drawers, Drawees, and Acceptors i. Problem, page 82 1. Facts: Drawer signs and delivers check for $1k to payee in payment for goods purchased. Check drawn on drawee bank. 2. Hypos a. Payee presents check to drawee and drawee dishonors because drawer stopped payment. i. Drawee is not liable on the check to payee because drawee did not accept under 3-408. A draft is not an assignment of funds from drawer to payee. 1. Because bank has not accepted by not signing, not liable. ii. Drawer is liable to payee because upon dishonor of the check, the drawer can be made to pay the payee or holder. b. Payee presents check to drawee for payment, and drawee dishonors even though no stop payment order had been received and drawer had sufficient funds in account to pay the check. i. Drawee not liable to payee. Drawer becomes liable to payee upon dishonor. ii. Drawee may be liable to drawer for wrongful dishonor. c. Payee presented check to drawee for acceptance; drawee certified the check. Payee presented certified check for payment. Drawee dishonored check because after certifying, received stop payment order from drawer. i. Drawee is now liable to payee for accepting the check, under 3-414(b). ii. Drawer is now not any longer liable to payee. The effect of the drawee accepting the check through certifying discharges the drawer’s obligation to payee. d. Drawee refuses to certify check when payee presents the check, even though drawer had sufficient funds. i. Bank had no obligation to certify the check. ii. A bank has no obligation to certify a check; the refusal to certify a check is not dishonor. ii. Fundamentals 1. When a draft is issued, no one is primarily responsible/liable on the draft at that point a. The drawee is simply the person to whom the order to pay is being made i. The drawee’s responsibility is to the drawer to act in accordance with their contract b. Upon dishonor of the draft, though, the drawer has an obligation to pay a PETE/holder. But this is secondary liability. Because the condition is dishonor by the drawee that triggers the drawer’s liability to the payee. i. However, a drawer may draw a draft “without recourse,” which under 3-414 means that drawer is not liable to payee under (e). But this cannot be done for a check under (e). Therefore, drawer writing a check cannot write “without recourse” on the check. A drawer using a check will always be liable to payee when check is dishonored by drawee. 2. Types of drafts a. Seller may make draft upon buyer i. Documentary draft ii. Often times the draft would have to be accompanied by a bill of lading showing that the seller has delivered the goods b. CHECKS i. Virtually everything we will discuss that is a draft is a check 3. Acceptance a. Draft can be accepted, which means under 3-409(a) that that the drawee has signed the draft i. Acceptance: Signed agreement to pay a draft as presented; may consists of drawee’s signature alone ii. **Do not confuse acceptance of a check with payment of the check. Acceptance is a technical term, referring only to some transaction by which the drawee undertakes the obligation to pay the instrument by virtue of drawee’s signature on the instrument. This is not the same as drawee paying the instrument to payee. b. Certification or other Acceptance i. Certification, This is a type of acceptance, 3-413 ii. The effect of acceptance is to make the drawee liable. Upon acceptance, drawee becomes obligated to pay instrument’s terms at that time. Drawee then becomes primarily liable. c. When drawee accepts, the drawer is discharged from the obligation to pay the instrument. d. In practice, commercial entities want the promise of a bank; not just a drawer’s draft ordering a bank to pay. This is why cashier’s or teller’s checks have meant that banks don’t in practice certify checks at all any more. It is much more convenient for banks to issue a check themselves, rather than certifying/accepting a drawer’s check. 4. Time Draft a. Presented first to drawee for acceptance, and then after the passage of some prescribed period of time, the draft is to be re-presented to drawee for payment. b. Often used in connection with letters of credit issued by a bank. c. Not payable on demand; payable only on the elapse of some period of time after the drawee’s acceptance. d. The refusal of drawee to accept a time draft is dishonor; whereas with other normal checks, refusal to accept a regular demand draft is not dishonor. iii. Problem page 85 1. Seller contracted to sell real property to buyer for $150k, payable on settlement date by certified check. Buyer arrived with uncertified check drawn on drawee. Seller refused to accept it; “I wanted a certified check from a bank.” Buyer got seller to call drawee bank to ask about buyer’s bank account balance; bank teller said there were sufficient funds. Teller also told seller that funds would be there when check was presented; teller then faxed in writing that bank would put holds on the funds so that they would be there. Later on, when seller presents the check for payment, drawee dishonors because of insufficient funds in account. Bank teller was mistaken as to the account balance. 2. To certify the check, the bank would have had to sign it; therefore, the fax was not an acceptance of the draft. There was no acceptance; therefore, drawee is not liable to seller. 3. This is the Harrington v. MacNab case: a. How else could drawee bank be held liable, outside of Article 3? b. There’s no consideration for bank’s promise to pay, so there is no general contract obligation payment. c. However, seller could not sue the bank in tort, the court said, e.g. negligent misrepresentation. i. The case could have been argued either way on this point. But this particular court found that it would not be appropriate to recognize a cause of action ii. This factual scenario doesn’t happen any more, because tellers are told to never discuss any information about the balance in a customer’s account, let alone say that they will put a hold on a customer’s account! d. Holmes didn’t address this, but what about promissory estoppel/detrimental reliance as a form of recovery?! c. Liability of Indorser i. UCC 3-415 1. Just like a drawer, an indorser of an instrument makes a contract to pay the instrument according to its terms at the time of indorsement. But like the drawer, the indorser’s liability is secondary. It is owed only upon dishonor of the instrument; conditional liability, just like with the drawer. 2. (b) By indorsing “without recourse,” (which is possible for any instrument including a check), the indorser can disclaim liability to pay the instrument. a. This is a good practice, highly recommended to us as attorneys, by the professor. b. Any time you indorse an instrument for purpose of transfer, for example a settlement check or loan closing check, should probably indorse without recourse. c. This insures that the indorser cannot be made thereafter to pay the instrument as an indorser. 3. Multiple Indorsers a. The obligation is owed to a PETE or subsequent indorser who paid the instrument b. Hypo i. On back of instrument, there are three successive indorsements (A B and C). ii. Therefore, if C paid the instrument, he could seek payment from either B or A. If B paid the instrument, he could seek payment from A. If A pays the instrument, he can seek payment from neither one. iii. Any one of them can sue either the drawer of the instrument or maker if it’s a note. c. Different rules apply where multiple indorsers indorse as co-payees, or where there are multiple indorsements by sureties (aka accommodation parties). ii. Problem, page 85 1. #1 - Employer sent Peter his paycheck, drawn on Bank One. Peter indorsed in blank and deposited the check in Bank Two. Bank Two gave immediate credit in account and Peter withdrew before Bank Two learned that Bank One had dishonored the check because employer was insolvent. a. When Peter indorsed and deposited in his account, he thought he was just indorsing for purpose of collecting. b. But by indorsing, he has legally guaranteed payment of the check. Therefore, Peter is liable to Bank Two if Bank Two chooses not to proceed against the insolvent employer. 2. #2 – Seller sold real property to buyer. Financed $25,000 of the $100,000 purchase price. Seller was willing to finance $20,000 himself. At closing, buyer executed the 20k note and a second mortgage securing payment of the 20k to seller. Investor third party purchased the note from seller for 15 cash. Seller indorsed in blank and assigned mortgage to investor. Buyer defaulted in payments on the note. Under states that have this particular law, investor could not sue buyer. Can investor sue seller? a. Seller is liable for full amount of the note to investor because seller is an indorser. b. Seller should have negotiated for “without recourse.” c. Problem once again shows that indorsers are often not aware that they are liable by indorsing an instrument. i. Particular hardship in this case because not only must seller pay on the note that he should have been receiving, but also under this particular state’s antideficiency law he is not able to sue the buyer! iii. Dishonor and Notice of Dishonor 1. See text and 3-502—3-504 2. Practically speaking, this is rarely an issue for indorser liability a. Banks that have remedies against an indorser often have other more efficient remedies under Article 4 d. Liability of Transferor i. Transfer Warranties 1. 3-416(a) a. A person who transfers an instrument for consideration warrants to the transferee, and if the transfer is by indorsement, to any subsequent transferee: i. The warrantor is a PETE ii. All signatures on the instrument are authentic and authorized iii. The instrument has not been altered iv. The instrument is not subject to a claim or defense of recoupment that can be asserted against warrantor v. Warrantor has no knowledge of insolvency proceeding commenced with respect to maker or acceptor, or in case of unaccepted draft, the drawer. b. (b) If there is breach of transfer warranty, the warrantor is liable for damages equal to an amount equal to the loss suffered as a result of the breach, but not more than the amount of the instrument plus expenses and loss of interest incurred as a result of the breach. 2. Problem, page 87 a. Maker signed and delivered note to payee. Payee, who fraudulently induced maker to issue the note, indorsed without recourse and sold to Holder. Holder presented the note to maker. Maker refused to pay because of fraud. i. Holder has rights against payee as transferor. Under 3-416(a)(4) the instrument was subject to a defense against warrantor, therefore the payee/indorser/transferor violated warranty. ii. A without recourse warranty only disclaims the basic indorser contract liability. Writing “without recourse” only negated the payee’s liability as indorser, under 3-416(c). But writing “without recourse” does not negate the transferor’s liability as warrantor of transfer warranties. iii. Transferor would have had to write “without warranties” to disclaim the transfer warranties. 1. However, under (c), the transfer warranties cannot be disclaimed with respect to checks. ii. More to come much later. e. Cashier’s Checks and Teller’s Checks i. Use in Payment of Obligations 1. Generally a. Prior to 1990, there was very little statutory law about cashier’s and teller’s checks. b. Therefore, for decades courts had to grapple with whether checks issued by banks should be treated differently from checks issued by individuals. The case decisions were inconsistent. c. 3-104(f) “Check” is a draft payable on demand and drawn on a bank; it includes cashier’s and teller’s checks. d. Cashier’s check is a check in which the drawer and drawee are the same bank. A draft drawn by a bank upon itself. i. Imposes the same liability upon issuer of a cashier’s check as the maker of a note. Primary liability exists upon the bank issuing the cashier’s check. e. Teller’s check is a draft drawn by a bank upon another bank. i. This is often used by smaller banks or credit unions, in small communities, in which the drawee is often a federal reserve or bigger bank. ii. The drawee bank has no liability generally until the bank accepts it. iii. The drawer is liable in the same way that any other drawer is. Secondary liability; only liable if the check is dishonored by drawee. iv. The drawer bank of the check can stop payment like any other drawer by issuing a stop payment order upon the drawee bank. 4-403. 2. UCC 3-310 a. (a) Fundamental difference between an uncertified check and certified cashier’s and teller’s checks (“c/t check”): when c/t check is taken for payment of an obligation, this discharges the obligation the same as if the obligee had taken cash. i. When someone agrees to take a c/t check, they agree they are giving up other rights against the person giving the check. b. (b) Uncertified check simply suspends the underlying obligation until either payment or dishonor (if subsequently paid, obligation is discharged, if dishonored, then the suspension is lifted). At that point obligor can be sued on underlying obligation or upon the instrument. 3. Problem, page 90 a. Seller contracted to sell goods to buyer with payment by cashier’s check. Buyer purchased the cashier’s check for 10k from bank made payable to seller. Before delivering the check to seller, buyer found out that seller intended to not comply with the contract. Buyer asked bank to return the money buyer paid to issue the check, but bank delayed. Is buyer, the remitter, a PETE? b. 3-103(11) Remitter – a person purchasing an instrument from its issuer if the instrument is payable to an identified person other than the purchaser. (Practically speaking, this is a c/t check). i. A fundamental reason for buyer being a remitter in paying seller, is that the buyer does not have to indorse a check, which would incur personal liability. C/T check allows the person purchasing the check to avoid liability on the instrument. ii. The seller’s reason is to have a reliable indication that it will get payment, rather than just a check written by the buyer; get a bank on the hook, the promise of a bank to pay. c. The prevailing view is that buyer is not a PETE. But there are new comments to 3-301 that say that a remitter is a PETE. i. Why this change in the comments to say something contradictory? ii. Buyer obviously is not a holder; there was no negotiation of the instrument to him. He could only be a nonholder in possession of the instrument with the rights of the transferor. Perhaps, the comments are trying to say that the buyer is entitled to a refund on the check. Just an indication to the courts that because the bank has debited customer’s account for the cashier’s check, the bank has no excuse for not taking the check back and re-crediting the customer’s account. iii. We could have reached this same result through theory of unjust enrichment. ii. Payment With Notice of an Adverse Claim 1. Right to Stop Payment a. Generally i. Often a dispute arises after check is given to seller. Buyer wants to insure that seller does not end up with his money. ii. UCC 4-403(a) A payor bank wrongfully dishonors an item if it dishonors an item that is properly payable, but a bank may dishonor an item that would create an overdraft unless it has agreed to pay the overdraft. iii. “Customer” is a person with an account at the bank at issue. b. The Right: 4-403(a) A customer may stop payment of any item (check) drawn on customer’s account by order to bank describing the item with reasonable certainty in time for the bank to act. i. The customer has a broad right. As long as he describes the item and gives reasonable time to the bank to act. ii. Page 91 1. Problem 1 – Buyer got cashier’s check payable to seller from Bank A. Bank A debited buyer’s account for the amount of the check, and Buyer delivered check to seller; seller did not deliver goods. Buyer suspected fraud, so he demanded seller give check back; seller refused. Buyer contacted Bank A to stop payment on the check. Under the statute, there is no right to stop payment because the buyer is a customer of Bank A, but the draft was not drawn on his account; the bank drew the draft on the bank’s own account. Therefore, the buyer has no right to stop payment on a cashier’s check. a. The 1990 Revision made it clear that the person buying a cashier’s check has no right to stop payment. b. The bank that issued the check may decline to pay, but this is not because of a stop payment order. 2. Problem 2 – Same, except Bank A issued teller’s check drawn on Bank B payable to order of seller. Buyer ordered Bank B to stop payment. a. Once more, the check was not drawn on buyer’s account, so buyer has no right to stop payment. b. On the other hand, Bank A can stop payment on the check because Bank A is the customer of Bank B and the check was drawn upon Bank A’s account with Bank B. But Bank A is not obliged to stop payment on buyer’s behalf; Bank A may do so. 2. Issuing Bank Refuses/Delays Payment a. Issue: What happens when the bank issuing the check refuses to make payment? b. Problem p.92 i. Seller wants cashier’s check from buyer. Buyer got cashier’s check from Bank payable to order of seller and delivered to Buyer. Buyer gave check to seller but then experienced “buyer’s remorse” and asked seller to call off the deal; seller refused. Buyer demanded that Bank not pay the check (“Just do it!”), promising to reimburse it for any litigation expenses if Seller pressed claim against Bank. ii. Should the Bank go ahead and pay the Seller on the check, or comply with Buyer’s demand? 1. 3-411 governs the Bank’s exposure: compensation for expenses of litigation (comments say this includes attorney’s fees), interest, and losses, as well as consequential (special) damages, as long as the Bank is on notice of the circumstances giving rise to consequential damages. 2. 3-411 makes a Bank liable for refusing to pay a cashier’s check to a PETE, the Seller in this case. 3. Therefore, the Bank should pay the instrument to Seller and should not listen to Buyer’s demands just in the interest of maintaining good relations with its customer/the Buyer. c. The policy in 3-411 is meant to discourage banks from refusing to pay cashier’s checks d. 3-411 Discussion i. Assume instead that the Buyer does not have buyer’s remorse, but rather believes he has been defrauded, and demands that the Bank not pay the check to Seller. 1. This should not make a difference because of the merger doctrine. 2. 3-602(a) An instrument is paid to the extent payment is made by or on behalf of a party obliged to pay to a person entitled to enforce. To the extent of payment, obligation to pay is discharged even though payment is made with the knowledge of a claim to the instrument by another person. a. The fact that the buyer may say he has been defrauded, and has an extrinsic legal right to have the transaction rescinded is irrelevant. b. The bank does not have to get involved in the dispute between the Buyer/customer and the Seller. c. The Buyer cannot force the bank to become the referee. 3. The bank has no way of knowing whether the Buyer/customer is telling the truth. 4. Thus, the rule is that the bank does not have to take the risk; as long as the bank pays a PETE, the bank receives a discharge of the obligation to pay. a. The Seller is a holder and has possession; therefore, he is a PETE. b. Bank receives discharge through paying the Seller. ii. Buyer’s Recourse 1. What can buyer do when he believes he has been defrauded by seller, after having purchased a cashier’s check made payable to seller? 2. 3-602(b) The obligation to pay is not discharged if a claim is enforceable against the person receiving payment and payment is made with knowledge by the payor that payment is prohibited by injunction of a court. a. So the buyer’s recourse is to get a court injunction that forbids the bank from paying. b. If the bank has (actual) knowledge of the injunction and pays anyway, the bank will be liable to the customer. Buyer needs to ensure that bank has been served with the injunction so that the bank will have actual knowledge. 3. If it’s not a c/t check, 3-602(b)(ii): “in the case of an instrument other than a cashier's check, teller's check, or certified check, the party making payment accepted, from the person having a claim to the instrument, indemnity against loss resulting from refusal to pay the person entitled to enforce the instrument.” This is saying that if the party making payment [bank] previously accepted from the buyer indemnity against loss resulting from refusal to pay the PETE, the obligation is not discharged by paying the seller, if the buyer had a claim to the instrument. iii. Regardless of the law, banks often refuse to pay the seller because they want to maintain the goodwill of their customers. 1. Therefore, seller will sue the bank to receive payment from the bank. 2. Bank would want to then third-party sue the buyer to bring him into the lawsuit. 3. 3-305(c) In an action to enforce obligation to pay the instrument, the obligor may not assert a defense, claim in recoupment, or claim to the instrument of another person… a. In general, someone obligated on the instrument cannot assert the rights of a third person to resist payment of the instrument. b. This is the doctrine of jus tertii – cannot assert rights of third persons. 4. 305(c) continued “, but the other person’s claim to the instrument may be asserted by the obligor if the other person is joined in the action and personally asserts the claim against the PETE. a. So if the buyer is joined in the action and asserts his claim to the instrument, the bank can also assert this right against the seller/PETE. b. The court can then decide on the merits whether the buyer is correct in his assertion. iv. Therefore, if bank does refuse to pay the PETE/seller, the bank should join the buyer in the action to be able to assert the buyer’s claim to the instrument. 3. Issuing Bank’s Right to Raise Own Claims or Defenses a. Pre-Revision Law i. Cases were split ii. The majority rule was the cash equivalents theory – a bank as obligor on a c/t check is absolutely liable. No defenses at all were available. iii. This was because of a perceived need to enhance the commercial viability of these instruments. iv. The cash equivalent theory was problematic—it had no basis in statute. It was a common law theory developed by the courts b. Revised Law i. 3-411(c) Expenses or consequential damages are not recoverable if the refusal of obligated bank to pay occurs because: 1. Bank suspends payments 2. Obligated bank asserts a claim or defense of the bank that it has reasonable grounds to believe is available against the PETE 3. Obligated bank has reasonable doubt whether person demanding payment is the PETE 4. Payment is prohibited by law; 5. or R.S. 10:3-312 is applicable (re: lost c/t checks). ii. Key in on #2 – If obligated bank has reasonable grounds to believe it has its own claim or defense against the PETE, the bank can refuse to pay the c/t check. c. Page 99 problem i. Rolando/buyer gets certified check from Bank One. Pays Bank One with a check drawn on Bank Two. Rolando delivered check to Parsons/seller. Bank One dishonored the certified cashier’s check because Rolando’s check drawn on Bank Two had been returned by Bank Two for insufficient funds. ii. In other words, fraud or failure of consideration between Bank One and Rolando existed (because Rolando’s check in payment of cashier’s check bounced). iii. Issue: What is reasonable grounds to believe that Bank One’s defense (fraud in the inducement or failure of consideration) is “available against the holder”? Because Parsons may very well be a HIDC. iv. The State Street case, res nova opinion, concluded that the Bank could raise the defense and still be free of sanctions, even if it turned out that Parsons was a HIDC. Professor thinks that this is right 1. The statutory language is ambiguous. But from a policy perspective it makes sense that “reasonable grounds to believe the defense is available” allows the Bank to not be liable to Parsons because Bank has its own defense on the instrument. 2. The Bank has no way of knowing whether the holder is a HIDC when the Bank refuses to pay the check, so the Bank should be able to raise the defense, even if the merits of the case later show that the holder was a HIDC. 4. Lost Instruments a. Lost Instruments Under Section 3-309 i. Generally 1. A PETE includes a person who lost the instrument but has rights of enforcement 2. 3. 4. ii. 3-309 1. Instrument may be lost, stolen, or destroyed UCC 3-309 (a) addresses standing (b) addresses burden of proof (a) A person not in possession of an instrument is entitled to enforce the instrument if a. (i) The person was in possession of the instrument and entitled to enforce when the loss of possession occurred, b. (ii) Loss of possession was not result of transfer or lawful seizure, and c. (iii) Person cannot reasonably obtain possession of the instrument because it was destroyed, its whereabouts cannot be determined, or it is in the wrongful possession of an unknown person or a person that cannot be found or is not amenable to service of process. 2. (b) A person seeking enforcement under (a) must prove the terms of the instrument and the person’s right to enforce the instrument. The court may not enter judgment for the person seeking enforcement unless it finds that the person required to pay the instrument is adequately protected against loss that might occur by reason of a claim by another person to enforce the instrument. Adequate protection may be provided by any reasonable means. iii. Problem, Page 100 1. Illustrated a glitch in the statute 2. Maker borrowed 100k from bank and evidenced its loan by note payable to order of bank. Bank failed, so FDIC acquired the note when it became receiver for bank. FDIC sold note in a batch of several hundred notes to Pooler. Later FDIC disclosed to Pooler that it lost the original note before sale and that possession of the note had never been delivered to Pooler. Pooler brings suit against Maker under 3-309 on a lost note. 3. The problem is that Pooler was never in possession of the note under 3-309(a)(i). In order to bring an action under the statute, the claimant must have been in possession of the note at time loss of possession occurred. It was the FDIC and not Pooler that was in possession at the time the note was lost. 4. The case held that the plain words of the statute did not allow Pooler to have a right of action. 5. Statute was amended to say you have to prove one of two things: either in possession at time it was lost, or acquired ownership from a person that was entitled to enforce at the time possession was lost. But this 2002 Amendment has not been adopted by many states. b. Lost Cashier’s, Teller’s or Certified Checks Under Section 3-312 i. 3-309(b) 1. Stiff burden of proof: prove terms of the instrument and how the claimant became a PETE. If that proof is made, the court cannot enter judgment unless the person required to pay is adequately protected against loss that might occur by a HIDC showing up and demanding payment. 2. So the threat of double liability is the ultimate problem with a lost instrument; the obligated person who pays someone claiming to have lost the instrument may have to pay a second time to a HIDC. 3. Diaz v. MHTC a. Pre-1990 law not every state took the same approach to what constituted “adequate protection” i. This is why we currently have 3-312 which deals exclusively with c/t checks b. Facts i. Plaintiff/payee had two cashier’s checks and lost them. Asked for money from the obligated bank. ii. Obligated bank required a bond in twice the face value of the checks. The plaintiff could not afford to post this bond. c. Court: Has no discretion, but must enforce the statute providing that security shall be required in not less than twice the amount allegedly due under the instrument. Plaintiff had to post the bond or she could recover nothing. d. Tough result because the state did not have a statute of limitations for cashier’s checks; therefore, there was no law addressing how long security had to remain posted. The security would have to remain posted forever. ii. 3-312 1. Applies only to c/t checks, certified checks, and in Louisiana, money orders. 3-312 is a more desirable alternative than 3-309 on general lost checks. But you can choose which one to proceed under if you have a c/t check. 2. (a) Definitions a. Check means c/t check b. Claimant c. Declaration of loss d. Obligated bank 3. (b) A claimant may assert a claim to the amount of a check by a communication to the obligated bank describing the check with reasonable certainty and requesting payment of the amount of the check, if (i) the claimant is drawer or payee of certified check or the remitter or payee of a c/t check or money order, (ii) the communication has a declaration of loss, (iii) communication is received at a time and manner affording the bank a reasonable time to act on it before the check is paid, and (iv) claimant provides reasonable identification if requested by the obligated bank. If a claim is asserted in compliance with this Subsection, the following rules apply: a. (1) The claim becomes enforceable at later of time that claim is asserted or 90th day following date of the check. b. (2) Until claim becomes enforceable, it has no legal effect and obligated bank may pay the check. Payment to a PETE discharges all liability. c. (3) If the claim becomes enforceable before the check is presented for payment, the obligated bank is not obliged to pay the check. d. (4) When claim becomes enforceable, the obligated bank becomes obliged to pay the amount of the check if payment has not been made to a PETE. Payment to the claimant discharges liability. 4. (c) If after bank pays the claim, and check is presented by person who has rights of HIDC, the claimant has to either refund payment to obligated bank or pay amount of check to the HIDC. iii. Problems, page 103 1. Background: Claimant purchases cashier’s check on January 2. 2. (#1) Thief stole claimant’s purse containing the check. Check had not been indorsed by claimant. Claimant asked for stop payment, but First Bank said that she would have to come in and fill out a declaration of loss, and she could get her money 90 days after date of check. If she wanted money immediately, had to file a bond. January 6, she signed the form asserting a claim, including declaration of loss under 3-312. Thief indorsed forged claimant’s signature and deposited at Second Bank on January 8. Check was promptly presented to First Bank for payment. Thief ran off with the proceeds. Claimant 90 days from date of check demanded payment from First Bank. a. Claimant has standing under the statute. b. Proceeding under 3-309, the court would have to find that First Bank is adequately protected against multiple liability. The court could “freeze” the funds—put them in a restricted account until the statute of limitations ran on the instrument (3118). Or require the posting of a bond. This is why 3-312 was added. c. Thief could not become a holder of the instrument because he forged the indorsement. Therefore, payment of the check to the thief did not discharge First Bank. Because neither Thief nor Second Bank was a PETE. Therefore, 90 days runs, and then Claimant may demand payment. d. If First Bank pays to thief and then claimant also, what rights does First Bank have against Second Bank? i. First Bank can recover from Second Bank. Because of presentment warranties (Chapter 5). 3-417 ii. Then Second Bank will have to pursue Thief for breach of transfer warranties. 3. (#2) Change facts above. Claimant indorsed the check by writing her name on the back; mailed the check to sister. But Thief stole check from the mail and deposited it at Second Bank. By January 10, Claimant realized something happened to check. Went to First Bank and requested stop payment; instead was told to do declaration of loss. 90 days Claimant sought payment on the check. a. The problem is that Claimant indorsed the check, it became bearer paper, so it became negotiated by involuntary transfer of possession to Thief. Thus Thief became a holder/PETE, and when he deposited with Second Bank, the Bank became a holder/PETE. b. During the 90 day period, the payment to the PETE/thief discharged First Bank’s obligation to pay. c. Thus the loss falls on Claimant. She should not have indorsed the check before placing it in the mail. 4. (#3) Change facts again. Check deposited by Thief in Second Bank on May 10. Second Bank promptly presented check for payment by First Bank. At time of presentment for payment, First Bank had already paid the Claimant because 90 days had elapsed since date of the check. First Bank dishonors the check when Second Bank presents it. a. Does Second Bank have rights against First Bank or Claimant? b. No rights. Because under (b)(3) if claim becomes enforceable before presentment, the bank is not obliged to pay the check. And payment to claimant after it becomes enforceable discharged First Bank’s liability. c. Therefore, after 90 days, claim became enforceable and obligated bank had to pay claimant. And this payment discharged First Bank’s liability, such that not liable to pay Thief later on. d. Note that under 3-312(c) if Second Bank was a HIDC, then this would complicate things. But here, Second Bank is not HIDC because the instrument was overdue at the time that the instrument was negotiated to Second Bank (a check is overdue after 90 days). e. However, Claimant has potential indorser’s liability to Second Bank. i. But under 3-415(e) unless check is either deposited with depositary bank or presented to drawee bank within 30 days of indorsement, the indorser’s liability is discharged. ii. Here, it was long over 30 days, so her liability as an indorser was discharged also. f. Accommodation Parties i. Liability of Accommodation Party and Rights Against Accommodated Party (3-419) 1. Accommodated Party is Individual a. Generally i. Practically speaking, while an accommodation party can be anyone who signs an instrument in any capacity, for the most part accommodation party issues arise in the context of promissory notes. ii. Every state has a general law of suretyship applicable outside of the law of negotiable instruments. See La. Civ. Code arts. 3041-3062 (be familiar with these). This presents the problem that general suretyship law is not the same as Article 3 suretyship. b. Problem, page 104 i. Bank would lend Son 25k only if Mom cosigned note. Mom did so by signing lower right hand corner on face of note. Bank then advanced the money. Proceeds used in Son’s business. Son defaulted; Bank asked Mom to pay. Mom estranged from Son. ii. Mom is a co-maker on the note; therefore she is solidarily bound (jointly and severally liable) for the whole thing (3-116). 3-419(b) she is liable in the capacity in which she signs, even as an accommodation party, even though she has received no direct benefit (did not receive any of the funds). Nothing requires proceeding against the Son first. iii. If she pays, she has the right to demand reimbursement (the entire amount) from Son. 1. Ordinarily several obligors receive only contribution from each other. 2. But here she gets reimbursement under 3419(e). iv. Son has no right of recourse against the Mom because accommodated party under 3-419(e) has no right of action against the accommodation party. v. This problem demonstrates that a solvent accommodation party will probably be called upon to pay first. 1. Mom was lending her credit for the benefit of her son. c. Problem, page 106 i. Bob/Ted borrow money from Bank to set up business. Bob’s parents and B/T’s wives are required to cosign by the bank. Ted defaulted. Bank demanded payment from the parents. ii. They signed as makers because they signed on the front of the note, as opposed to the back, in which case they would be indorsers. 1. Regardless of how you sign, you can still be an accommodation party, as long as you sign for the purpose of incurring liability, without being a direct beneficiary of the value given. 2. Under 3-419(b), an accommodation party can sign as maker, drawer, acceptor, or indorser. a. A maker, for example, can still be a surety. b. It’s not true that only an indorser can be a surety. i. Still some courts don’t realize this. ii. The confusion comes from the fact that indorser liability is only secondary (triggered by dishonor of the instrument by another party). c. A co-maker of a note can be a surety. iii. The nature of co-maker’s obligation is to pay the instrument voluntarily. Makers and co-makers are primarily liable. iv. UCC 3-419(b) Basic rule is that an accommodation party is obliged to pay the instrument in the capacity in which the accommodation party signs. It doesn’t matter whether the accommodation party receives consideration for being an accommodation party. 1. The contract liability on the instrument is the same as any other party signing the instrument in the same capacity. If accommodated party is maker, liability is the same as any other maker. 2. So what is the difference between accommodated party-maker and just pure maker? As accommodation party, there may be the benefit of special defenses, as long as the person seeking to enforce the instrument has notice of accommodation party status. 3-419(c): Person signing an instrument is presumed to be an accommodation party, and there is notice of their status if there is an anomalous indorsement or words indicating that the signer is a surety or guarantor. a. In other words, except for some special defenses available under UCC 3-605 (not in Louisiana statute), contract liability is not affected by the fact that person taking the instrument had notice that you signed as an accommodation party. b. Anomalous indorser – this constitutes notice to person enforcing that you are signing as an accommodation party. i. 3-205(d) Anomalous indorser – an indorsement by someone other than a holder of the instrument. Therefore, an indorsement by someone who signs solely for the purpose of incurring liability. Not a holder; signature is not necessary for negotiation, so the only reason to sign is to incur liability. ii. When there are ordinary serial indorsements, as among each other, an indorser is liable to a subsequent indorser. They are liable in the order in which they sign. iii. If indorser indorses anomalously, they are jointly and severally liable. Among themselves, they have rights of contribution c. A holder has notice of accommodation party status if he has actual knowledge or constructive notice through words on the instrument indicating the party’s accommodation status. d. Under common law and many state statutes, before creditor can pursue a surety, he must exhaust all rights against principal obligor. This used to be Louisiana law. Called “discussion.” Usually waived by suretyship agreements. In Louisiana, the obligor does not have to pursue the principal obligor first. v. 3-419(d) If signature of party to an instrument is accompanied by words indicating unambiguously that the party is guaranteeing collection rather than payment of the obligation of another party to the instrument, the signer is obliged to pay the amount due to PETE only if (i) execution of judgment against other party has been returned unsatisfied, (ii) other party is insolvent, (iii) other party cannot be served with process, or (iv) it is otherwise apparent that payment cannot be obtained from the other party. 1. So Parents and spouses should have indicated unambiguously that they were only guaranteeing collection, on the face of the instrument. Absent putting such unambiguous language, in signing the note they are primarily liable, though they still have certain suretyship defenses. vi. If accommodated party pays, can’t get anything from accommodation party. vii. If accommodation party pays, he can get full reimbursement from any accommodated party(ies). viii. If this was a community property state, the spouses would not be indirect beneficiaries; they would be direct beneficiaries so they would be co-owners of the business and therefore may become accommodated parties. ix. Assuming separate property state, there are four accommodation parties. 1. If parents pay, how much can they recover from spouses, the other accommodation parties? The right of contribution (25% each) among each other. Accommodation parties can recover contribution among each other. 2. However, if one accommodation party is insolvent, then the remaining three are each liable for 1/3. 2. Accommodated Party is Business Organization a. Problem, page 106–07 i. X owned 50% of stock of Corporation and also was President. Y and Z were officers who owned 25%. Corporation needed a loan and the note was signed: 1. Corporation By X, President X, individually 2. By signing first as representative, the president was not incurring personal liability. 3. But here, X also signed in his individual capacity. Intended to impose liability on him individually. ii. The loan was used entirely for corporate purposes. X paid the bank the entire 10k balance upon default. iii. Issue: Is X treated separately from Corporation as a distinct person, or are they indistinguishable, such that payment of the loan proceeds to Corporation was payment to X, such that X was a direct beneficiary? 1. There is no indication that we should pierce the corporate veil under these facts. Therefore, X should be treated as an accommodation party. If we pierced the veil, then X would not be an accommodation party; he would be treated the same as the Corporation, the maker of the note. 2. X only receives an indirect benefit by being a 50% shareholder; therefore he is treated as an accommodation party and can get reimbursement from the Corporation based on having paid the debt. b. Plein v. Lackey i. Facts 1. Corporation purchased property and in payment gave a promissory note for 75k and a mortgage securing payment (deed of trust) 2. Signed by corporate officers, representatives of the corporation. Also signed by the President and his wife, individually. This made President and wife jointly and severally liable because they are co-makers. 3. President paid off the note and so President received the mortgage note. 4. President argues that he as holder of the note and assignee of the mortgage has a first mortgage on the property. Wants to foreclose on the property and apply the proceeds to satisfy the note. He argues that as an accommodation party he can now pursue the accommodated party. ii. Issue: Is the President an accommodation party subrogated to the seller’s rights? Or is he a principal debtor, in which case the debt has been extinguished? iii. Court: President was an accommodation party 1. Only an indirect beneficiary; received no direct benefit of the proceeds of the instrument 2. Common law rationale that the bank would not have issued credit but for the President’s signature on the instrument iv. Under 3-419(e) when President paid the note, he now has the right to enforce it against the accommodated party ii. Suretyship Defenses 1. Background a. Sureties are extended certain rights and privileges that other obligors in the same position do not enjoy i. Sureties are in a favored position in the law ii. Historically, surety was gratuitous iii. When surety gives a helping hand without compensation, this is favored iv. The trade-off is that the law will give special rights and privileges b. For example, the obligee must exhaust its rights against the obligor before pursuing the surety. This is no longer the law, unless the surety unambiguously indicates that his signature is only guaranteeing collection of the instrument. c. Suretyship law has historically extended some special defenses to sureties i. The defenses arise out of transactions between the accommodated party/obligor and the creditor. The surety does not consent to these transactions. ii. Four categories: 1. Creditor discharges or releases the principal obligor from the obligation entirely (3-604) 2. An extension of time to pay 3. Other modifications of the principal debt; for example, an increase in the interest rate 4. Release of collateral iii. The surety who hasn’t consented may have his risk/burden increased by these transactions 1. Surety sometimes can raise these changes as a defense to payment d. The revision of UCC 3-605 and Restatement of Suretyship had some conflicting rules e. Modern: 3-605 was rewritten to make it consistent with the Restatement, making the rules even more complicated i. Louisiana has not adopted 3-605 ii. Louisiana addresses the issue in the Civil Code 2. In modern commercial transactions, these defenses often mean nothing because they are almost always waived in agreements 3. Civil Code a. Art. 3059 – The extinction of the principal obligation extinguishes the suretyship. i. If the obligation on the instrument terminates, the surety is always immediately released. ii. This results from the nature of accommodation. If the principal debtor is released, the surety is released automatically. b. Types of suretyship i. Legal suretyship – not an issue in negotiable instruments. ii. Commercial suretyship, Art. 3052 – One in which: 1. The surety is engaged in a surety business 2. Principal obligor or surety is a business association 3. The principal obligation arises out of a commercial transaction of the principal obligor; or 4. The suretyship arises out of a commercial transaction of the surety iii. Ordinary suretyship, Art. 3044 – One that is neither commercial nor legal. iv. Commercial suretyship is defined very broadly, but it does not include any requirement that the surety be compensated. c. Modification of the Principal Obligation (Art. 3062) i. Modification or amendment of the principal obligation, or impairment of real security held for it, by the creditor in any material manner and without consent of the surety, has the following effects: 1. For ordinary suretyship, the suretyship is extinguished. Regardless of whether there is any harm/risk to the surety. a. For example, parent guarantees child’s student loan. If there was no waiver in the agreement, and the principal obligation is changed, the parent is discharged. 2. A commercial suretyship is extinguished to the extent that the surety is prejudiced by the creditor’s action, unless the principal obligation is one other than for the payment of money [never true for negotiable instruments—this situation exists in construction contracts], and the surety should have contemplated that the creditor might take such action in the ordinary course of performance of the obligation. The creditor has the burden of proving that the surety has not been prejudiced or that the extent of the prejudice is less than the full amount of the surety’s obligation. a. Once the surety has established a modification or impairment of collateral, unless the creditor proves no prejudice or prejudice less than the full amount of the debt, the surety is off the hook entirely. iii. Accommodation Party Raising Defenses of Accommodated Party 1. Jus tertii – one obliged to pay the instrument cannot usually raise defenses of third parties unless they are joined in the lawsuit 2. But there is an exception in 3-305(d): a. If the action is against an accommodation party, there is no necessity of joining the accommodated party in the action, and the accommodation party may assert any defense or claim of the accommodated party to payment, except for the defenses of discharge in insolvency proceedings, infancy, and lack of legal capacity. b. So an accommodation party can raise accommodated party’s defenses generally, without necessity of joinder of the accommodated party. g. Signatures by Representatives i. Liability of Agent on Notes 1. Background a. The issue is often litigated whether the representative who signs an instrument is liable on the instrument 2. Statute: 3-401 a. One cannot be liable on the instrument unless that person signs the instrument or the person is represented by an agent who signs the instrument and the signature is binding on the represented person under 3-402. b. Signature is defined broadly to include a mark with the present intention to authenticate a writing 3. Signature by Representative: 3-402 a. (a) Liability of the Principal i. The statute is doing nothing more than incorporating by reference the state law of agency/mandate. ii. If person acting as representative signs instrument by signing either name of principal or name of signer, the represented person is bound by the signature under extrinsic state law of agency. If represented person is bound, the signature of the representative is the “authorized signature of the represented person” and the represented person is liable on the instrument, whether or not identified in the instrument. b. (b) Liability of the Representative i. If representative signs the name of representative to the instrument and the signature is an authorized signature of the represented person, the following rules apply: 1. If the representative signs and he does not have the agency power to bind the purported represented party, then we get to 3-403, which states that the signatures binds no one but the representative. ii. (1) If the form of the signature shows unambiguously that the signature is made on behalf of the represented person who is identified in the instrument, the representative is not liable on the instrument. iii. (2) Subject to special rules on checks in (c), if (i) the form of the signatures does not show unambiguously that the signature is made in a representative capacity, or (ii) the represented person is not identified in the instrument, the representative is liable on the instrument to a HIDC that took the instrument without notice that the representative was not intended to be liable on the instrument. With respect to any other person, the representative is liable on the instrument unless the representative proves that the original parties did not intend the representative to be liable on the instrument. 4. Page 114, Problems a. Treasurer is authorized to pay promissory notes on behalf of New Corp. b. #1 – She does not want to incur personal liability in signing the promissory notes, that will evidence bank loans and credit made to the company. How should she sign the notes, to gain full protection from liability under 3-402(b)? Write “New Corp., Inc., by Carolyn Park, Treasurer.” i. This format will ensure that she will not incur personal liability, even to a HIDC. ii. She has (i) named the represented party and (ii) unambiguously shown that she is acting on behalf of the represented person. It is unambiguous by using the longstanding custom of the word “by” showing that she is acting for someone else. c. #2 – Are the following signatures “ambiguous”? i. New Corp. Inc., by Carolyn Park 1. No indication of capacity as “treasurer” 2. But the comments indicate that this is still unambiguous ii. New Corp.. Inc., Carolyn Park, Treasurer 1. Comments indicate this is unambiguous, even without the word “by” because the corporate capacity of “treasurer” is indicated iii. Carolyn Park, Treasurer 1. Ambiguous iv. New Corp Inc., Carolyn Park 1. Ambiguous v. Any deviation from the customary form will be treated harshly by the courts. So just use “by” and indicate the person’s corporate capacity. d. #3 – Carolyn signs a note authorized by New Corp. merely by writing her name, “Carolyn Park.” i. Generally 1. This scenario is fairly common: a. Agent signs a form piece of paper, and then corporation says it will later fill in the rest of the blank form. And eventually the instrument is given to a third party, and only the agent’s name is on the note. ii. The modern law varies from the pre-1990 law. 1. The original law would have been that New Corp. would not have been liable. Under the common law, New Corp. would not have been liable unless it would have been named in the instrument. 2. Modernly, under 3-402(a) the represented person, New Corp. is liable even though not identified 3. Carolyn’s Liability a. If the person seeking payment is a HIDC, then Carolyn is definitely liable on the instrument because her signature did not indicate unambiguously that she was signing in a representative capacity. b. If not a HIDC, then Carolyn can defend by showing that under (b)(2) there was an understanding between the original parties that the representative would not be liable on the instrument. c. The generally rule is that if either she doesn’t indicate her representative capacity unambiguously or the represented person is not identified, or both, then the agent is liable when signing the instrument. i. Carolyn neither indicated her representative capacity nor identified the represented person. ii. So her only hope is under the ending language of (b)(2), proving that she and the payee originally agreed that she would not be personally liable. iii. Prior to 1990 if she had signed in this fashion, she would be liable to anyone and would not have been able to avoid liability. iv. Now, Carolyn would in effect have to prove a modification of what was shown on the face of the instrument. This is a 3-305/3-117 ordinary defense not applicable to a HIDC. In Louisiana, such a modification, a counterletter, would have to be in writing to be enforceable. So Carolyn would have to prove using written evidence, to avoid liability by showing that she and original payee agreed that she would not be personally liable. e. #4 – In order to evidence loan obligation to New Corp., Carolyn signs in front of note unambiguously to name represented person. However, on back she signs as “Carolyn Park.” The usual reason one signs on the back is to guarantee payment as an indorser. It would make no sense for her to sign as an issuer/representative of principal unless she intended to be personally liable. i. This was an anomalous indorsement, which is presumed to be for accommodation. But she can defend, again, under (b)(2) by proving intent between the original parties that she would not be personally liable (as long as the person seeking to enforce is not a HIDC). ii. Liability of Agent on Checks 1. Statute a. 3-402(c) If a representative signs the name of the representative as drawer of a check without indication of the representative status and the check is payable from an account of the represented person who is identified on the check, the signer is not liable on the check if the signature is an authorized signature of the represented person [signing with authority]. b. The rule of signatures of representatives is different for checks. i. Different from the old rule: 1. Old Rule: a. If you neither named the principal nor indicated signing as representative, you were liable b. These indications had to appear next to the signature on the check. c. Having the represented person’s name in the upper left hand corner of the check was not sufficient to “identify” the represented person. ii. So the reason for the new rule is to allow the representative to sign a check without having to rewrite the company’s name beneath the signature line. If the company’s name is indicated elsewhere on the check, this is sufficient for the representative to not be personally liable. 2. Triffin v. Ameripay a. Facts i. Outsourcing of payroll function to third parties ii. The payroll company performed the payroll function for various employers/companies. The payroll company in this case opened an account upon which the payroll company could draw funds to pay the employer’s employees. iii. The payroll company issued checks; some employees cashed the checks and the checks were dishonored for insufficient funds. Plaintiff is in the business of purchasing dishonored checks and seeking to enforce them against drawers of the checks. iv. Plaintiff’s theory is that the payroll company is the drawer of the checks and is liable b. Court i. The name on the check determines the status. Payroll company was only acting as agent of the employer. ii. The employer is actually the drawer of the check; only the employer is liable. iii. Even though payroll company opened the account, it opened the account on behalf of the employer to pay funds that the employer sent to the account. 1. Therefore, under 3-402(c) because the represented person is identified on the check, the payroll company is not personally liable on the check, even though the payroll company’s name is on the account. 3. Other issues: a. Where the name of identified represented person is not the exact name of the company i. Subsection (c) is not clear as to what it means to “identify” the represented person ii. Where Comfort Plus Inc. is actual name, the court said “Comfort Plus” is sufficient to “identify” the represented person. iii. Don’t have to reproduce the exact legal name. Only have to identify the represented person. b. Use of trade names i. If XYZ’s trade name was ABC, and “ABC” appeared on the check. ii. One court held that “ABC” was sufficient to “identify.” But this is more arguable, where the trade name linguistically bears little relation to the company’s actual name. iii. It’s better for a company that uses checks to have the actual name and “d/b/a [trade name]” h. Accord and Satisfaction i. Defined 1. Falls underneath “compromise” in the Louisiana Obligations articles 2. The process by which disputed debts/obligations can be settled 3. Common law: accord is the agreement to settle the disputed debt, and the satisfaction is the performance of the agreement. ii. Background 1. Use of checks as settlement mechanisms has long been widespread 2. The person tendering payment will put a legend on the back of the check indicating “paid in full,” such that the payee’s accepting payment under the check extinguishes the underlying claim. 3. Common areas of use a. Insurance companies b. Consumers 4. Previous law a. In Article 1, 1-207 provided seemingly that the settlement could be avoided by writing “under protest,” “without prejudice” or the like and scratching out the “paid in full” language, and then cashing the check. b. The new statute makes it plain that 1-207 does not apply to accord and satisfaction. Payee cannot now unilaterally modify the check to avoid a settlement. iii. Statute: 3-311 1. (a) If person against whom a claim is asserted proves that (i) person in good faith tendered an instrument to claimant in full satisfaction of the claim, (ii) the amount of the claim was unliquidated or subject to a bona fide dispute, and (iii) the claimant obtained payment of the instrument, the following rules apply: 2. (b) Unless (c) applies, the claim is discharged if the person against whom the claim is asserted proves that the instrument or an accompanying written communication contained a conspicuous statement to the effect that the instrument was tendered in full satisfaction of the claim. 3. (c) Subject to (d), a claim is not discharged under (b) if either of the following applies: a. (1) The claimant, if an organization, proves that (i) within a reasonable time before the tender, the claimant sent a conspicuous statement stating that accord and satisfaction instruments should be sent to a designated person, office, or place, and (ii) the instrument or accompanying communication was not received by that designated person, office, or place. i. This addresses the concern of a large retailer that is not able to carefully visually examine all the thousands of checks it receives every day, to look for accord and satisfaction language on checks. IV. ii. Allows organizations to designate a specified office or person to whom such instruments should be sent. b. (2) The claimant, whether or not an organization, proves that within 90 days after payment, the claimant tendered repayment of the amount. i. Allows an escape hatch for those who receive a settlement by mistake. If you cash the check, you can repay within 90 days to avoid a binding settlement. Then you are still a claimant; the payor does not receive a discharge. ii. This led to concern from consumer groups who were concerned that (c)(2) was too big-guy company friendly…so they added (d). 4. (d) Notwithstanding (c), if claimant or his agent having direct responsibility with respect to the disputed obligation has actual knowledge of instrument issued in full satisfaction, then that controls. a. If payment is made to someone on claimant’s behalf that has “direct responsibility” for the obligation, as long as that person has actual knowledge of the full satisfaction, then the claim is discharged although (c) would otherwise apply. 5. Most litigation is over the basic question of whether or not the language is “conspicuous.” Payment Systems: Checks and Credit Cards a. Check Collection i. Generally 1. U.S. is the only country in which checks are the most commonly used noncash method of payment 2. Finally the volume of checks processed in the new millennium has begun to subside 3. Still, billions of checks remain in circulation a. Mountains of checks are physically transported every day —Apocalypse Now reference in the casebook! 4. Article 4 is the backbone of our focus now. ii. Article 4: Check Deposits and Collections 1. As opposed to Article 3 a. Article 4 did not have a pre-UCC counterpart; there was some common law, but no comprehensive framework. Whereas Article 3 had the benefit of NIL. 2. The drafter (a lawyer)’s approach to writing Article 4 was not to use theory, but actual intimate knowledge of how check collection works, what banks actually do. Article 4 was drafted to codify “best practices” of the mid-twentieth century. a. A criticism has been that it is a banker’s statute. That it is too banker-friendly. b. The law was designed to fit the transactions. Not designed to force the transactions to fit the statutes. 3. Effect of computerization a. Revision of 1990 brought Article 4 up to date b. Federal law plays a much bigger role in this area than it did prior to 1987, when Congress passed the Expedited Funds Availability Act i. Congress in the Act delegated plenary power to the Federal Reserve Board to make changes governing check collection ii. Therefore the Fed can preempt state law in the area of check collections where it believes this is necessary iii. So Article 4 has been adopted by the states, but federal law makes some modifications to these rules, which we will address later 4. The Process a. 4-104 and 4-105 are the primary definitions sections b. Scheme: i. Drawer issues check to payee. Payee deposits in depositary bank (“collecting bank”). Usually, the depositary bank would issue a provisional credit to the payee’s account. Now we are concerned with what happens after depositary bank takes the check. ii. Depositary acts as payee’s agent for obtaining payment of that check from the drawee bank (“payor bank”). 1. The depositary could do that through sending the check directly to payor bank, but this is not what commonly occurs. 2. More typically, the check passes through at least one, often more than one, “intermediary bank(s).” 3. DrawerPayeeDepositary Bank (Collecting)Intermediary Bank (Collecting)Intermediary Bank (Collecting, Presenting)Drawee Bank (Payor) iii. The two intermediary banks are also collecting banks. The intermediary, collecting bank that actually presents the check for payment to the payor bank is the “presenting bank.” iv. Each intermediary will give a provisional credit to the bank the check is received from. This is “settlement.” v. When intermediary #1 receives from collecting bank, it gives provisional credit. When intermediary #2 receives from #1, it gives #1 a provisional credit as settlement. When #2 presents check for payment to payor, the payor will give intermediary #2 a provisional credit. 1. All these credits are provisional only, subject to revocation (4-214) if the check is not paid. vi. Why Intermediary Banks? 1. Depositary may be small, local bank that sends check to its regional federal reserve bank. That regional federal reserve might send to regional federal reserve for the drawer. Then that bank presents to the bank upon which the check is drawn. iii. Time Check Is Paid by Payor Bank 1. The Midnight Deadline a. Settlement i. Provisional credit/settlement is ordinarily to be given on the day the check is received by payor bank ii. Payor bank must then make a decision about whether to pay the check or dishonor it. 1. If bank does not dishonor in a timely fashion, then under the statute, the provisional credit statutorily becomes final, no longer subject to revocation. Under 4215, the payor bank is deemed to have paid the check. a. Important terminology: A check can be paid only by the payor bank. Any bank can settle for a check by giving its customer a provisional credit, but only the payor bank can pay a check. i. This is different from a depositary bank giving value for a check deposited by a customer. This is buying, or “paying for” a check, differing from “paying” a check, which is only by the payor bank. b. If bank dishonors in a timely fashion, it can revoke the credit given to presenting bank by returning the check. iii. If properly revoked, then each bank in the chain will revoke the provisional credit given to previous intermediary banks, and last intermediary will revoke credit given to depositary bank, who will ordinarily revoke the credit given to payee. 1. So the timely dishonor by payor bank means that the check goes all the way back to payee, who then pursues action against the drawer of the check. But this is dependent upon the payor bank’s compliance with 4301. b. Law—Statute i. 4-301 1. Payor bank that settles for item (other than one presented over the counter) before midnight of day of receipt can revoke the settlement and recover settlement if before it has made final payment and before midnight deadline, it a. Returns the item; or b. Sends written notice of dishonor or nonpayment if item is unavailable for return. 2. Problems, page 124 #1: Drawer on Bank A pays check to payee, who deposits in Bank B. Bank B gives provisional credit and presents to Bank A. Bank A gets the check in a bundle Monday morning. Bank A provisionally settles by sending Bank B a Fedwire for total amount of the cash letter with all the checks in the bundle. Checks in the bundle went through Bank A’s readersorter computer on Monday afternoon. a. (a) Reader-sorter picked out the check because account balance was insufficient to pay. On Tuesday, Bank A reviewed the customer/drawer’s account and found that there was still insufficient funds. Bank A decided to dishonor and sent to check return office on Tuesday afternoon. Check not returned until 3 a.m. on Wednesday morning by courier that left the bank at that time, because of a mix-up. Check arrived at Bank B on Wednesday afternoon. On Thursday Bank B revoked the provisional account in payee’s account and returned check to payee on Friday. i. Midnight Deadline – 4104(a)(10) is midnight on the next banking day following the banking day on which bank receives the relevant item. “Banking day” is the part of the day the bank is open to carry on substantially all of its banking functions. ii. Since receipt was on Monday, the midnight deadline is end of day Tuesday. Thus, Bank A missed its midnight deadline. iii. Under 4-301(a) revocation of the settlement made on the day of receipt (Monday) may only be made if the check (1) is returned [sent [deposited in mail or delivered] or delivered to customer or transferor physically] or (2) when the check is not available, giving written notice . iv. The bank was not sent until given to the courier at 3 a.m., which was after the midnight deadline. Therefore, the bank is “accountable” for the check under 4-215. Check is deemed finally paid. Bank A is liable for face amount of the check regardless of whether the payee has suffered any loss as result of the late return—strict liability. This “strict liability” is because the payor bank must act in a timely fashion, or else the depositary bank cannot know if it’s safe to allow the payee/customer to withdraw the money. b. (b) Check selected for visual inspection because of large amount. After inspection, Bank A decided to pay and drawer’s account debited at 1:00 p.m. on Tuesday. Check sent to filing clerk who was supposed to mail with other canceled checks at end of month. Bank A then learned that mistake was made—the drawer had insufficient funds. But courier had already left and file clerk left, couldn’t find the check. Check was found at 9 pm and put in the mail at 10 pm, addressed to presenting bank, Bank B, where it arrived on Friday. i. Bank revoked the settlement timely because it was “sent,” or placed in the mail, before the midnight deadline. ii. Putting check in the mail at 10 pm was a “return of the check” under 4-301(a)(1). iii. Therefore, bank is not accountable on the check; no liability. iv. Banks know that they just have to get the checks physically out of the bank in some way that meets the definition of “send,” by the midnight deadline. v. The time of receipt is important, but not under state law, rather under Regulation CC. vi. The filing clerk is a red herring. Under original law, payment of the check required a payor bank to complete its “process of posting” the check to the drawer’s account. In the 1990 Revision, this “process of posting” was eliminated as a concept. c. (c) Coming back to this later. 3. Problem #2, page 125 a. Drawer drew a Check on account with Bank payable to Payee. Payee deposited its account, which was also with Bank, on Monday. (Bank is both payor and depositary bank.) Bank gave Payee a provisional settlement on Tuesday. Wednesday morning Bank discovered that Drawer’s account was insufficient; in the afternoon erased the credit from Payee’s account and returned check to Payee. b. The credit was not properly revoked; Bank is liable for the amount of the check. c. The problem is the statute’s wording of 4-302(a)(1)—if the bank, in any case in which it is not also the depositary bank, retains the item beyond midnight of the banking day without provisionally settling for it, or, whether or not it is also the depositary bank, does not pay or return the item or send notice of dishonor until after the midnight deadline. d. Carefully read, the statute gives two separate deadlines: (1) where payor bank is not also the depositary bank, the payor bank must settle provisionally by midnight on the day of receipt. (2) In all cases, whether or not the payor bank is also the depositary bank, the bank must return or send notice of dishonor by the true midnight deadline, midnight of the banking day following day of receipt. e. Thus in this problem, the failure to provisionally settle until Tuesday does not matter; because the bank is both payor and depositary. But the bank is still subject to the midnight deadline; the bank waited until Wednesday to do this, missing the midnight deadline. c. Blake v. Woodford Bank i. Facts 1. K+K, drawer, sent 2 checks to Blake, payee, who deposited at Morristown bank. Dec. 3 and Dec. 17 check. The Dec. 3 check was dishonored, but Blake still said to send the Dec. 17 check. 2. The checks arrived at Woodford, payor bank, for presentment on Dec. 24 and were returned on Dec. 27. ii. Analysis 1. Dec. 25 is Christmas, not a banking day. Therefore, the midnight deadline was midnight, end of day Dec. 26. 2. Woodford missed its midnight deadline. 3. The only thing Woodford can do is raise a force majeure defense to full liability on the amount of the check: 4-108(2), Interruption of communication facilities, suspension of payments by another bank, war, emergency conditions, or other circumstances beyond the control of the bank provided it exercises such diligence as the circumstances require. 4. Woodford alleges that under this statute it is excused because of the heavy workload of Christmas and two of the check posting machines had broken down; additionally a key bookkeeper of the bank was ill and thus not present at the bank. 5. Held: It was foreseeable that there would be an increased number of checks on Christmas and that machines might break down and people get sick. Therefore, the bank did not exercise due diligence as required under the statute; the failure to meet the midnight deadline is not excused. iii. Purpose of Midnight Deadline 1. Because the drawee/payor bank is not personally liable on an instrument until certifying the check, there has to be some deadline, or else the payor bank will wait indeterminably to choose whether or not to accept the check. 2. The deadline that has been selected is midnight of next day; in effect gives banks a two-day turnaround in processing checks. a. Some argue that this is too bank friendly. b. It costs the customer a day’s interest. For a big business like Wal-Mart this could be serious revenue foregone by giving payor banks a two-day rather than one-day turnaround. iv. Other Force Majeure Cases 1. Breakdown of an armored car was not a force majeure 2. However, in another case, a computer breakdown was a force majeure. This case is an anomaly because the vast majority of cases will not excuse banks. Computer failure is ubiquitous and will never excuse banks. v. Re-presentment of Check 1. The Dec. 3 had already been dishonored once and returned by Woodford on a timely basis. 2. Woodford argues that it should at least avoid liability on the Dec. 3 check that was represented because it already discharged its obligation to dishonor the check once, in a timely manner. 3. Leaderbrand, Kansas Supreme Court—held that re-presentment of check did not require bank to meet midnight deadline. a. KSC got it wrong because of misinterpretation of the law. b. Time draft is one that by its terms must be presented initially for acceptance by drawee, who signs, and then after the lapse of a prescribed period of time, the check is presented a second time for payment. i. The first presentment is really a contract to pay. The second presentment is when the timelines start running. ii. KSC was looking at the rules on time drafts when it addressed a re-presented check. iii. The rules applicable to time drafts have nothing to do with checks and representment of checks. 4. All courts now recognize that Leaderbrand was wrong and that a re-presented check must still be timely dishonored. a. It’s very common for dishonored checks to be re-presented, and many times they are paid the second time. b. This is because laypersons deposit a check in their account and then immediately draw a check on their account, not realizing that the funds deposited won’t be immediately available. Therefore, often when the check is re-presented, the customer’s deposit will have cleared and therefore the re-presented check will be honored. c. Also, the depositary bank has no way of knowing of a check’s dishonor without this rule. Depositaries never receive notice of payment; they only receive notice of dishonor. The depositary bank infers honor of the check when it has not received notice of dishonor by the time it expects notice to come. This is the importance of the midnight deadline; it allows the depositary bank to assume at some point that the check it presented to the payor bank has been honored by the payor bank. d. Settlement by End of First Day of Receipt i. Almost always, banks in practice do provisionally settle by midnight on the first day, as is required by the statute. ii. Only one case of record, Hanna, in which payor bank was held liable for failing to settle provisionally on the first day. 1. It’s not even clear from the court’s opinion how the bank failed to settle. 2. Court only said that payor bank had presented no admissible evidence of settlement. So perhaps it was just a failure of proof. 2. What Is a Payor Bank? a. 4-302(a) says that presentment to payor bank starts the running of the midnight deadline period. b. 4-107: A branch or separate office of a bank is a separate bank for the purpose of computing the time within which and determining the place at or to which action may be taken or notices or orders shall be given under this Article and under Article 3. i. The comments to this statute admit that this statute is not specific. The courts must resolve the issues based upon the facts of each case. c. Problems, page 139 i. #1 Bank has 20 branches in large city and a large processing center to which all checks drawn on any bank are automatically routed. The Check is received by the Center at noon on Day 1 and run through computers; more than 5k, so delivered to Branch at 8 a.m. on Day 2. Branch decides to dishonor and sends back to Center at 5 p.m. On Day 3, Center dispatched check to motor courier. 1. The processing center and banks are not treated as separate banks. Given the way that they function. 2. Deadline started running when the Center received the check; so it should have dispatched by end of Day 2, and was not. Thus bank is fully liable. ii. #2 – Bank has 100 branches; processing centers in Eastern area and Western area of city. Check drawn on Eastern branch and deposited in account at Western branch on Day 1. Delivered to Eastern Center on Day 3. Delivered to Eastern Branch on Day 4. Eastern Branch decides to dishonor and returns to Eastern Center on Day 4. Eastern Center dispatches at 11 p.m. on Day 4, where it arrived to Western Center on Day 5. 1. Eastern and Western branches are treated as separate banks. 2. Thus, when Eastern Center received check on Day 3 is when deadlines started running. Check was put in the mail from Eastern Center an hour before midnight on Day 4, so the deadline was met. 3. Check Kiting a. Defined i. Open accounts in several banks, in one account having only a nominal amount of funds ii. Write a check on the nominal account and then draw on account at another bank to deposit that amount at the other bank iii. The reason it is called “kiting” is that the checks “float” iv. The scheme involves seeing how many banks you can make withdrawals from before the bank will not allow you to withdraw when the bank learns that the check deposit in that bank has been dishonored b. First National Bank in Harvey v. Colonial Bank i. Background 1. Check kiting between related entities 2. The entities were essentially the same entities; same shareholders and directors 3. There are competing equities involved in the application of the midnight deadline in a check kiting situation 4. Kiting is an attractive scam because depositary banks are required to make the funds available quickly under federal law. Thus federal law makes kiting possible, notwithstanding computers that could normally discover kiting schemes. ii. Facts—Generally 1. World Commodities and Shelly are the related companies. The transactions occur all on the same day. 2. World is the drawer of 13 checks ($1.5 million) drawn on Colonial, paid to Shelly, who deposits the checks at FN 3. Shelly draws 17 checks ($1.5 million) on FN, giving them in payment to World as payee, who deposits at Colonial 4. So both FN and Colonial are the depositary and payor banks, respectively, because each related entity (Shelly and World) has a role as drawer and as payee iii. Facts—Detecting the Kiting Scheme 1. FN realized that it might be the potential victim of a kite; an officer of the bank froze Shelly’s account with FN. On Wednesday, FN decided to dishonor the checks presented by Colonial. They dishonored the checks by sending notice by Fedwire (Fed’s communication system) that Colonial received during the day. The reason for the return originally was “uncollected funds” but was changed to “refer to maker” (refer to “drawer.”) a. Regulation CC requires that in cases where payor bank dishonors check of $2,500 or more, direct notice of dishonor is required to be sent to the depositary bank no later than 4 p.m. local time for depositary on second business day following the presentment of the check. If payor bank fails to do this, it is liable for depositary’s actual losses, if any (not liability on face value of check) b. Here, therefore, FN did both necessary things: under Regulation CC [giving the requisite notice] and under the UCC/state law [dishonored the checks and returned before midnight deadline] 2. Colonial now had to decide about what to do with the 13 checks drawn on it by its customer. To avoid liability it must return them by midnight that day—the midnight deadline. Therefore, only had from 2:45 to 12:00 to decide. Colonial asked its customer/drawer what was going on. The customer/drawer/kiter lied and said that the checks were good and would be paid when re-presented. 3. Colonial waited until Thursday to return the checks—after the midnight deadline expired. 4. FN sues Colonial for violation of the midnight deadline, arguing that Colonial is now accountable for the face amount of the checks. iv. Cause of Action 1. Colonial’s liability under 4-302(a)—failure to take timely action requires in accountability on the amount of the checks a. Colonial’s defense is that when FN returned the checks drawn on it, FN knew or strongly suspected a kite. That FN is trying to get out before the kite crashes. FN will get a windfall. b. Colonial argues for relief from strict liability of 4-302(a) because of these circumstances. 2. So issue is potential bad faith of FN v. Accountability 1. It does not make any difference whether FN suspected a kite 2. Article 4-109 establishes a defense for payor bank based on force majeure. But the statute does not suggest that the defense should be extended based upon the depositary’s suspicions about a kite. 3. A separate statute, 4-103(e) makes a bank liable when it fails to exercise ordinary care in handling a check, but only to the extent that the item could have been collected in the observance of ordinary care. Recovery is reduced by the amount that would have been uncollectible. In other words, this is liability on account of negligence. a. The defense is that strict liability is not fair where the customer is telling Colonial one thing and that Colonial should be excused because it exercised ordinary care b. But the court focuses on the fact that the role of the payor bank in check collection is crucial. The whole system would break down if banks were allowed to delay these decisions. 4. Court upholds the strict requirement of the midnight deadline vi. Good Faith? 1. The UCC imposes a duty of good faith in the performance or enforcement of every contract or duty within the UCC 2. Colonial alleges that it is bad faith for FN to not disclose its suspicions of kiting to Colonial. That FN’s return of the checks indicating “refer to maker,” or “ask the customer about it,” was not sufficient to disclose the kite. That the overriding obligation of good faith required FN to disclose the suspected kite. 3. Held: FN was not in bad faith; it did not have an obligation to disclose the suspected kite. a. A depositary bank that suspects a kite does not have a duty to disclose suspicions to the payor. b. The depositary may both return checks drawn on it as payor and seek to collect checks drawn on another bank. c. There is a dissenting view in Oregon; but that is the only jurisdiction taking the view that FN was in bad faith. 4. Banks are competitors. They are not fiduciaries. Thus FN had no general duty of disclosure. FN’s decision to return the checks drawn on it and still pursue collection of deposits from Colonial was a business decision that a bank is allowed to make. c. Good Faith? i. Observance of reasonable commercial standards of fair dealing. This definition has been added to the previous definition of merely “honesty in fact.” ii. Perhaps this is why Oregon courts have held that a bank in FN’s position would have been in bad faith. iii. It might not be “fair dealing” for FN to act the way it did. d. UCC 4-302(b) i. Text: The liability of a payor bank to pay an item [because of failure to meet the midnight deadline] is subject to defenses based on breach of a presentment warranty or proof that the person seeking enforcement of the liability presented or transferred the item for the purpose of defrauding the payor bank. 1. Comment says that in a check kiting scheme, the payor bank should not be liable. 2. So if the payee or presenter of the check is perpetrating fraud, the payor bank should not be liable. 3. The above case held differently because a. The purpose of the comment is to ensure that the check kiter will not be able to enforce payment of the check b. But in the case, FN was not operating a check kiting scheme. Therefore Colonial may not raise an affirmative defense to payment of the check to FN because FN did not defraud Colonial; FN was only caught up in the check kiting scheme. ii. This is an affirmative defense to the midnight deadline rule of liability 4. Effect of Regulation CC on the Midnight Deadline a. Regulation CC i. 12 CFR pt. 229, Section 229.30(c) ii. Why federal law got involved 1. It used to be that the depositary bank would not allow the depositor to withdraw the funds deposited until at least week, allowing the depositary to present the check to the payor bank and collect, and thus finally credit the depositor’s account for that amount 2. Depositors squealed to the government about banks waiting so long to make funds available. a. The banks’ answer was that this was necessary to protect them. b. The check often passed through an intermediary bank (“forward collection”)—moving the check through intermediary to the payor c. The checks would be machineprocessed and not be seen by a human being until payor bank received, and even then only under special circumstances d. But when checks were dishonored, this was handled manually because each bank involved in the process must physically erase the credit given to the transferor, all the way back to the depositary bank, who will erase the provisional credit given the customer e. Therefore, depositary bank had to protect itself by waiting sufficient time to make sure that the check was not dishonored 3. In 1987, Congress passed the Expedited Funds Availability Act, requiring depositary banks to make funds available according to federal deadlines—as set by the Federal Reserve Board iii. Under midnight deadline, as long as bank gets the check in the mail before the midnight deadline, it may avoid final payment of the check. But the mail is slow, so the transferor bank may not receive the dishonored check for several days. 1. The midnight deadline rules under the UCC have only focused on the time of dispatch into the mail, without considering how long it would take for notice of dishonored items to get to the transferor bank. 2. This is why Regulation CC changes the UCC midnight deadline. It focuses on time of receipt by the bank of notice of dishonored check. iv. The Text: 1. Extension of deadline. The deadline for return or notice of nonpayment under the UCC is extended to the time of dispatch of such return or notice of nonpayment where a paying bank uses a means of delivery that would ordinarily result in receipt by the bank to which it is sent a. (1) On or before the receiving bank’s next banking day following the UCC midnight deadline; this deadline is extended further if a paying bank uses a highly expeditious means of transportation, even if this means of transportation would ordinarily result in delivery after the receiving bank’s next banking day i. The “highly expeditious” exception is not often used. An example would be the payor bank paying Fedex to pay for the fastest method of delivery possible. b. Oak Brook Bank v. Northern Trust Co. i. Background 1. Judge Posner—leading jurist wrote the opinion 2. Facts a. Checks were drawn by unidentified check kiter on Northern. Deposited in Oak Brook and presented for payment to Northern on Feb. 11. Did not decide to dishonor until Feb. 13, after the UCC midnight deadline had expired. But notified Oak Brook of nonpayment by telephone on Feb. 13, complying with Regulation CC. b. Evening of Feb. 13, Northern puts the checks into transport. 3. Court a. Regulation CC extends the deadline for return to the time of dispatch, as long as payor bank uses a means of delivery that ordinarily would result in receipt by the transferor bank’s next banking day. b. Therefore, Regulation CC’s focus is different from the UCC midnight deadline rule. UCC only requires sending, or putting notice in the mail by midnight deadline. Regulation CC requires sending the notice by a means in which the receiving bank will receive the notice by the end of the receiving bank’s next banking day after the midnight deadline. ii. “Banking Day” 1. This is a federal reserve bank. In light of such a bank’s functions, which are primarily check processing, the banking day is 24 hours per day. 2. The statutory standard is the time of the day during which a bank is carrying on substantially all of its banking functions. Which is all day and night for federal reserve banks. 3. In this case, Regulation CC was met because the notice was sent by the end of the second banking day. 4. The comment to 4-104 says that under the definition of “banking day,” the part of a business day when a bank is open for only limited functions, e.g. to receive deposits and cash checks, but with loan, bookkeeping and other departments closed, is not part of a “banking day.” Regulation CC adopts a similar definition. 5. Federal Reserve banks exist primarily to process checks—so this is its primary function. a. The plaintiff wants the court to separate the bank’s daily activities to find that at the time the bank received the notice, the banking day expired. b. The court refuses to do this. It would be impractical for payor banks to monitor internal operations of returning banks in order to make sure that sending a check by courier at a given hour on a given day would be within the returning bank’s “banking day.” c. Posner is suggesting that the Fed. Reserve Board goofed in drafting this rule in tying the “banking day” standard to a subjective determination—the Regulation should have just adopted a “midnight of the next banking day” standard. 6. This case is ultimately limited only to Federal Reserve banks. This leaves open the possibility of a fact-specific inquiry in other types of banks as to whether it is carrying substantially all of its main functions at time of receiving notice. c. Regulation CC speeds up the check payment process by authorizing the payor bank to pay directly to the depositary bank or to return the check to a “Regulation CC returning bank” i. A “returning bank” is defined in Regulation CC as a bank that undertakes return of the check in an expedited fashion ii. A returning bank does not even have to be one that was involved in the forwarding process at all iii. Practically, the regional Federal Reserve banks predominate the “returning bank” function 1. These banks get paid fees for performing this function iv. Right of Collecting Bank to Revoke Settlement on Dishonored Check 1. Statute: 4-214(a) a. If a collecting bank has made provisional settlement with customer, the bank may revoke the settlement, charge back the credit, or retain refund from customer, if by its midnight deadline or within a longer reasonable time after it learns the facts it returns the item or sends other notification of the facts. i. Depositary’s Remedies 1. If depositary bank receives notice of dishonor of check, it has several options. Proceed against customer based on customer’s indorsement; proceed against customer on breach of transfer warranty; bring action against drawer of check. But banks rarely pursue these remedies. 2. If it hasn’t allowed the customer to withdraw the proceeds, all the depositary bank has to do is erase the provisional credit. If customer has withdrawn the proceeds, the bank may obtain a refund from the customer under this statute. 3. Only when the depositary cannot take these steps will it have to sue the drawer. ii. If return or notice is delayed until after the bank’s midnight deadline or a longer reasonable time after learning of the facts, the bank may revoke settlement, obtain refund, or charge back credit but is liable for any loss resulting from the delay. iii. These rights terminate when a settlement for the item received by the bank is final. 2. Essex Construction Corp. v. Industrial Bank a. Facts i. Payor bank notifies depositary of dishonor of check drawn by drawer because drawer stopped payment ii. Depositary gave notice to customer through mailing written notice before the midnight deadline, but the customer did not receive the mailed written notice until several days later, and customer wrote checks against the funds it thought were available. iii. Therefore, customer wants to sue for its loss in writing checks on funds it thought were available. iv. Customer argues that timely notice of dishonor was not given b. Court i. Notice of dishonor was mailed by the bank’s midnight deadline. This is sufficient. All depositary bank had to do was mail the check or notice by the midnight deadline. ii. Court notes that even if the deadline were missed, the depositary bank would only be liable for loss resulting from the delay; bank could still revoke the credit under the statute. 4-103(e) c. This case illustrates the problem with the midnight deadline —the mail is slow. This is why Regulation CC and Ex. Funds Av. Act attempt to speed up notice of revocation of settlement/provisional credit. d. Once final payment occurs, a collecting/depositary bank loses its ability to revoke the provisional settlement or charge back provisional funds. 4-215(d). Final payment by the payor bank means that provisional credits given by collecting banks become final. i. 4-214(a), toward the end: If the return or notice is delayed beyond midnight deadline or longer reasonable time after learning the facts, the bank may revoke the settlement, charge back the credit, or obtain refund from its customer, but it is liable for any loss resulting from the delay. These rights to revoke, charge back, and obtain refund terminate if and when a settlement for the item received by the bank is or becomes final ii. Example of Bank Being Liable for Damages: 1. March 1 drawer on payor bank gives payee a check. Payee deposits at depositary bank. The drawer’s account has sufficient funds at the time. However, the teller at depositary bank loses the check, where it sits for 3 weeks, until teller finds it. 2. The check is then presented to payor. On March 15, drawer went bankrupt. Payor bank timely dishonors because of nonsufficient funds and sends notice to depositary bank, who then timely notifies payee of dishonor and revokes the provisional settlement. 3. Result: Depositary bank can revoke the settlement. The return of the check was timely. a. However, depositary was negligent in forwarding check to payor bank. This does not prevent the bank from revoking the settlement. 4-214(d). But a bank failing to exercise ordinary care is liable under 4214(d). b. Under 4-103(e), the bank obviously failed to exercise ordinary care through not timely presenting the check for payment. The bank is liable to the customer for damages; damages would consist of not being able to recover from the drawer because he is bankrupt and there is an automatic stay. Customer will sue the depositary bank to prove that had the bank acted timely, sufficient funds would have been in drawer’s account, and customer would have received payment on the check. 3. Duties of Collecting Banks (4-202) a. Exercise of ordinary care in presenting an item, sending notice of dishonor, settling for an item when the bank receives final settlement, and notifying its transferor of any loss or delay in transit within a reasonable time after discovery thereof. b. There is a midnight deadline for these actions. c. However, taking proper action within a reasonably longer time may constitute ordinary care, but bank has burden of proving this. d. 4-103(e) If a collecting bank does not exercise ordinary care, its liability is limited to whatever actual damage the party claiming injury can establish. v. Check Encoding 1. Background a. Magnetic Ink Character Recognition (MICR) technology i. Paved the way to the automation of check collection ii. Once the check is received by the depositary bank, a human being is not likely to view the check again until it’s the drawer looking at his monthly statement iii. Allows the check to be mechanically routed based on federal reserve district number, account number of drawer, and the check number and bank number b. The problem is the amount of the check is not in the MICR line; it cannot be. It must be added at the end of the MICR line either by the payee, depositary, or some other collecting bank. Usually added by the depositary, unless the payee is some large merchant like Wal-Mart that can add the amount. c. This leads to underencoding (less than face amount of check) and overencoding (more than face amount of check) i. Courts came up with common law solutions for these issues ii. The payor bank pays what is encoded, not the face amount. A human being will only examine the check if they need to verify a signature by sight to detect forgery. iii. 4-209 was the solution 1. It imposes a warranty that the information encoded is accurate. 2. Statute: 4-209 a. (a) A person who encodes information on or with respect to an item after issue warrants to any subsequent collecting bank and to the payor bank that the information is correctly encoded. If the customer of a depositary bank encodes, that bank also makes this warranty. b. (c) A person to whom warranties are made under this Section and who took the item in good faith may recover from the warrantor as damages for breach of warranty an amount equal to the loss suffered as a result of breach, plus expenses and loss of interest incurred as result of the breach. 3. Problem, page 159 a. Drayton (drawer) drew on Park Co. (payee/customer), who deposited in Bank 2 (depositary), who forwarded to Bank 1 (payor). Check arrived to payor on May 1. 10k check. b. (a) Depositary misencoded for 1k and on May 1 payor sent wire transfer for 1k as provisional settlement. Debited drawer’s account for 1k. When depositary only received 1k settlement for check, it reduced credit in customer’s account to 1k. When customer learned about this, it was unhappy and complained that it did not get credit for 10k. i. Stipulation: Payor is accountable for 10k face value of the check because it did not meet its midnight deadline. ii. What we need to know is how much was in drawer’s account. If drawer has 10k in account, no problem because payor who underpaid the face value of the check can just debit the remaining 9k from drawer’s account. Payor has suffered no loss. Because payor suffers no loss, even though there was a breach of warranty by depositary, payor may not recover anything from depositary. This is because the encoding warranty under the UCC is only strict liability (liability without fault) if there has been loss; not absolute liability, which would allow recovery even absent loss. iii. If there were not sufficient funds in drawer’s account, then payor would have an action for damages against depositary for depositary’s breach of warranty that the information was correctly encoded. iv. So underencoding is a breach of warranty but is not likely to create an actual right for damages. c. (b) Overencoding. Check misencoded for 100k. Payor sent wire transfer for 100k. i. (i) Drawer had more than 100k in account and payor debited for 100k. 1. Drawer has right to recover 90k from payor. But payor bank can then recover 90k from depositary bank because depositary bank breached its encoding warranty and payor has suffered loss as a result. ii. (ii) On May 2, payor bank discovered drawer had only 25k in the account and dishonored the check before midnight deadline. Drawer may have rights against payor bank for wrongful dishonor. 1. If drawer recovers such damages, then payor bank can recover damages from depositary. 4. First Union National Bank v. Bank One, N.A. a. Facts i. Drawer issues check for over 500k. Payee deposits in depositary bank’s account. Depositary misencodes for $0.00! ii. Depositary sends to Intermediary Bank, who settles for $0, who forward to Payor, who settles with Intermediary for $0. iii. Payor is the first to discover the error. Payor then pays intermediary the actual face amount of the check (about 500k). 1. The intermediary bank claimed it was confused about what to do with the 500k settlement it received. Stuck it in a suspense account—parked the money for months 2. Depositary asked for payment, and payor paid the amount a second time to the depositary. 3. Therefore, under 4-215(d), the depositary is suing intermediary to recover on payor’s behalf. b. Court i. Ignores Section 4-209 altogether and uses common law principles that developed before the Revision. ii. Issue: What is the intermediary liable for? 1. Held: The face amount, NOT the MICR encoded amount. 2. The intermediary is liable for the face amount of the check. a. The intermediary argues that the depositary bank should be estopped because depositary bank made the encoding error. b. Court says no because the intermediary has suffered no loss; it would receive a windfall if it does not have to pay the face amount vi. Electronic Presentment 1. Under UCC a. Article 4A Generally i. **Article 4A is in the big green statute book ii. Very complex statute b. “Truncation” i. Old meaning--The cost cutting measures that banks use through obtaining agreement from customer; example, sending customer a statement without returning the physical checks themselves ii. Radical Truncation—AKA electronic presentment 1. Check never leaves possession of depositary bank; depositary bank only forwards electronic information for the purpose of presentment to have the check paid by payor bank 2. Banks, retailers, etc. all agree to radical truncation, which is the use of electronic checks 3. In 1990, the UCC allowed electronic presentment under 3-501. Includes the ability to present a check for payment in electronic form. 4. Allows presentment notice, rather than having to present the check itself iii. Mandatory electronic presentment has not occurred 2. Under Federal Law: “The Check 21 Act” a. Check Clearing for the 21st Century Act (2003) b. The feds have never required electronic presentment. It is left up to the banking industry to decide. Electronic presentment is still a matter of agreement c. Check 21 allows the use of electronic presentment and return of checks without electronic truncation agreement among banks. It creates the substitute check, which is a paper reproduction of an electronic image of the original check, which is the legal equivalent of the original check for all purposes. d. Note that electronic presentment can proceed without the creation or transfer of a substitute check—a substitute check is useful only when an individual or bank prefers to create or receive a paper check. e. Substitute Check i. This is the chief creation of the Act ii. As long as the requirements are met, the bank does not have a choice, it must accept the substitute check iii. A bank converts the information to paper form, which is a substitute check, which the payor bank must accept. iv. This saves the expense of forwarding the physical check through the process. v. This does not resolve the basic issue of how long it will take until the substitute check becomes obsolete, and we move into a regime of full electronic presentment. vii. Funds Availability and Regulation CC 1. Generally a. Traditionally, the depositary banks had long hold periods on deposited checks because the return of dishonored checks has been traditionally slow, having to go through the return process of going through returning banks. So depositary banks would not allow customers to withdraw on checks for around two weeks to protect the banks in case the checks proved uncollectible. i. The forwarding process is much faster than the return process. 1. MICR is available to speed up check forwarding; but there is no automated system for returning checks b. Additionally, depositary banks had the incentive to keep funds longer because they could accrue interest. In effect, an interest free loan from the customer. The bank’s use of the money to accrue interest was called the “float.” i. In many cases, banks were withholding payment for deposited checks for which they had already received payment. But the banks were able to hold onto funds because the holding periods were automatic. c. The Electronic Funds Availability Act (EFAA) and Reg. CC attempt to solve these problems and create shorter holding periods, making funds available to customers more quickly 2. Funds Availability a. Page 84, Funds Availability Schedule under Regulation CC i. Most banks just make deposits available the next day because of the complexity of the Schedule ii. The schedule in brief: 1. For low risk deposits, next day 2. For local check, not later than second day after banking day of deposit 3. For nonlocal check, not later than fifth business day following banking day of deposit 4. But customer may withdraw up to $100 on next banking day after deposit of either local or nonlocal checks. 3. Check Collection and Return a. Under Regulation CC, provisional settlements made by collecting banks are made final. i. This does not mean that there is final payment of the check. ii. This simply means that when the payor bank dishonors a check, that instead of revoking a provisional settlement made by the payor bank, the payor may recover the amount of the check from a bank to which the check is returned. iii. That amount can be recovered only when the bank physically receives the check. 1. The payor can return the check to any bank that acts as a returning bank. a. The returning bank does not have to be one that was involved in the collection process. 2. This gives the payor bank the incentive to return the check as quick as possible to get it back to the depositary 3. If payor returns the check to any bank other than the depositary and recovers the settlement, than the returning bank can recover the settlement from the depositary b. If the payor returns the check directly back to the depositary, the credits given by the intermediary banks will expire at some point. c. Regulation CC’s Important Points: i. Payor bank that dishonors a check of $2,500 or more must, in addition to meeting the midnight deadline, must give direct notice to the depositary bank no later than 4 pm local time of the depositary bank on the second business day following presentment 1. The notice can be in writing, by phone, Fedwire, fax, in person, whatever ii. A bank that fails to comply with a duty imposed by the Regulation has liability for actual loss [not strict liability as under the midnight deadline] b. Credit and Debit Cards i. Liability for Unauthorized Use of Cards 1. Credit Cards a. Section 1643, Truth in Lending Act i. A cardholder shall be liable for the unauthorized use of a credit card only if: 1. (A) Card is an accepted card 2. (B) Liability is not in excess of $50 3. (C) Card issuer gives adequate notice to the cardholder of the potential liability 4. (D) Card issuer has provided cardholder with description of means by which issuer may be notified of loss or theft 5. (E) The unauthorized use occurs before the card issuer has been notified that an unauthorized use has occurred or may occur as the result of the loss, theft, or otherwise; and 6. (F) Card issuer has provided a method whereby the user of such card can be identified as person authorized to use it [signature on back of card] b. Problems, page 177 i. #1—Oscar paid for meal at restaurant. Waiter copied information on card by a device that he concealed in his belt and sold this information to an enterprise that fraudulently produced replica cards. These cards were used to make purchases at retail establishments. Oscar protested to paying the charges that appeared on his monthly statement. 1. Under 1643(A), it’s not an accepted credit card because it’s a counterfeit card. Therefore, the statute does not apply to counterfeit cards at all. Thus, Oscar has zero liability 2. The credit card issuers can protect themselves by monitoring credit card charges and then refusing to honor the card under suspicious circumstances, e.g. purchases made in certain locations or over certain amounts ii. #2—Oscar is absent minded. Obtained card from Bank A but forgot to sign the back. He used it only a couple times by buying gas; this mechanism did not search for presence of a signature. The card was stolen, but he never noticed and he did not open his mail which contained statements showing many fraudulent purchases. Bank A demanded payment of $5,000 for purchases made on the card, some as long as three months after disappearance of the card, all of which were noted on Bank A’s statements. 1. Oscar is only liable for $50 under the statute. 2. He would have been liable for zero if he had notified the bank of the loss of the card before the unauthorized uses had occurred. c. Through the statute, Congress forces the credit card industry to internalize these losses. i. The industry must absorb the loss, as opposed to the card user. ii. With only a $50 limit of liability, why are people so worried about loss of credit cards? 1. They don’t know about the $50 limit. 2. Have to report loss to get a new card. 3. Don’t want the hassle of having to prove that the use was unauthorized. iii. The credit card industry has had no problem in absorbing the losses; it continues to thrive 2. Debit Cards a. Generally i. Banks make money because of receiving interest on customers’ funds ii. Card issuers of credit cards make their money off fees that they charge the merchants to accept such cards. iii. Unauthorized use of debit cards is not governed by the Truth in Lending Act, but by the Electronic Funds Transfer Act (EFTA) b. EFTA Rules: See problem below. c. Problem, Page 179 i. How would Oscar, Supra,’s case have been different if it was a debit card and after 2 days he learns of the loss? 1. If you don’t report within 2 days after you should have learned or learned of the loss, you are liable for $500. 2. If you report within 2 days, then $50 is the limit. 3. There is no limit if there is failure to report within 60 days of transmittal of a statement. a. But the card issuer (bank) has the burden of loss of proving actual damage beyond 60 days. ii. The debit card holder is held to a higher standard because the unauthorized use of a debit card holder is more likely to occur through the card holder’s negligence—because to use a debit card, you need a PIN. 1. But this rationale might break down because we don’t have to use our PIN’s to use debit cards in certain situations. iii. Now the federal legislation says that the function that the card holder elects (debit or credit) is what governs, for dual use (debit or credit) cards. 3. When Is Use Authorized? a. Statute, Section 1602: when the user lacks actual, implied, or apparent authority to make a purchase with the card. b. Minskoff v. AMEX i. Facts 1. M hires Ms. B as her office manager; and B proceeds to steal M blind. 2. B applied for a corporate card in her own name from AMEX and began using the corporate card for various personal purchases. 3. B upgraded her corporate card and M’s corporate card to Platinum status 4. How did she accomplish this? a. It is not clear from the record whether the invitation to upgrade was directed personally to M or not b. The invitation was sent to M’s personal home address; how did Ms. B get it? [I smell an affair…] 5. Her actions were eventually discovered many months letter, after Ms. B had used forged checks to pay for the monthly statements sent to the business 6. AMEX counterclaims, asserting that M is not allowed to get anything back. M sued claiming that this was unauthorized use, so its liability is limited to $50. 7. AMEX contends that the use was authorized under agency law principle of apparent authority ii. Court 1. Apparent authority cannot be established by the manifestations of the agent; it is the principal’s manifestations to the third party that lead to the third party’s reasonable belief that the agent had authority, which creates apparent authority 2. M was grossly negligent in never examining a single credit card billing statement; there were no internal controls set up; only Ms. B ever looked at the billing statements. 3. The simplest auditing of the company’s records would have disclosed the fraud 4. This gross negligence established apparent authority of Ms. B; therefore the use was authorized a. However, the initial use of the card up until the first billing statement was sent were not authorized because M was not grossly negligent up until that point 5. Court finds within 4-406 that the customer has a duty to look at a bank statement to detect any forged items; the customer then has a duty to promptly report such forged items to the bank a. If the customer does not timely report, it cannot assert the forgery against the bank b. The policy underlying this statute is related to the present case; M was in a much superior position to be able to determine if the charges were fraudulent c. It is much easier for the cardholder to determine if a charge made on the account was legitimate, authorized, as opposed to the card issuer (AMEX), who has no way of knowing that use was unauthorized d. But what does this have to do with the law of agency? The court is really imposing the loss on M not because of apparent authority, but really because of M’s negligence. The Truth in Lending Act (TILA) asks whether there was apparent authority of the user, not whether the cardholder was negligent in allowing use. Therefore, the court’s analysis is not correct. e. Apparent authority is based on contract principles; but agency by estoppel has a tort basis. The court is really using agency by estoppel; saying that because M was negligent in not detecting the fraud, M will be estopped from pleading that Ms. B’s use of the card was unauthorized. iii. Thus in cases of serial fraud by the employee, the loss can be passed upon the employer if the employer does not examine the card statements it receives. This is often the case because the person conducting the fraud is the person to whom the employer’s financial affairs are delegated. c. Problem, page 187 i. Wife married Husband and she opened a credit card account with Bank, requesting card issued to her and duplicate card to Husband in his name. Upon divorce, wife notified bank that she would no longer pay for husband’s charges on the card. Credit card agreement provided that account could be closed by returning all cards. Bank immediately revoked both cards and gave numerous notifications to both parties of revocation and requests that the cards be returned. Both Wife and Husband continued to make purchases. Wife contended that for charges made by Husband after her notification to the Bank, her liability should be limited to $50; the card should be treated as a lost or stolen card since she had no power to compel the Husband to return the card. 1. Wife is the cardholder for purposes of the statute; because the account is issued in her name. This is important because unauthorized use is by someone other than the cardholder; Husband is not a cardholder. 2. Wife certainly had notified the bank upon divorce that Husband was no longer authorized to make purchases; but she is arguing that this makes it as though the card was either lost or stolen. ii. This is Walker Bank v. Jones 1. The court stated that the TILA focuses on whether or not there is actual or implied, or apparent authority. As long as the Husband had a card with his name on it, this created apparent authority for him to use the card. As long as the Husband’s name was on the card, he had apparent authority to make purchases with the card. a. The court focuses on apparent authority from the perspective of the merchant who honors the card. b. The statute does not make it clear whether the apparent authority is from the perspective of the person honoring the card or from the perspective of the issuer of the card c. The dissent obviously viewed it that the statute means apparent authority from the perspective of the issuer; and in this case, the bank could not reasonably believe that the Husband had authority to use the card because Wife notified the bank that Husband was no longer authorized 2. This is largely unresolved: is apparent authority from the merchant’s perspective, or the card issuer’s perspective? The dissent views the purpose of the statute as focusing on whether there has been notification between the cardholder and card issuer. Therefore, the focus should be upon the card issuer’s belief or lack thereof in authority. 4. Assertion of Cardholder Defenses a. Issue: To what extent may the cardholder raise its defenses against the merchant from whom goods were purchased against the card issuer, to avoid payment of the card charges to the issuer? b. Legislation—Fair Credit Billing Act, Section 1666i i. Congress decided that under limited circumstances, the cardholder should be able to assert defenses arising out of the underlying transaction against the issuer of the card ii. Conditions for raising defenses: 1. Cardholder (obligor) must make good faith attempt to obtain satisfactory resolution of the disagreement with the party that honored the card 2. Amount of underlying transaction must exceed $50 a. This requirement is probably that for de minimis amounts, it’s not so much an extension of credit as it is a substitute for the cardholder paying with cash b. In this era that the statute was drafted, ATM/debit cards did not exist 3. Place where initial transaction occurred must be same state as mailing address provided by cardholder to issuer or within 100 miles of such address a. The reason for this is that a merchant or other person honoring the card that is a great distance from the buyer’s residence would not want to accept a card if the merchant knew that the cardholder could assert a defense and then the merchant would be left with an unsecured claim against the purchaser who lives many miles away. iii. 2 and 3 supra as conditions do not apply in certain circumstances: 1. Honorer of card is the same as the issuer, is under control of the card issuer, etc. c. Problem, page 189 i. California tourist buys syrup in Maine and pays with Visa card issued by SD bank. Tourist believed she had been defrauded. First called the seller to try and resolve; but seller said what was mailed was what she purchased and there would be no refund. Tourist then does not want to have to pay Visa. ii. Under the statute, the amount exceeds $50, but the initial transaction was neither within the cardholder’s home state nor within 100 miles of her mailing address. Therefore, the tourist cannot raise her defense against the issuing bank. d. The statute only governs rights between cardholder and card issuer. As between card issuer and person honoring the card, this is governed by the system rules of Visa, Mastercard, etc. e. Citibank (South Dakota) v. Mincks i. Background 1. Case law interpreting Section 1666i has been hard to come by 2. This is the first authoritative, reported appellate opinion involving two previously unaddressed issues in the case law ii. Facts 1. Mary applies for a credit card and gets one issued in her and her husband, Chuck's, name. She uses the card for personal purchases pretty much exclusively. Her husband uses the card to buy some sort of stupid postcards for his business. They never come. He makes several attempts to get the postcards and they never get back to him. Several months later he finds that the company went out of business 2. Mary tries to get her money back by getting it back from CitiBank who declines to do so because she didn't do it within 60 days and because it was for a business purchase. iii. First Issue: Section 1666i allows consumer to, in some circumstances, get his/her money back from the card issuer. This only applies when a card has been issued under an "open end consumer credit plan". The purchase made by Chuck was clearly for his business. However, the card was issued as an "open end consumer credit plan". What controls? The specific transaction or is it the "overall purpose" of the card's issue? 1. The "overall purpose" test was used by the Court and, therefore, it held that Mary's card was an "open end..." card. 2. Holmes likes this decision. iv. Second, more technical, issue: 1. Relationship between cardholder defense rule in 1666i and the separate billing error provision in 1666a. 2. The billing error rule gives the consumer the right to request correction of a billing error within 60 days of the incorrect statement. a. CitiBank attempted to use this as a defense because Mary didn't try to get any sort of redress until months after the 60 day time period. b. Court determines that these provisions of 1666a are entirely separate and have no effect on Mary's ability to assert the defense of non-delivery under Section 1666i against CitiBank. c. Further, these provisions exist for different purposes. i. 1666a billing provisions is to "call off the dogs" when there is an error as to the bill and the consumer notices the error. v. Court says that the Mincks are entitled to assert their defenses. Their failure to give notice within 60 days had no relevance to this issue. f. Note 1 following CitiBank i. Limitations on 1666i - The statute offers no guidance as to where, in fact, an "initial transaction" occurs. As is commonly the case today, people order things over the phone/internet. The statute was drafted when credit card transactions were done in face-to-face scenarios. ii. In a non face-to-face transaction, the transaction occurs where "acceptance" of the contract takes place. The "last act necessary to complete the contract" is where the contract is complete and, thus, where the location is for purposes of 1666i. 1. Often they're just going to come down on the side of the consumer-purchaser. Seems like courts will have to do a bit of stretching on the doctrine of offer/acceptance in order to reach this result. 5. Internet Fraud V. a. In cases of e-fraud, the seller is the one who bears the loss. If someone gets your credit card info and uses it to make a fraudulent order over the internet, the merchant is the one who "eats" it. How can seller protect itself? i. Ship solely to home address ii. Require telephone confirmation for large transactions Payment Systems: Electronic Transfers a. Electronic Funds Transfers i. The Basic Transaction Covered By Article 4A 1. Background a. Article 4A deals with whole sale wire transfers – substantial amounts; not the Electronic Funds Transfer Act which deals with small credit card and debit card and other small wire transfers. b. Wire transfers account for far more in dollar volume than either checks or credit cards. While 98% of volume of transactions are through credit cards and checks. 85% of value is through wire transfers. Average value of wire transfer is several million dollars. c. Two important things to understand about wire transfers – why do they account for 85% of value? i. Speed ii. Cost d. Wire transfer system gives you advantage of instantaneous payment for substantial amounts of money on which you don’t have to pay much. Charge to make a wire transfer is simply on the amount it takes to complete the transaction. e. One of the truly astonishing things – article 4A of UCC was not promulgated until 1989. All states adopted it by 1996. Thus astonishing for a system that handles such large amounts of money, there were no governing laws until mid 1990s. Before that had to be handled through common law processes. The world is much simpler now that we have article 4A. But 4A does require some close attention. 2. The Concept of Funds Transfer a. Funds transfers under Article 4A—accomplished by one or more payment orders, as defined in the statute, that are made to a bank. b. Bank is defined in the statute: broader than a commercial bank, but it also includes several other institutions. c. Section 108 excludes consumer transfers made under the federal Electronic Funds Transfer Act (EFTA) that we discussed in the context of debit cards. The debit card is therefore not subject to these rules. We're talking about transactions that take place among banks and banks alone. 3. Definitions a. 4A-103 and 104 are the main provisions b. When we talk about funds transfers (wire transfers), we are dealing with two basic concepts: 1) the sending of payment orders as defined in 4A-103 and 2) by those payment orders the effecting of a funds transfer under 4A-104. c. 103(a)(1) payment order – Payment order means an instruction of a sender to a receiving bank, transmitted orally, electronically, or in writing, to pay, or to cause another bank to pay, a fixed or determinable amount of money to a beneficiary if: i. The instruction does not state a condition to payment to the beneficiary other than time of payment, ii. The receiving bank is to be reimbursed by debiting an account of, or otherwise receiving payment from, the sender, and iii. The instruction is transmitted by the sender directly to the receiving bank or to an agent, fund-transfer system, or communication system for transmittal to the receiving bank. d. 103 (a)(2) beneficiary – the person to be paid by the beneficiary’s bank. e. 103(a)(3) beneficiary’s bank – the bank identified in a payment order in which an account of the beneficiary is to be credited pursuant to the order or which otherwise is to make payment to the beneficiary if the order does not provide for payment to an account. f. 103(a)(4) receiving bank – the bank to which the sender’s instruction is addressed. g. 103(a)(5) sender – the person giving the instruction to the receiving bank. h. 103(b) and (c) tell us that if more than one payment is to be made, each is a separate payment order and that a payment order is issued when it is sent to the receiving bank. i. 104(a) funds transfer – means a series of transactions, beginning with the originator’s payment order, made for the purpose of making payment to the beneficiary of the order. The term includes any payment order issued by the originator’s bank or an intermediary bank intended to carry out the originator’s payment order. A funds transfer is completed by acceptance by the beneficiary’s bank of a payment order for the benefit of the beneficiary of the originator’s payment order. j. 104(b) intermediary bank – a receiving bank other than the originator’s bank or the beneficiary’s bank. k. 104(c) originator – the sender of the first payment order in a funds transfer. l. 104(d) originator’s bank – (i) the receiving bank to which the payment order of the originator is issued if the originator is not a bank, or (ii) the originator if the originator is a bank. 4. 4A-104, Comment 1 Hypotheticals a. Facts i. X wants to pay Y several million dollars and wishes to do so via a wire transfer. ii. X is the originator; Y is the beneficiary. b. Case 1 i. Bank A has accounts both for X and for Y. Thus X as the sender of payment order instructs bank A to credit the account of Y. For purposes the statute, X is sender of payment order and originator of funds transfer. Bank A, bank to whom instruction has been sent, is the receiving bank of the payment order and also the originator’s bank of funds transfer as well as beneficiary’s bank. Thus when bank A notifies Y that the funds have been credited to its account or made available to it…the funds transfer is complete. One bank, one payment order scenario. ii. Called a book transfer because it’s all on the books of the same bank. iii. Is the least common because most often the originator and the receiver of the transfer will not have the same bank. c. Case 2 i. X and Y do not have accounts in same bank. X’s account is with Bank A and Y’s account is with Bank B. We assume that A and B have a contractual arrangement. So Bank A (under X’s instruction) is going to wire 1 million to bank B for ii. iii. iv. v. Y. With respect to this payment order, X is the sender, Bank A is the receiving bank, and Y is the beneficiary. Bank A carries out X’s order by instructing Bank B to pay 1 million to Y’s account. For this payment order, Bank A is the sender of payment order, Bank B is the receiving bank and Y is the beneficiary. In the funds transfer, X is the originator, Bank A is the originator’s bank, and Bank B is the beneficiary’s bank. When Bank A executed X’s order, X incurred an obligation to pay Bank A the amount of the order. When Bank B accepts the payment order issued to it by Bank A, Bank B incurs an obligation to Y to pay the amount of the order, and Bank A incurs an obligation to pay Bank B. Funds transfer is completed when bank B notified Y of availability funds. Two bank, two payment order transfer. This scenario is possible because Banks A and B have a contractual arrangement. d. Case 3 i. What happens when Banks A and B don’t have accounts with each other? The intermediary bank comes in. ii. Bank C is the receiving bank of A’s order and the intermediary bank as to the funds transfer. Section 104 defines intermediary bank as any receiving bank other than the receiving bank or beneficiary’s bank. iii. X needs to pay 1 million to Y and does so by wire transfer. Three bank, three payment order funds transfer. A is X’s bank and B is Y’s bank. In this case, Bank A may not be able to move the funds directly to Bank B because A and B may not have any relationship with one another. In order for funds transfers to work, the bank receiving the funds transfer must be able to debit the account of sender and credit account of person they are sending payment order to. Need direct contractual relationship as in #2 above. In many instances, A and B may not have an existing relationship…thus unless both are parties to a funds transfer system (fedwire and chips)…then basically they will have to find a correspondent bank that they can use… bank that has relationship with originator’s bank and beneficiary’s bank. iv. X gives payment order to bank A to wire funds to Y. X is sender of payment order and originator of funds transfer. Bank A as is receiving bank of payment order, originator’s bank of funds transfer, and sender of second payment order. Bank C is receiving bank of payment order and intermediary of funds transfer and then sender of third payment order. Bank B is receiving bank of Bank C’s payment order and beneficiary bank of funds transfer. Y is beneficiary. The funds transfer is completed when bank B notifies Y of availability of funds. (Note: in crediting Y’s account, Bank B was not sending a payment order). e. These Scenarios Generally i. In each of the three cases there is a transaction that could be completed within a matter of minutes. Even the most complicated orders will only take a few hours at most. High Speed is the "first imperative under 4A". Secondly, a transfer which can be accomplished using fairly little money. 1. The fees that banks charge are not based upon a percentage of what's transferred. Rather, they're made based upon mechanical function and with a modest amount of money for profit. 2. Because of the speed involved, these funds transfers are often deemed superior to even cashier's checks. There does remain the possibility that you could get "stiffed" even if the funds are in your account. 5. Article 4A does not apply to consumer electronic funds transfers such as point of sale transactions, ATM transactions, direct deposit and preauthorized debits, wire transfers like those of western union (because western union is not a bank). 6. In Summary a. Article 4A and wire transfers mean high speed, low cost, and irreversibility. b. The downside is that there is a huge risk because of the often enormous amounts of money involved. If things go awry, then it becomes a problem. c. The comments indicate that the law is a deliberate decision to make funds transfer a particular form of payment governed by unique rules. ii. Payment Orders 1. Background a. A funds transfer is one or more payment orders b. If there is no payment order, there can be no funds transfer under Article 4A. c. Payment order – an instruction of sender to a receiving bank, transmitted orally, electronically, or in writing to pay or cause another bank to pay a fixed or determinable amount of money to a beneficiary if: i. the instruction does not state a condition to payment to the beneficiary other than time of payment, ii. the receiving bank is to be reimbursed by debiting an account of, or otherwise receiving payment, from the sender, and iii. the instruction is transmitted by the sender directly to the receiving bank or to an agent, funds-transfer system, or communication system for transmittal to the receiving bank. 2. Trustmark Insurance Co. v. Bank One a. Facts i. Trustmark has accounts at Bank One. ii. Trustmark gives an instruction to Bank One that at any point in time when the amount in a certain account exceeds a 10k balance, that Bank One should transfer everything in excess of 10k to an interest-bearing account that Trustmark held in a separate bank. iii. For the first time ever, in Sept. 1996, the balance rose above 10k, but Bank One did nothing, and the balance in the account continued to grow until Dec. 1997, when the Bank One finally transferred the funds. There was over 19M in the account at this point! b. Breach of Contract i. Bank One claims that its agreement with Trustmark would prevent any substantial recovery under breach of contract theory. ii. There are rules governing receiving banks’ delay in issuing a payment order. Article 4A significantly limits the receiving bank’s liability for delay, though. However, Article 4A does entitle the sender the amount of lost interest resulting from the delay or failure. This is the basis of Trustmark’s claim: lost interest resulting from the receiving bank’s delay in issuing a payment order. iii. The claim here is for over 500k in interest lost as a result of Bank One’s delay in issuing a payment order. c. Payment Order? i. Article 4A states that to be a payment order, the instruction may not state a condition to payment to the beneficiary other than time of payment. ii. Ordinarily, payment orders are given to be paid immediately. 1. However, as long as the payment order is to pay at a fixed time in the future, there is no problem. 2. However, in this case, the time of payment is determinable, but not specifically stated. iii. Held: This is not a payment order because Trustmark’s instruction required Bank One to constantly monitor the account. 1. This was more than a condition stating the time of payment. 2. There was a condition requiring responsibilities than go beyond Article 4A funds transfer. a. The obligation to make an ongoing inquiry into the account balance removes the transfer from the definition of a payment order. 3. Because there was no payment order, there can be no recovery under Article 4A. a. This does not preclude a potential breach of contract claim of Trustmark because of Bank One’s failure to comply with their mutual agreement. iii. Acceptance of Payment Orders 1. Rules a. A receiving bank other than beneficiary’s bank accepts a payment order when it issues a payment order itself pursuant to instructions given in sender’s payment order. b. A beneficiary’s bank accepts by paying the beneficiary pursuant to the rules in 4A-405(a): crediting the beneficiary’s account and advising the beneficiary that the funds are present and available for withdrawal. 2. Problem, page 203 a. There is an ambiguity in the statute. There are three methods by which payment can occur: (4A-405(a)) i. Beneficiary is notified of right to withdraw ii. Bank lawfully applies the credit to a debt of the beneficiary (setoff) iii. When the funds are otherwise made available to the beneficiary by the bank—ambiguous. b. Beneficiary’s Bank (BB) received payment order and credited B’s account. BB notified B that credit had been received but said nothing about availability. But B was given immediate access at time account was credited. Was payment made at the time of the credit or at the time of notice? i. The originator’s liability is discharged when payment is made. This is why in this case the issue of when payment was made is important. ii. Held: Payment occurred as soon as the beneficiary had access to the funds, even though the bank had not given the beneficiary notice at that time. iii. Once the account is credited, payment occurs, even if the beneficiary bank has not given notice to the beneficiary. iv. Receiver Finality 1. Aleo Int’l Ltd. v. Citibank a. Background i. Many obligees view funds transfers as an optimal method of payment b. Facts i. Aleo instructed Citibank to send an amount to x in a Germany Bank. Citibank issued a payment order to Germany Bank. ii. Germany Bank credited the amount of the payment to x at 3:59 a.m. on October 14. 1. At this point, Germany Bank accepted Citibank’s payment order. 2. Aleo however, changed its mind and instructed Citibank to stop the transfer, which Citibank refused to do. Now Aleo sues. c. Held: Once acceptance has occurred, the transfer may not be stopped. i. Beneficiary was paid by the bank, so acceptance occurred. ii. Germany Bank credited at 3:59 a.m.; this was payment. iii. The attempt to cancel the payment order occurred later on, so it was ineffective. iv. Therefore, Citibank cannot be liable for refusing to stop the transfer. 2. Cancellation of Payment Order, 4A-211 a. Ordinarily can only occur before acceptance of a payment order. b. Once acceptance has occurred, the statute allows cancellation of payment order to beneficiary’s bank only in four defined circumstances: i. 1) Payment order was unauthorized ii. 2) Duplicate of previous payment order iii. 3) Payment to wrong beneficiary iv. 4) Payment was made in the wrong amount. c. “Buyer’s remorse” is not sufficient to cancel, once acceptance has occurred. That was the Aleo case. i. Even when cancellation may occur, the beneficiary’s bank must consent. ii. Rarely will the beneficiary bank consent to the funds being taken away from its customer, the beneficiary. Because this would be a bad customer relations move. 3. Absorption of Loss a. When one bank becomes insolvent, who bears the loss? b. With the exceptions of transfers in the Fedwire system (where there is immediate credit), all that is involved is a series of bank credits made by the banks taking part in the transfer. At the end of the day, all these “net out.” What happens if during the course of the day, one bank becomes insolvent and thus cannot settle? c. If beneficiary’s bank does not receive a settlement in this case, the beneficiary’s bank eats the loss. May not recover the funds back from the beneficiary. v. The “Money-Back Guarantee” 1. Background a. *A bedrock principle in Article 4A 2. Grain Traders, Inc. v. Citibank a. Background i. First authoritative opinion discussing the MB Guarantee ii. 2d Cir. b. Obligation of Sender: i. To make payment to bank to which order is sent ii. However, obligation is excused if funds transfer is not completed 1. Receiving bank must then refund to sender c. Facts i. GT (originator)  BCN (originator’s bank)  Citibank (intermediary bank)  BCIL (intermediary bank)  Extrader (beneficiary’s bank)  Kraemer (beneficiary). 1. Unless the parties to a funds transfer all have accounts with each other, there are intermediary banks. 2. This involves debiting and crediting banks among banks that have mutual agreements. ii. GT owes Kraemer a bunch of money; so does a funds transfer. GT instructs BCN to make payment to Kraemer. iii. This involves BCN debiting GT’s account and crediting Citibank’s account, etc., down the line to Kraemer. iv. BCN accepted GT’s payment order by issuing a payment order to Citibank. Citibank accepted by sending payment order to BCIL. But after this, we don’t know what happened. But we do know that Kraemer never got the money. v. Presumably BCIL never issued a payment order to Extrader because of Extrader’s precarious financial position. vi. GT asks BCN to ask Citibank to return the money. vii. After several unsuccessful efforts to get through to BCIL, a message was received saying that BCIL’s account could be debited to reverse the series of payment orders. However, Citibank did not debit BCIL’s account and return the money to BCN. viii. Citibank asserts that BCIL had exceeded its credit limitations. Citibank refused to undo the payment order from BCN; claimed that BCIL had an insufficient balance in its account so it couldn’t return the money to BCN. ix. BCIL owed Citibank money and in light of BCIL’s financial distress, Citibank determined that it was unlikely to get paid. So Citibank froze BCIL’s account and refuses to return the money to BCN. x. Therefore, GT is out of its money paid to BCN. Citibank has the money now in its account. It appears that Citibank is getting a windfall. xi. GT still owes Kraemer the money. xii. GT sues Citibank. d. Statute: 4A-402 i. Under the MB Guarantee, GT’s action is strictly against its receiving bank, BCN. ii. The sender cannot sue a receiving bank with which the sender is not in privity. iii. The funds transfer was not completed, therefore, under 4A-402(c), GT’s obligation to pay BCN is excused and therefore under (d), GT is entitled to a refund (the MB Guarantee) from BCN. iv. The MB Guarantee Defined 1. The statute makes no provision for a sender to seek refund from any bank other than the receiving bank of that sender’s payment order. 2. The MB Guarantee is that if the funds transfer is not completed, the sender can receive its money back from the receiving bank to which the payment order was sent. 3. 4A-402(d) “If the sender of a payment order pays the order and was not obliged to pay all or part of the amount paid [because the funds transfer was never completed], the bank receiving payment is obliged to refund payment to the extent the sender was not obliged to pay.” This is the MB Guarantee. 3. Policy Behind the MB Guarantee a. Effect an orderly unraveling of a funds transfer in the event that it is not completed b. Provides a predictable scheme by only making receiving banks liable to the sender with whom the receiving bank is in privity 4. Article 4A-402(e) a. Provides a narrow exception to the MB Guarantee: when the originator instructed the sender to use a certain intermediary bank that becomes insolvent. b. Originator instructs Bank A to use Bank C to pay B with account in Bank B. i. Bank C is an intermediary that is insolvent, so it fails to complete the transfer. ii. The ordinary MB Guarantee would be that the originator would get its money back from Bank A. And Bank A would be left holding the bag because it can’t get its money back from Bank C. iii. This would be unfair in this case because the originator instructed Bank A to use C as an intermediary. iv. Therefore, the exception to the MB Guarantee is that Bank A may recover from the originator, and the originator is subrogated to Bank A’s right to recover from Bank C. 5. Common Law a. Common law principles should not be integrated into the MB Guarantee statutes b. The official comment expresses that the statute is intended to be the exclusive authority for addressing rights and duties. c. This comment begs the judiciary to ignore common law principles outside of Article 4A. vi. Erroneous Execution of Payment Orders 1. Sending Bank’s Errors a. General Article 4A principle is that the sender is liable for its own errors. b. Problem, page 214 i. OriginatorOriginator’s BankIntermediary BankBeneficiary’s BankBank. ii. Because OB has no relationship with BB, OB needs IB to complete the funds transfer. iii. Case #1. OB executed the payment order by instructing IB to pay BB 100k for the account of a certain beneficiary. However, IB mistakenly instructed BB to pay 100k for the wrong beneficiary. This can easily occur by mistyping one digit, thus sending the money to the wrong beneficiary. 1. a) IB did execute the payment order of OB. Because execution occurs when a bank sends a payment order intended to carry out the order it received from a sender. 2. b) The funds transfer was not completed; this is the MB Guarantee. The wrong beneficiary was paid, so the transfer was not completed. O’s obligation to pay OB is excused. 3. c) IB, therefore, is not entitled to payment from OB. Because the funds transfer was not completed, OB’s obligation to pay IB is excused. 4. d) BB is entitled to payment from IB. Because the BB accepted the payment order, it is entitled to payment under 4A-402(b). 5. e) IB may be entitled to recover from the mistaken beneficiary. Under 4A-303(c), when the executing bank issues an order to the wrong beneficiary, the sender of the erroneous order may recover to the extent allowed by the state law governing mistake and restitution. a. The IB made the error, so it bears the loss, unless state law of restitution changes this result. iv. Case #2 – OB mistakenly instructed IB to pay too much money. 1. Under 4A-303(a), O is obligated to pay OB 100k, not the greater amount that OB mistakenly ordered IB to pay. 2. OB who made the error is then allowed to pursue the beneficiary for the excess amount, under state law governing mistake and restitution. 2. Discharge-for-Value Rule a. Hypothetical: the originator’s bank sends the payment order to the beneficiary’s bank, but to pay the wrong beneficiary. However, if by happenstance the wrong beneficiary happens to be a creditor of the originator, if the amount is in excess of $100k, the creditor may keep the money in certain situations. b. Two different rules: i. Mistake of Fact 1. The more restrictive rule. 2. Under the common law, this meant that to keep the payment, the person receiving payment would have to show change in position; detrimental reliance. 3. For example, show cancelation of a mortgage, delivery of goods, etc.., in reliance on receiving the originator’s money. 4. If no reliance was shown, the creditor/wrong beneficiary would have to return the money to the originator. ii. Discharge-for-value Rule 1. Creditor has no duty to make restitution as long as the creditor can show that (1) he had no notice of the mistake and that (2) the creditor was in good faith (made no false representations) 2. Article 4A adopts this rule as the majority principle. c. In Re Calumet Farms i. Note: This scenario—where the wrong beneficiary will actually be an obligee of the originator’s obligation to pay—is very uncommon. The more common situation is where someone is overpaid and wants to keep the excess amount. ii. Facts 1. Originator owes $1 million; instructs First National (FN) Bank to make a payment on the debt. 2. The money was sent to the correct account of the correct beneficiary, but FN added a zero, sending a higher amount in its payment order to the next bank in the chain. 3. FN now brings an action to recover the overpayment from the beneficiary. iii. Court 1. The discharge-for-value rule applies. 2. Issue: When does notification of the mistake to the beneficiary occur? 3. Restatement on Restitution: the creditor who receives a benefit in discharge of the debt is under no duty to make restitution, although the discharge was given by mistake, if the creditor was in good faith and had no notice of the mistake. 4. There must have been a discharge of Calumet’s debt on the beneficiary’s books, which did not occur until after the beneficiary had been notified of the error. a. Thus the discharge came after the beneficiary received notice, and the beneficiary must return the overpayment. b. Therefore, FN is entitled to restitution. i. Note that FN incorrectly sent an order for an overly high amount; so it could only recover from Calumet the amount for which it sent an overpayment order. FN can only recover the amount of the originator’s payment order from the originator under 4A-303. iv. 4A-406(a)(1) – The originator’s obligation to the beneficiary is discharged whenever the beneficiary’s bank accepts the payment order sent to it. 1. Under this standard, if the correct amount was sent, at the instant the beneficiary’s account was credited, the originator’s obligation would have been discharged. 2. However, the statute specifically says that the discharge is made to the extent of the amount specified in the originator’s payment order. 3. In a case of overpayment, like this case, the payment of the originator’s debt only occurs to the extent of the intended payment amount. Therefore, the over-amount has not been “paid” under the statute at the time that the beneficiary receives the funds. 4. Because the discharge for an overpayment only occurs at the time that the beneficiary applies it to the originator’s account, therefore in this case, the discharge did not occur until after the beneficiary had notice of the overpayment; therefore, there was no discharge-for-value. The beneficiary had notice of the overpayment and thus must make restitution for the overpayment to the originator’s bank. vii. Failure of Receiving Bank to Execute Payment Order 1. Evra Corp. v. Swiss Bank Corp. a. Facts i. Originator needed to pay a certain amount of money to beneficiary by a certain date in order for the originator to keep its charter to use the beneficiary’s ship. ii. Originator issued a payment order to his bank, who issued payment order to intermediary bank, who issued an order to Swiss Bank (intermediary). iii. Swiss Bank received the order but did not execute the order to the beneficiary’s bank. 1. Ordinarily the result of this would be the Money Back Guarantee. 2. But the issue is that because Swiss Bank made a late payment, beneficiary did not receive the money on time and canceled the originator’s ship charter. b. Issue: Can Swiss Bank be liable for consequential damages of the originator (the economic losses in not obtaining the charter from the beneficiary)? c. Held: Swiss Bank did not have a reason to know of the importance of the ship charter and the potential for consequential damages; they were not foreseeable, so Swiss Bank was not liable for consequential damages under contract law. i. Judge Posner’s opinion ii. This opinion was written without the benefit of the modern statute. 2. Article 4A Extent of Liability a. 4A-212 i. A receiving bank only has to execute a payment order to the extent it has obliged itself to do so by express agreement. ii. If it does not comply with the agreement, it is liable as expressed in the agreement or in accordance with this statute. iii. The receiving bank will be in privity with the originator’s bank; this will be the applicable agreement governing the receiving bank’s duty to execute a payment order. iv. The parties have freedom of contract and can contract their liability in most cases. v. An originator will never be in privity with an intermediary bank. Thus there will not be an agreement between the originator and intermediary, so the intermediary owes no duty to the originator. 1. Therefore, the result in the case above will not exist today. 2. Because an intermediary owes no duty to the originator of the funds transfer, there can be no recovery for damages, much less consequential damages. vi. However, the originator’s bank is in privity with the originator. Thus there is the possibility of the originator’s bank failing to execute a payment order issued by the originator, and the bank may have a duty by virtue of contract with the originator and may be liable for failure to execute the payment order. The extent of liability is expressed in 4A305(d). b. 4A-305(d) i. If a receiving bank fails to execute a payment order that it was obliged by express agreement to execute, the bank is liable to the sender for its expenses in the transaction and for incidental expenses and interest losses resulting from the failure to execute. Additional damages, including consequential damages, are recoverable to the extent provided in an express written agreement of the receiving bank, but are not otherwise recoverable. ii. Incidental expense may be the cost of issuing a new payment order; only incidental expenses and interest losses are recoverable by the originator, and only if there is a duty to execute the payment order provided in an express agreement. iii. The statute “hard-heartedly” denies consequential damages to the originator, except if an express written agreement provides for them. 1. The policy behind this rule is that the banks convinced the statute drafters that high damage costs would prohibit high speed and low cost that are pillars of the electronic funds transfer system. 2. The originator is in the best position to monitor the progress of the transfer. The originator can pick up the phone and call to make sure that the process is moving along. a. Evra Redux i. The case demonstrates this point—the originator did not monitor the transfer. ii. Twice, the originator waited until the day before the payment was due to initiate the funds transfer. The originator was clearly in the best position to manage the risk. viii. Fraudulent Payment Orders 1. Statutes a. The drafting was a contentious process as to whether the customer or the bank should bear the loss where the originator purports to be the customer but is a crook and initiates a funds transfer. In these situations, fraudulent originator orders payment to his own bank account or that of an accomplice. b. Agency Law i. The initial determination of whether the transfer was authorized is a matter of agency law. Ask whether the person was authorized by the sender to make the transfer. ii. 4A-202(a) – A payment order received by receiving bank is the authorized order of the person identified as sender if that person authorized the order or is otherwise bound under the law of agency. iii. But this doesn’t add much—because crooks will not be authorized under the law of agency. c. Guiding Concerns: i. Whether the bank made available to its customer a commercially reasonable security procedure ii. Whether the bank complied with the security procedure. iii. If these two requirements are met, the bank will ordinarily not be liable. d. A bank cannot claim that a mere signature comparison constitutes a security procedure. e. 4A-202(b) – If customer and bank have agreed on security procedure, a payment order received by bank is effective as the order of the customer whether or not authorized, if (i) the security procedure is commercially reasonable and (ii) bank proves that it accepted the payment order in good faith and in compliance with the security procedure and any written agreement between customer and bank. i. Exception, allowing allocation of loss to the bank: 4A-203(a)(2) If a payment order is effective, receiving bank is not entitled to enforce or retain payment if customer proves that the order was not caused directly or indirectly by a person (i) with duties to act for the customer with respect to payment orders or the security procedure, or (ii) who obtained access to transmitting facilities of the customer, or who obtained, from a source controlled by the customer and without authority of the receiving bank, information facilitating breach of the security procedure. 2. Problems, page 220 a. #1 i. Fraudulent transfer; customer did not authorize. ii. Need to know whether there was a security procedure that was commercially reasonable and whether the bank followed it. If not, then the bank is liable to the customer. iii. If commercially reasonable procedure was followed by the bank, the loss falls on the customer, unless the customer can invoke the 4A-203 exception… 1. …That no one connected with the customer provided the information to the crook who gained access. b. #2 i. “Cyber Caper”—international fraud by Russian grad student who penetrated a security system so sophisticated that industry experts said what he did was “almost impossible.” ii. Same answer was problem #1. Procedure was commercially reasonable and was followed, so customer would bear the loss. iii. However, if the customer invokes the exception, proving that the crook did not obtain the information from a source associated with the customer, the bank would bear the loss. 1. **The comments to 4A-203(a)(2) are helpful in interpreting the somewhat ambiguous exception. 2. Simple theft of information a. E.g. the Russian is an expert lockpicker, goes to customer’s offices and rummages through the code book, using it to make fraudulent transfers. b. The statute is ambiguous on this fact pattern. c. Cmt. 5 – Indicates that the loss shifts to the bank if the customer can prove that the crook did not obtain the information from an agent of the customer. 3. The statute may be fairly interpreted to say that if there is simple theft, without a voluntary action by an agent of the customer, the exception applies and the customer can shift the loss to the bank. iv. Another criticism of the exception is that it requires the customer to prove a negative—that none of the customer’s employees or other agents was responsible for the disclosure of the information. 1. For Wal-Mart as a customer, it is impossible to prove that none of its thousands of employees was responsible! 2. The comments to the statute indicate a belief that ultimately “the truth will come out.” The crook will eventually be caught through criminal investigations. Thus it’s not as much of a burden as customers claim to prove what is required by the statute. c. Commercial Reasonableness i. 4A-202(c) – Question of law determined by considering the wishes of the customer expressed to the bank, the circumstances of the customer known to the bank, including the size/type/frequency of payment orders normally issued by the customer to the bank, alternative security procedures offered to the customer, and security procedures in general use by customers and receiving banks similarly situated. ii. …However, if the bank offers a customer a procedure that’s reasonable, and customer refuses and chooses a different one, the one selected by the customer will be deemed to be commercially reasonable. ix. Incorrectly Identified Beneficiary 1. Statute: 4A-207 a. *One of the most common issues under Article 4A b. Problem, page 221 i. Thief impersonated Investor by ordering a payment to the account of Investor. ii. The account number in the order was xyz. iii. Payment order was made to OB, which executed payment order to BB, who credited the account bearing number xyz. Xyz was actually the account of Coin Dealer. iv. Who bears the loss? 1. Under 4A-207(b), the beneficiary’s bank may rely upon the account number as long as it has no actual knowledge of the discrepancy. a. Thus in this case the BB is not liable. b. This is an automated system, and the bank is not required to compare the account number with the name of the listed beneficiary. It is economically not feasible to require the bank to perform this comparison. c. This leaves the originator with a possible cause of action in restitution. Originator bears the loss, unless under (d)(1), originator can recover under restitution from the Coin Dealer—the incorrect beneficiary. 2. If the beneficiary’s bank has knowledge of the discrepancy between name and account number or simply pays the named person rather than the account number, then the beneficiary bank bears the loss. a. If a bank has knowledge of the discrepancy, it has the duty to clarify. b. Therefore, if bank knows of discrepancy and pays someone not entitled to payment, acceptance cannot occur. Beneficiary bank could not accept the payment order sent to it. And effectively, BB has just given its money away to Coin Dealer. i. This leaves the possibility of BB recovering under restitution from Coin Dealer, or to recover from Thief— which is unlikely because he has absconded. v. (c) addresses customer concerns: 1. For the originator to bear the loss, the bank must notify the originator that in the case of a discrepancy between name and account number, the beneficiary bank will be entitled to rely upon the account number. 2. Thus the originator’s bank must provide some sort of notice to the originator of the practice of relying upon the account number, to make the originator liable for the loss. c. Text i. (a) Subject to (b), if payment order received by beneficiary’s bank contains name or bank account number referring to a nonexistent or unidentifiable person, no person has rights as a beneficiary and acceptance cannot occur 1. Error in the statute—“or” should say “and.” ii. (b) If a payment order received by beneficiary’s bank identifies the beneficiary both by name and account number and the name and number identify different persons: 1. (1) Except as in (c), if the beneficiary’s bank does not know that the name and number refer to different persons, it may rely on the account number. 2. (2) If beneficiary’s bank pays the person identified by name or knows that the name and number identify different persons, no person has rights as beneficiary except the person entitled to receive payment from the originator. If no person has rights as beneficiary, acceptance cannot occur. iii. (c) If a payment order in (b) is accepted, the originator’s payment order described the beneficiary inconsistently by name and number, and beneficiary’s bank pays the person identified by number under (b)(1): 1. (1) If originator is a bank, originator must pay its order. 2. (2) If originator is not a bank and proves that person identified by number was not entitled to receive payment, originator not obliged to pay unless originator’s bank proves that originator had notice—before acceptance of its order—of a policy that someone will be paid based on account number even if inconsistent with the named beneficiary. iv. (d) In a case under (b)(1), if beneficiary’s bank rightfully pays the person bearing the number and that person was the wrong beneficiary, the amount paid may be recovered from that person under law governing mistake and restitution as follows: 1. (1) If originator is obliged to pay its payment order under (c), originator may recover. 2. (2) If originator is not a bank and is not obliged to pay its payment order, originator’s bank may recover. 2. Corfan Banco Asuncion Paraguay v. Ocean Bank a. Background i. This case results from a drafting error in 4A-207 ii. The account number identified no one iii. Statute: 4A-207(a) 1. Subject to (b), if name, bank account number, or other identification refers to a nonexistent or unidentifiable person or account, no person has rights as a beneficiary and acceptance cannot occur. b. Facts i. OB to IB to BB to B is the transaction. ii. B was described by name, but also by an account number that did not exist. iii. BB noticed the discrepancy. Could not pay anyone because the account number did not exist. But BB then contacted the named B and verified the correct account information. iv. OB then discovers its mistake and sends a duplicate payment order in exactly the same amount, this time with the correct account number. Therefore, B has been paid twice. v. OB sues BB to recover the amount of duplicate payment. c. Analysis i. Court applies the literal language of the statute and finds that acceptance could not occur, so BB must refund the money to OB. ii. Statute says that if any item of identification (name, number, etc.) does not exist, then acceptance cannot occur. 1. Court applies this literally. Can’t get to (b) because (b) only applies if the name and number refer to different persons. 2. The account number in this case identified no one. Therefore, acceptance could not occur. 3. Statute should be amended under (b) to say that acceptance may occur if name and account number do not refer to the same person. x. Bank-Customer Agreement 1. Regatos v. North Fork Bank a. Background i. Two basic rules: 1. 4A-204 in the case of an unauthorized payment order entitles the customer to a refund a. The bank “shall” make the refund. b. Customer must exercise ordinary care to notice the error and notify the bank within a reasonable time. 2. 4A-505 If the customer fails to notify the bank within one year of the facts, then the bank is not obligated to refund the payment. b. Facts i. Two fraudulent payments orders ii. Bank did not comply with its own security procedure, which was itself “ludicrously deficient” 1. The comparison of a signature alone is not a procedure at all. Bank was supposed to compare the signature and made a phone call. 2. Bank did not make a phone call. iii. But customer did not notify the bank until a couple months after the fraudulent orders; customer had agreed to not receive his bank statements until later than normal. But when customer did receive the statement, he notified the bank promptly. c. Analysis i. Customer takes the position that 4A-505 is a mandatory rule trumping a bank-customer agreement, so he has a full year to notify the bank of the fraudulent payment order. ii. The bank takes the position that the bank-customer contract requires the customer to notify the bank within 15 days. 1. Agreement: the customer must exercise reasonable care in examining bank statements, including for unauthorized signatures must notify the bank no later than 15 days after the bank statement is first made available to the customer. iii. Article 4A-501(a)—The parties may vary their rights and obligations by agreement, except as otherwise provided in Article 4A. 1. So the bank argues that this provision provides a general freedom of contract. a. Specific provisions say that they are not unalterable. b. 4A-505 says nothing suggesting that it is not alterable by agreement. d. Court i. Argues that 4A-505 and 4A-204 are in pari materia. ii. 4A-505 states a fundamental right of a customer to be refunded, when there has been an unauthorized payment order, if it notifies the bank within one year. iii. The 15 day window in the contract is trumped by 4A-505. e. Criticism i. Article 4A represents carefully crafted compromise between customers and banks ii. 4A-505 should be viewed as merely a default rule because it does not contain language saying that the one-year period is unalterable by agreement. iii. Still, maybe the failure to tie together 4A-505 nonvariable was a drafting error. 2. Rule of Reason a. Some courts take the viewpoint that while 4A-505’s oneyear period is alterable by agreement, there is a rule of reasonableness governing a bank-customer agreement giving a customer a time period lesser than one year VI. i. This is foreshadowing of the next chapter—the loss can be imposed upon the customer if the customer does not examine his statement and report a forgery within a certain amount of time. b. Case law has addressed not whether the one year period can be altered by agreement, but by how much the period can be shortened. c. Jurisprudential rule: The one year can be shortened but must be reasonable. i. 10 days would not be reasonable. ii. 60 days might be reasonable. iii. The lower court in Regatos has used this approach to reach the same result used in the appellate court: bank could vary the one-year period by agreement, but 15 days was unreasonable. Fraud, Forgery, and Alteration a. Forgery i. Allocation of Loss Between Customer and Payor Bank 1. Introduction a. Generally i. *******This is the meat of the course. ii. Check fraud is a huge problem. iii. Think Wal-Mart just filling out the check for you as a “debit card” –type transaction; the crook does the transaction without leaving information on the check. iv. ***It is CRUCIAL that we learn these rules. b. Forged Checks i. Scenario 1. Drawer has check that Thief steals, and Thief forges Drawer’s signature. 2. Thief passes the check to a Payee, who deposits with Depositary, who forwards the check to Payor/Drawee for payment. 3. We are concerned with Drawer/Payor relationship. ii. Outcome 1. Thief’s forgery is “ineffective” as the signature of the Drawer. The check does not represent Drawer’s order under 3-403(a). Thus check is not properly payable under 4401(a) because not “authorized by the customer.” 2. Payor Bank must re-credit the amount to Drawer’s account c. Forged Indorsements i. Scenario 1. Drawer issues check to Payee. Thief steals check from Payee. 2. Thief forges Payee’s indorsement on check and deposits with Depositary, which presents check for payment to Payor/Drawee. ii. Outcome 1. The general result is the same as with forged checks: the Thief’s forgery is ineffective as the signature of the Payee. 2. The Payor was authorized to pay based on Drawer’s signature, which did not occur. 3. The check was not properly payable and thus Payor Bank must re-credit Drawer’s account for amount of the check. d. General Rule: The customer/drawer is protected from forgery. When forgery occurs, the payor bank has to recredit the customer’s account after the thief’s fraud is perpetrated. i. However, there are exceptions, which we explore below. ii. The payor may be able to reallocate some of the loss to the customer under these exceptions. 2. Negligence of Customer Contributing to Forgery a. Statute: 3-406(a) i. The statute imposes a duty of ordinary care on the customer ii. Summary of text: A person whose failure to exercise ordinary care substantially contributes to an alteration of an instrument or to the making of a forged signature on an instrument is precluded from asserting the alteration or forgery against the bank iii. Therefore, the loss because of a forgery can be shifted to the customer if (1) the customer did not use ordinary care and (2) this failure substantially contributed to the making of the forgery. 1. Thompson Maple Products’ ordinary care analysis is incorporated into this statute b. Thompson Maple Products v. Citizens Nat. Bank i. Facts 1. Plaintiff purchases timber from local businesses, uses local truck haulers to bring the timber to plaintiff’s mill 2. When logs were delivered by haulers, the plaintiff’s employee was supposed to fill out scaling slip—give original to bookkeeper and give copy to the truck hauler. 3. However, the plaintiff rarely ever followed these internal procedures. In actuality, plaintiff’s employee gave slips to the hauler, who then brought the slips to the bookkeeper 4. The fraudster was a truck hauler who would get blank slips and fill them out to himself, bring them to the bookkeeper, and have a check written, and volunteer to bring the checks to the timber owner. Fraudster then would forge payee’s signature (forged indorsements) and deposit them at the bank, have them paid to himself. ii. Court 1. Thompson is precluded from asserting the forged indorsements against the bank because of the customer’s failure to exercise ordinary care that contributed substantially to the loss. 2. “Substantially contributes”—there must be a showing that the customer’s negligence made it easier for the forger to commit the fraud. Customer is precluded from pleading the forgery because its negligence made it easier for the fraudster to commit the forgery. iii. Ordinary Care 1. Making blank slips available to truckers and not using sequentially numbered slips, in addition to allowing truckers to bring the slips to the bookkeeping office—in totality, all these acts constituted a failure to exercise ordinary care. 2. In this case, the negligence of customer is related to the payee’s indorsement. This is a rare case; usually if the payee’s indorsement is forged, the customer’s negligence will not contribute. Usually, the customer-drawer’s negligence will lead to a forged check, not a forged indorsement. c. Modern Cases i. There has been some shift away from the strictness of the UCC. One case found that the negligence was not “proximately related” to the forgery, so the bank would still be liable. This “proximately related” standard of causation is pre-UCC standard. The actual UCC standard of “substantially contributes” only requires that the negligence make it easier for the forgery to occur. ii. Where insurance company had two insureds named John Doe in different states and mailed check to the wrong John Doe, this substantially contributed to the ability of a forgery to occur, and the customer was precluded from shifting loss to the bank. d. Problems, Page 239 i. 3-406(b) creates an exception to the exception. Despite the rule of customer negligence, (b) provides that if the bank fails to exercise ordinary care and that failure substantially contributes to the loss, the loss is allocated between the customer and the bank in a sort of comparative negligence analysis. ii. #1 – In the Thompson Maple Products case, the checks were “on us” checks. In other words, the drawee bank was the bank in which the fraudster deposited the check. Drawee/payor bank and depositary bank were the same bank. Normally, the payees of the checks might not have a reason to transfer the checks to the fraudster. The payees would normally deposit these checks in their own accounts. 1. This might raise at least some curiosity of the bank as to why the farmers would have paid the hauler for services by negotiating the check from the plaintiff to the hauler. In most instances, check would be deposited in payee’s account, and payee would make a separate check payable to the truck hauler. 2. This suggests possible lack of ordinary care on the bank’s part. Therefore, there would be comparative fault applied between bank and customer; each would bear part of the loss from the forgery. a. Note that the statute does not give any indications of how to allocate percentages of fault. iii. #2 – In this hypo, these are not “on us” checks; the fraudster deposits the check in his own depositary bank. Assume that the checks to the timber companies were made to corporate payees, and indorsements of these companies would ordinarily be printed and “look official.” The fraudster made crude indorsements, so the customer/drawer may have an argument that the payor/drawee bank failure to exercise ordinary care in not questioning the appearance of the indorsement. 1. But in this case, the fraudster had no account with the payor bank, so the payor bank would have no reason to be familiar with the fraudster’s signature. 2. Held: the drawee bank had no duty to examine a check to determine irregularities with regard to indorsements. a. The drawee bank pays by automation and never looks at an indorsement of a check. b. Further, the depositary bank warrants that the indorsements are valid, so the drawee/payor has no duty to look at the indorsements. Payor can pass the loss back to the depositary bank. The depositary bank would thus be liable in such a case for breach of its presentment warranty—foreclosing a need for a negligence analysis with respect to the depositary bank. The next case discusses the potential liability of a depositary bank in this scenario. e. Halifax Corp. v. Wachovia Bank i. Facts 1. The fraudster had access to the signature stamp for the President of the company; would stamp the checks, fill out the remainder of the checks by hand, and either deposit these checks in her account or cash them. 2. The depositary bank never raised any questions at all about these activities. Even though the depositary bank knew that this fraudster could not have the salary, as an employee, necessary to be payee of this many successive checks from the employercompany. ii. Court 1. These were forged checks because the fraudster’s act of stamping was unauthorized. 2. Perhaps the drawee bank was negligent. However, the customer-drawer company failed to report any of the forgeries to the drawee/payor bank until the one year cutoff in 4-406(f) had accrued. a. Therefore, if the customer recovers anything, it has to find a way of shifting the loss to the depositary bank. b. Depositary banks make no guarantees with regard to the drawer’s signature. c. Legal doctrine: 3-406 is broader than relationship between drawer and drawee. It implicitly does create an affirmative cause of action for the drawer against the depositary whose negligence contributed to the loss. d. This Court: Rejects the legal doctrine and finds that 3-406 does not create a cause of action against the depositary bank. e. Professor’s observation: the law is still evolving, and the White & Summers’ legal doctrine is highly persuasive. But in this case, the court’s finding makes sense because a depositary bank has no duty to discover a forged signature of the drawer, because depositary is only concerned with its customer, the indorser. 3. Failure of Customer to Report Forgery a. Background i. It is easier for a customer to detect forgeries than it is for a payor bank to detect, thus 4-406 imposes a duty on the customer to report forged checks to the bank. ii. As the volume of checks has grown, banks have stopped doing sight review to verify signatures. iii. 4-406 was originally designed to codify the duty of the customer/drawer to examine bank statements with reasonable promptness, and if the customer discovered forgeries or unauthorized checks, to report this to the bank on a timely basis 1. Under original 4-406, if the customer could show that the bank was negligent, the bank was contributorily negligent and would bear the entire loss. However, now, this is only comparative negligence. 2. Traditionally, to shift the loss, the customer would argue that the failure of the bank to perform sight review of check signatures was negligence that should cause the bank to bear the loss. iv. Banks shifted from sight review of all checks to payment by machine with no human examination 1. Customers then argued that in eliminating sight review, this was elimination of a traditional service and lack of ordinary care 2. Early cases were deeply divided. Medford held that failure to perform sight review was negligence as a matter of law. 3. The banking industry put major efforts into this litigation and later cases adopted the Hand Formula—if cost of sight review outweighed the benefit, it was not negligence as a matter of law. a. The 1990 Revision adopted these cases. New definition of ordinary care. b. “Ordinary Care,” 3-103(a)(7): in the case of a person engaged in business, means 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. In the case of a bank that takes an instrument for processing for collection or payment by automated means, reasonable commercial standards do not require the bank to examine the instrument if the failure to examine does not violate the bank’s prescribed procedures and the bank’s procedures do not vary unreasonably from general banking usage not disapproved by this Chapter or Chapter 4. i. Comment acknowledges the banking industry’s position that sight review is very costly. ii. The costs of sight review outweigh the benefits— often sight review does not catch forged checks, anyway. c. Espresso Roma Corp. v. Bank of America i. Facts 1. Employee fraud—classic inside job. Steals blank checks from employer, prints out blank checks from computer and forges signatures. Removes forged checks from bank statement that were mailed to the company. 2. More than $330,000 stolen over one and a half years 3. There was a lack of internal controls 4. The bank abandoned all sight review of checks. ii. Held: The bank established sufficient evidence that it exercised ordinary care. iii. 4-406 discussion 1. Where the customer does not report on a timely basis, the customer eats the loss 2. However under (e), if the bank did not exercise ordinary care and this contributed to the loss, the loss is apportioned between the bank and its customer 3. The bank’s procedures were reasonable because other similarly-sized large banks in that geographical area had abandoned sight review 4. These cases almost always come down to trials with “dueling experts.” The customer and banking expert will each state what he believes to be standard banking usage. a. The bank’s expert testified that for similar banks in northern California, no similar bank used sight review. b. The court found that this provided a prima facie case that the bank’s procedures were reasonable. c. The customer’s expert testimony was not persuasive because it focused on other types of banks in the same geographic area. iv. Additionally, even if failure to do sight review was negligent, in this case, it did not contribute to the loss. v. 3-103 Comment 5 states that a customer may prove that the rules followed by a particular bank are unreasonable, arbitrary, or unfair. 1. This comment addresses the some concern that banks could get together, in collusion, and follow the same practices; to essentially collectively set the benchmark for ordinary care. 2. This comment just states that even though a practice is general banking usage, the customer can introduce evidence that the usage followed is unreasonable, arbitrary, or unfair—and therefore a lack of ordinary care 3. However, one court found that the language of the statute trumped the comment. d. Time Limitations i. 4-406(f) If a customer does not report a forgery within one year after the statement is made available, the customer cannot raise the forgery against the bank, regardless of lack of ordinary care by bank and/or customer. ii. 4-406(e) states that if the bank pays the instrument in bad faith, the bank bears the loss. 1. This addresses the situation where the forger has inside help from the bank. e. Bank Statements i. Some banks no longer mail canceled checks to their customers. ii. The customer’s duty to report forgery is triggered by the bank’s sending a statement of account. This raises the question of how much information about the check the bank must provide in order for the customer’s duty to report to be triggered. iii. There is no duty to report; therefore, if the bank does not return the checks, this just means that the customer’s duty to report is not triggered. iv. However, if check number, amount of check and date are provided, the customer has significant information, and the duty to report is triggered. As of now, there is no requirement of returning an image of a check to the customer to trigger the duty to report. f. Agency Law Issue i. The customer cannot satisfy his duty to report, when the forger is the one authorized by the customer to oversee financial matters. ii. As a matter of agency law, if authority is delegated to a forger to receive bank statements, and that person takes advantage of that authority, the customer is bound by apparent authority. iii. Therefore, if the customer hires a crook, this is the customer’s “tough luck.” The duty to report is not excused by virtue of hiring a crook. “Duty of supervision” is not an issue. g. Problems, page 249 i. Agreement between Bank and Company, its customer, is that Bank may pay checks drawn on account only if signed by CFO—Hardy and deputy —Olsen. ii. #1 – Olsen signed his name, but Hardy did not. Even though there was no forgery, under 3-403(b), the signature was unauthorized. If more than one signature is required on a check by virtue of bankcustomer agreement, if a signature is missing, the check is unauthorized. iii. #2 – Olsen fraudulently wrote 3 checks on Company’s account payable to Olsen. He forged Hardy’s signature. Under Bank’s procedures, it did no sight review for checks less than $2,500. Fraud was discovered by Company in June. Olsen was then insolvent. Company notified bank on June 7, immediately after discovery of the fraud. 1. (a) First check for $1,000 paid on Jan. 2 and returned on Jan. 4. a. The starting point is 4-406(c): The customer must exercise reasonable promptness in examining the statement. If customer should have reasonably have discovered the unauthorized payment, the customer must promptly notify the bank of the relevant facts. This is the basic duty of the customer. b. “Reasonable promptness” is not defined. The 30 day period of (d) is not part of (c). Whether there is an excuse for the delay is the starting point of the analysis—consider all the facts and circumstances if there is a delay in reporting. If there were extenuating circumstances, the customer does not violate the duty by not reporting immediately. We only reach (d) if the customer does not meet his duty in (c). c. 4-406(d) – If the customer failed to comply with the duty imposed, the customer may not assert: (1) the customer’s unauthorized signature or any alteration if the bank also proves that it suffered a loss by reason of the failure; and [may not assert] (2) customer’s unauthorized signature or alteration by the same wrongdoer on any other item paid in good faith by the bank if payment was made before the bank received notice from customer and after customer was afforded a reasonable time, not exceeding 30 days, in which to examine the item and notify the bank. d. (d)(1) refers to the rare occasion where there is one isolated forgery, and also refers to the first check (in a series of forgeries) that is apparent in the first statement. (d)(2) refers to the checks after the first check in a serial forgery. e. (d)(1) says that for the one-time forgery or the first check returned in a forgery, the customer bears the loss if the customer unreasonably delayed under (c) and the bank suffered a loss under (d)(1). In this case, there is no way that the customer complied with its duty under (c); it delayed 6 months between receiving notice of the first check and notifying the bank. However, under (d)(1), the bank must prove that it suffered a loss by reason of the customer’s failure to give notice of the forgery. Therefore, under (d)(1), the bank will probably still be liable for the amount of the check. i. In effect, the statute requires but-for causation: but-for the delay in reporting, that the bank could have recovered the check from the forger. ii. This has nothing to do with customer negligence contributing to the forgery; only negligence in failing to report the forgery. iii. In this case, it will be difficult for the bank to carry its burden of proof that it could have recovered from the forger, but for the customer’s negligence. Because even if customer had given timely notice, the bank suing the thief would not have allowed recovery because the thief went bankrupt. 2. (b) Second check in amount of $2,000 paid on Feb. 20 and returned on Mar. 3. a. Under (d)(2), there was a 30 day window for the customer to report this forgery. This was the second check in a series of forgeries, so (d) (2) applies. January 4 was the day that the statement was made available to the customer, so this is the date that the 30 days start ticking. b. Note that the statute says, for forgeries by the same wrongdoer, the time to discover and report the forgery is a reasonable time not to exceed 30 days. However, banks usually allow the full 30 days. c. When the bank paid the second check on Feb. 20, the 30 days had expired. Therefore, after 30 days from January 4, the loss presumptively shifts to the customer. The bank does not have to prove its loss. d. However, if under (e), the customer can show that the bank failed to exercise ordinary care and that this negligence contributed to the loss, the customer can introduce comparative fault between the customer and the bank. In this case, the bank’s policy is to not sight examine any check below $2,500. It would be a fact inquiry as to whether this policy is reasonable. This is the Espresso Roma issue redux. 3. (c) Third check for $5,000 paid by Bank on Feb. 28. Before check was paid, employee examined check but failed to detect the forgery. Returned on Mar. 3. a. The question becomes how good the forgery was. If under (e) the clerk did not make an adequate inspection, then perhaps some of the loss can be shifted back to the bank. b. But otherwise, under (d)(2), more than 30 days have passed since Jan. 4, so the customer is presumptively liable on the amount of the check. h. 4-406(f) One-year statute of limitations i. There is a one-year statutory cutoff for the customer to report a forgery. One year from the date that the statement is made available to the customer. ii. The one year runs from any given check for any given statement. Thereafter, negligence on either party’s part is irrelevant. The customer is precluded from raising the fact of the forgery against the bank. iii. This only applies to the customer’s unauthorized signature or alterations of the check—it does not apply to forged indorsements. 4-111 provides the statute of limitations for forged indorsements: 3 years. i. Fraud Prevention Measures i. Banks have other fraud filters, instead of sight inspection, to guard against forgery losses. Sequencing of checks, unusually large amounts, and software that monitors account activity are all fraud filters. ii. Banks also insure against forgery losses. 4. Validity of Contractual “Cutdown” Clauses a. National Title Ins. Co. Agency v. First Union Nat. Bank i. Issue: Under what circumstances may bankcustomer agreements cut down reporting times for forgeries? 1. Freedom of contract. 4-103 allows varying by the agreement the provisions of Article 4, except for (1) disclaiming a bank’s responsibility of good faith, (2) disclaiming responsibility for failure to exercise ordinary care, and (3) limiting the measure of damages for lack of this failure. ii. Facts 1. Bank-customer agreement purported to absolve the liability of bank if customer did not report a forgery within 60 days. 2. Customer did not report forgeries within 60 days of the date that checks were returned. iii. Court 1. Held: The one-year period could be varied by agreement. 2. Analysis a. This agreement vastly cut down the statutory 365-day period to 60 days. b. This substantially reduces the bank’s risk of paying forged checks. c. But the court sees this as a freedom of contract issue. d. 4-103 seems to allow the modification. The shortening of the one-year period does not disclaim bank’s good faith obligation, or its duty to use ordinary care, or its liability for damages resulting from lack of ordinary care. iv. Another court upheld a 20 day cutdown. 1. This is the judicial trend—banks usually win in these disputes. 2. Article 4 is basically a series of default rules. 3. This raises the question of how much the agreement can shorten the time period for reporting. ii. Right of Payor Bank to Recover Mistaken Payment of Check 1. Forged Checks a. Price v. Neal i. Old English case from 1762. Lord Mansfield. **Be able to recognize this case by name. ii. Restitution 1. The law of restitution prevents a party from being unjustly enriched. iii. In this case, the drawee believed that drawer’s signature was authorized; but in fact it had been forged. 1. Common law of restitution suggested that drawee could get the money back. 2. Held: drawee could not obtain the money back. 3. The rationale was that as between the person paid and the drawee, the drawee is in a better position to be familiar with the drawer’s signature. It was incumbent upon the drawee to know the drawer’s signature. (Clearly this rationale has no value in modern banking transactions.) 4. However, the modern statute retains the holding of this case. iv. Rationale for modern rule 1. The need for a bright-line rule as to who will bear the loss between drawee and payee, in the case of a forged check. b. Statute: 3-418 i. Text 1. (a) The drawee may recover from the payee under a theory of restitution, but subject to (c). 2. (c) The remedy may not be asserted against a person who took the instrument in good faith and for value or who in good faith changed his position in reliance on the payment or acceptance. However, the presentment warranties (3-417 and 4-208— parallel provisions) are still available to the drawee. ii. 3-417 Presentment Warranties for Unaccepted Drafts 1. (a) If the drawee pays, the person obtaining payment and person presenting for payment warrants that: a. (1) the warrantor was a PETE; b. (2) the draft was not altered c. (3) the warrantor had no knowledge that signature of drawer was unauthorized. c. Problem, page 257 i. Employee forged check payable to herself, using this check to buy groceries. The grocery store usually cashed third party payroll checks, which this check appeared to be. The forgery was well done. Grocery store deposited, depositary presented, and payor bank paid. 1. (a) Payor bank may not demand that depositary bank reimburse for the amount of the check. This is the rule of Price v. Neal. Under 3-418, the possibility of recovery in restitution is cut off because the depositary has changed its position in reliance on the payment. a. Additionally, there is no remedy for suing in presentment warranty. Because depositary only warranted under 3-417 that it had no knowledge that the signature was unauthorized. Therefore, the payor cannot push the loss to the depositary. b. Also, the depositary makes a warranty that he was a PETE. Both the grocery store and depositary bank were PETEs. Even though the employee forged the employer’s signature, this is treated under the statute as if he had signed his own name; therefore the employee has become liable on the check. A forged check is not an absolute nullity; it may be negotiated. This is a fundamental difference between a forged check and a forged indorsement. Thus because the check was able to be negotiated, the grocer and then the depositary became PETEs/holders. Therefore, there was no breach of transfer warranties by grocer and depositary. So payor has no right to recover on a breach of transfer warranty theory from either grocer or depositary. 2. (b) When Payor learned of forgery, it demanded that Grocer pay, on the theory that Grocer dealt with the crook, so Grocer should bear the loss. a. Grocer is not liable, just like depositary bank was not. b. The presentment warranty is made by prior transferors, not just the presenter. But here, the grocer did not breach its warranty. It was a holder, and therefore a PETE. c. The grocer only makes the presentment warranty that it does not have knowledge of a forgery/unauthorized signature. d. The transfer warranties, however, also warrant that transferor is a PETE and that all signatures are authentic and authorized. This is a broader warranty than the presentment warranty—which is merely that there is no knowledge of an unauthorized signature. Still, the Grocer did not breach its transfer warranty. The payor is not a transferee. When the depositary bank presents the check to payor, depositary does not “transfer” to payor, but rather seeks payment. Therefore, payor does not get the benefit of transfer warranties—only of presentment warranties. e. Notably, Grocer did breach the transfer warranty in a technical sense because it warranted that previous signatures were authorized—and the employee’s signature was not authorized. However, this technical breach gives rise to no action because the transferee, depositary bank, has suffered no loss in this case. To recover from a warrantor, a plaintiff must show proof of actual loss. d. The rule of Price v. Neal was argued against by banks when Articles 3 and 4 were drafted but the rule was adopted because it gives payor banks an incentive to be vigilant about forgeries, and because the common law was settled for 250 years. 2. Forged Indorsement a. Generally i. **Big difference from forged checks ii. **Very important for rest of the course. b. Problem, page 258 i. Drawer issues check to Payee. Thief steals check and forges Payee’s indorsement. Payee sells check to Customer, who takes in good faith and without notice of forgery and deposits at Depositary Bank. Depositary presents for payment to Payor; Payor pays. Customer withdraws amount of the check from Depositary. ii. As between Drawer and Payor, Payor will have to re-credit Drawer’s account like we learned at beginning of the chapter. But can Payor shift loss to either Customer or Depositary?—Yes! Warranties are the key. iii. Customer and Depositary have breached transfer warranties. They both warranted that they were PETEs; they were not PETEs because the forgery of the indorsement prevents future transfers of the instrument. Payor can recover from either Customer or Depositary. iv. Depositary could recover from Customer if Payor sues Customer. Because Customer breached its transfer warranty to Depositary. c. Analysis i. Forged indorsements are treated radically different from forged checks under warranties. The warranty is that the transferor is a PETE; but neither Customer nor Depositary was a PETE because of the forgery. Because of the forged indorsements, there could be no negotiation of the check to subsequent transferees. ii. Common Law 1. Rule was that collecting banks were not liable. Therefore, collecting banks guaranteed prior indorsements. Prior indorsements guaranteed. 2. In the face of this custom of guaranteeing indorsements, the UCC drafters just imposed a warranty—the presentment warranty is placed on the presenting bank and prior transferors that they are PETEs. 3. The presentment warranty is made by the depositary. If the payor sues the depositary, the depositary may pass the loss back onto the customer because of customer’s breach of transfer warranty. Additionally, the customer breached its presentment warranty under 3-417. iii. Forged indorsements usually result in the loss being passed back to the person who dealt with the forger. This leaves the person who dealt with the forger having to pursue the forger for recovery. iv. This is why business establishments and depositary banks are hesitant to accept from customers checks that contain indorsements to the customer; depositary cannot determine whether the previous indorsements were forged or not. v. Justification for treating forged indorsements differently from forged checks 1. White & Summers argue strongly that there is no justification. 2. But common law precedent is essentially the justification. 3. However, one rationale is that the transferee dealing with the forger is able to require identification from the forger to determine the validity of forger’s signature. 3. Remotely Created Checks a. Generally i. Checks created by telemarketers with consent of their customers. ii. If the telemarketers was guilty of fraud, the UCC placed the loss on the depositary. b. Now, Regulation CC imposes a warranty… 4. Overdrafts a. Generally i. The majority rule in many states is to follow the Restatement of Restitution, which recognizes a cause of action to recover the payment. ii. Overdrafts are problematic. The equities are not clear cut. No bank in its right mind would pay a forged check or a check with a forged indorsement on which payment has been stopped. It would have to be a mistake for a payor bank to pay such a check. However, banks pay checks that create overdrafts all the time. They do this as a short-term extension of credit to the customer, if the customer is trustworthy, rather than having the check bounce. iii. Therefore, the bank may pay the check in hopes that the drawer will later put enough funds in the account. Then later the drawer may not put money in the account, so the payor bank may want to recover under 3-418, that it paid the check by mistake and is entitled to restitution. b. So the payor bank who pays an overdraft may sue under restitution, but again under 3-418(c), no right of restitution may be asserted against a person who took the check in good faith and for value or who in good faith changed position in reliance on payment of the check. iii. Conversion Actions Regarding Checks Bearing Forged Indorsement 1. Action by Payee a. Introduction i. Example: Drawer issues check to Payee. Thief steals and forges Payee’s indorsement. Deposits with Depositary, who obtains payment of the check from Payor. What are the rights of the payee? Because the payee has not received payment of obligation, now that check has been stolen. ii. The ordinary rule is that the drawer does not receive discharge on obligation to payee until the check is accepted by payor bank. Upon dishonor of the check, the drawer can be liable on the check itself or on the underlying obligation to payee. However, under the above example, 3-310(b)(4), the payee cannot sue on the underlying obligation because it is suspended. The payee may only sue the drawer under 3-309, the rules regarding lost, stolen, or destroyed instruments. Payee will have the burden of proving the terms of the instrument, etc. iii. If Payee can get Drawer to stop payment and give Payee another one, then problem is solved. However, this requires cooperation from the Drawer. Additionally, usually the check will already have been paid. iv. Therefore, Payee may try to shift the loss to Payor or Depositary, on the theory that they have converted the check. A theory of tort liability. v. Conversion: the unwarranted exercise of dominion over the property of another. The theory is that when payor pays the check or depositary takes it, this is dominion over the check without the payee’s authority. 1. The Louisiana version of the statute is a bit longer because our adoption of the Revision includes the fact that we don’t have the common law tort of conversion. a. Under the UCC, the payee has no right to obtain a substitute check from the drawer. However, the Louisiana statute (3-420(e)) states that the owner of an instrument may obtain a substitute check. There have been no cases on this point, but this Louisiana provision, that nothing in the statute should prevent payee from obtaining substitute check from drawer, is seemingly in conflict with the statute that the payee’s only remedy can be to sue the drawer under 3-309 for a lost check. vi. Problem, page 261 1. Walks through the rules 2. Company sells products online and by mail order. Thief, former employee, steals cash and checks payable to company from buyers. Thief forges indorsements to himself. Deposits checks. Various payor banks on which checks were drawn pay the checks. Depositary allowed Thief to withdraw the funds before forgeries were discovered. 3. Company as payee wants to pursue remedies to recover these checks. 4. Thief was a converter, and depositary was a converter because took without negotiation of the checks. Because there could be no negotiation, since the indorsements were forged. The payor banks are also converters because they have made payment with respect to an instrument to a person not entitled to enforce. 5. Rights of Payee a. Sue the drawer. But not a good remedy because payee has to prove the terms of the checks to be able to recover from these companies that wrote the checks to payee. Also, these drawers of the checks are spread out all over the company— would require a multitude of lawsuits. b. Sue payor banks for conversion. But they are also as diffuse as the drawers, requiring a multitude of lawsuits. If payee did recover from payors, payor banks could shift the loss back to depositary banks because of depositaries’ breaches of presentment warranties. c. Best remedy is sue the depositary. The one bank the dealt with all the checks. The depositary is a converter because it took the check in a transfer other than negotiation from a non-PETE. b. Delivery of Check to Payee i. Statute: 3-420(b) An action for conversion cannot be brought by a payee who did not receive delivery of an instrument. 1. Prior to 1990 Revision, this was not clear. 2. Conversion is a property principle—the unwarranted exercise of dominion over someone else’s property. If payee never receives delivery, it has never become his property. Additionally, if payee never received a check, the underlying obligation was not suspended—therefore, the payee has a clear action on the obligation against the drawer. There is no need for a conversion action against one of the banks. 3. Rule: If payee has not received delivery of the check personally, through a co-payee, or through an agent, there can be no conversion action by the payee. c. Liability of Depositary Bank as Agent for Collection i. Background 1. Original Article 3 recognized a right of action to sue a depositary; also said that representatives, including depositary banks, would only be liable if they still had check proceeds in their possession. 2. This rule did not make any sense; the payee would just sue payor, who would then sue depositary. Therefore, the depositary would ultimately be liable regardless of whether it still possessed the check proceeds. ii. Rule: only applies to representatives other than depositary banks. A collecting bank through whom the check passes is not liable in conversion, unless the collecting bank still holds onto the proceeds. This applies to collecting banks other than depositaries. But the depositary bank is liable in conversion, regardless of whether it still has the proceeds. 3-420. d. Unauthorized Indorsement i. Background 1. Check indorsed by company and deposited. Under 3-110(d), in which cases should bank have demanded signature before taking check? 2. #1 – Check payable to “company company2.” Only one signature is needed. If there is any ambiguity as to whether check is payable alternatively or not, it is deemed to be paid in the alternative; thus only one indorsement is needed. 3. #2 – “Company / company2.” Paid in the alternative. 4. #3 – “Company-company2.” The hyphen is also ambiguous and thus payable in the alternative, so that only one signature is necessary. ii. Courts addressed what the drawer intended, by looking at the way the check was written out. But this was a recipe for confusion—depositary could not determine intention of drawer, with regard to how many indorsements were needed. iii. Thus now there is a safe harbor: if it is ambiguous, the depositary is protected; a single authorized indorsement is enough under 3-110(d). Thus the depositary would not be liable for conversion. e. Forgery by Entrusted Employee of Payee i. Generally 1. This addresses the relevance of the payee’s behavior to payee’s ability to recover for conversion. 2. Cooper v. Union Bank, pre-Revision Case a. Lawyer hired former client to be bookkeeper/secretary. This employee was known to have been a compulsive gambler who went through bankruptcy; she stole checks payable to lawyer and expertly forged indorsements. Deposited at her bank, which was the same bank as the employer-lawyer’s bank. Payee lawyer sued bank for conversion. b. The issue is the payee lawyer’s negligence—failure to exercise ordinary care that substantially contributed to the forgery. This could be raised by the depositary bank as a defense. c. Lawyer made no effort to oversee this known gambler. But bank would have burden of proving the lack of care. Should there be a more direct way of allowing the bank to defend rather than requiring bank to prove payee’s negligence? Yes. There is. ii. Statute, 3-405 1. In certain types of employee fraud, the loss should be imposed upon the employer without the need to show actual negligence. 2. Where employer has delegated to employee certain types of responsibility with regard to financial affairs, there can be avoidance of bank’s liability. 3. (a) Responsibility means authority to sign/indorse instruments, process instruments, prepare instruments for issue, etc. 4. If this responsibility is delegated to employee who then forges employer’s signature, that signature is effective as indorsement of the employer. So under (b), the depositary would avoid liability, unless the depositary also was negligent, in which the loss will be apportioned between the depositary and the payee-employer. iii. Sidenote: The employee depositing the check in her own account is less plausible than employee cashing the check. Because in the latter case it might make sense that the employee might be cashing the check to give the petty cash to the employer. Whereas with a deposit, why would an employer indorse a check payable to it over to the employee for deposit in the employee’s account? Therefore, perhaps in the case of employee depositing the check, this is negligence of the bank in accepting the deposit, such that under 3-405(b), some of the loss can be allocated to the depositary. 2. Action by Drawer a. Stone & Webster v. First National Bank i. Background 1. Res nova addressing ability of drawer to sue for conversion 2. Employee forged indorsements and deposited checks in employee’s bank. 3. Issue: Under Article 3, could the drawer sue the depositary bank for conversion? ii. Court 1. Held: No action was available to drawer. The drawer’s rights were exclusively against the payor/drawee bank. 2. Analysis of opinion a. However, if drawer successfully imposes loss on payor bank, payor can then recover from depositary; thus it may make sense to allow the drawer an action against the depositary directly. b. But the court says that this makes sense only if it is absolute that the drawer will be able to recover from the payor bank. And in many cases, the payor can defend against such an action based upon the drawer’s lack of care under 4-406. c. Thus drawer should be able to sue payor; then if there is recovery, payor sues depositary on breach of presentment warranty basis. b. 3-420, Statute i. (b) An action for conversion may not be brought by the drawer or issuer. ii. Rule on presentment warranty is that if a payor voluntarily re-credits the drawer’s account, and then sues depositary, the depositary is allowed to assert against the payor the 3-404—3-406 defenses. iv. Impostors and Fictitious Payees 1. Intent of Issuer a. Generally, 3-110(a) i. Rules regarding identification of a payee 1. Requires more than looking at the name on an instrument. Because several people may have the same name! ii. Rule: The intent of the person issuing the instrument, whether or not authorized, determines who the payee is. The identity of the payee is determined by the intent of the issuer. 1. Note that the identity of the payee can be determined by the forger of a check under this rule. Because the intent of the issuer “whether or not authorized” is what determines the identity of the payee. 2. Determination of intent is difficult when there is an impostor as a payee—when the person to whom the check is written is someone other than whom he claims to be. This is difficult because the issuer intended to deal with someone else, but also apparently in some way intended to deal with the actual person “standing before them.” 2. Impostors a. Statute: 3-404(a) i. If an impostor induces the issuer of an instrument to issue the instrument to the impostor by impersonating the payee of an instrument or by impersonating a person authorized to act for the payee, an indorsement by any person in the name of the payee is effective as that of the payee in favor of a person who in good faith takes the instrument for value or collection. ii. Problem, page 273 1. Pauley fraudulently induces Martini to write a check to Herman by convincing Martini that Pauley was Herman. Pauley then indorses, with Herman’s name, the check to himself. Pauley deposits the check. Martini claims that payor bank cannot debit his account because Herman’s indorsement was forged. 2. This is the classic impostor rule: because Pauley obtained the check fraudulently, Martini is the fool and should bear the loss. 3. An indorsement by any person in the name of the payee is effective in favor of persons who in good faith take the instrument for value or for collection. The depositary acted in good faith. The check is properly payable. 4. The indorsement is valid. iii. Problem #2 1. Pauley induced Martini to write a check to the chair of the Red Cross, claiming he was chair of the Red Cross. Pauley then indorsed as the chair of the Red Cross and as Pauley. 2. Pauley forged the indorsement by writing Red Cross as an indorsement. 3. Bank must re-credit Martini’s account because there was no impersonation. This is not fraud covered by the statute. The fraud was the representation that Pauley was an agent of the Red Cross—not that he was any one other than Pauley. 4. If Pauley had claimed to be Herman, the chair of the Red Cross, the result would be different. 5. Here Pauley claimed to be no one other than Pauley. A false representation of one’s status as an agent is not covered by 3-404— the bank has to re-credit the account in this case. iv. The critical element is impersonation—claiming to be someone other than who you are. If the fraudulent character impersonates a payee, the fraudster’s indorsement in the name of the impersonated payee is effective as the indorsement of that impersonated payee. Thus payor bank does not bear the loss. b. 3-404(c)—a minor discrepancy does not matter. Discrepancy between name on the check and how it is indorsed. An indorsement is made in the name of a payee if made in name substantially similar to that of payee, or whether or not indorsed, deposited in a depositary bank to an account in a name substantially similar to that of payee. i. Example, payee is Blue County Red Cross. Signature is Red Cross of Blue County—this is substantially similar. c. 3-404(d) However, if there is comparative fault of payor and/or depositary bank, loss can be allocated to banks. 3. Fictitious Payees a. Statute, 3-404(b) i. This addresses instance where the employee forges the indorsement of a payee other than the employer. ii. If (i) a person whose intent determines to whom an instrument is payable does not intend the person identified as payee to have any interest in the instrument, or (ii) the person identified as payee of an instrument is a fictitious person, the following rules apply until the instrument is negotiated by a special indorsement: iii. (1) Any person in possession of the instrument is its holder. iv. (2) An indorsement by any person in the name of the payee stated in the instrument 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 collection. b. Hypo i. Treasurer has authority to sign checks for Employer. Treasurer, to defraud, includes checks payable to part-time employees who aren’t actually owed anything. Treasurer then, when signing those checks with authority, indorses the names of the employees and deposits the checks. Employer bears the loss. 1. As to the checks payable to the part-time employee payees, the Treasurer’s intention controls—and the Treasurer did not intend the payees to have any interest in the checks. Therefore, Treasurer’s signature is effective as their indorsements. 2. Because they were payable to fictitious payees, the statute makes the instruments valid if anyone signs the names of the payees. 3. The result is the same whether (i) Treasurer writes checks payable to ex-employees who are not technically fictitious but whom the Treasurer does not intend to have rights under the instruments, or (ii) Treasurer writes checks to fictitious payees.” a. A payee is “fictitious” not just if there is no one else in the world with that name (which would be highly unlikely), but if the person is made up by the forger. c. The effect of the fictitious payee rule of 3-404(b) is to shift the loss from the depositary to the payor bank. d. Because the signature of the fraudster is effective as the signature of the named, fictitious payee, this is not a forged indorsement. v. Payroll Padding 1. Payroll padding is yet another type of employee fraud scheme. 2. Hypo a. Same hypo as above, except checks are signed by not only Treasurer but also another officer. (This only means that the instrument is payable to any person intended by either of the officers.) b. The Treasurer did not prepare the checks; someone else prepared them. This person, Clerk, included some checks payable to part-time employees who did no work. They are actual persons not owed any money. Clerk gets Treasurer’s signature, pulls out the employees’ checks, indorses them, deposits them in Clerk’s account. c. Now the problem is that the Treasurer’s intention under 3404(b) is what determines who the checks are payable to. The Treasurer intended that the payees of the check receive the funds—this would be the part-time employees. i. Therefore, 3-404(b) does not work—these are not fictitious persons, and Treasurer as signer intended for these employees to get the money. Therefore, this would be a forged indorsement and checks would not be properly payable. But this makes no sense as a policy matter ii. Statute: 3-405. 3. Statute, 3-405 a. Forged indorsements where the employer as drawer has validly issued them. b. (a)(3) the clerk was entrusted with responsibility to determine the payees of the checks to be issued in the name of Employer. i. This statute does not apply if an employee merely has access. He must have responsibility as an agent of the employer. ii. Because the clerk has responsibility, (b) provides the rule. c. (b) If an employee entrusted with “responsibility” over an instrument makes a fraudulent indorsement, the indorsement is effective if made in the name of the payee. i. ***In this case, the statute speaks of an indorsement made either by an employee or someone acting in concert with the employee. Applies strictly to these indorsements—not just anyone making the indorsement. vi. The Double Forgery 1. Gina Chin & Assoc. v. First Union Bank a. Background i. The 1990 Revision addressed what to do with checks that are both forged and bearing a forged indorsement b. Facts i. Employee of Employer forged name of one of the authorized officers on a series of checks. Made them payable to creditors of Employer. ii. Then Employee forged the creditors’ indorsements. This was done with the assistance of a Bank teller. Checks were deposited with Bank and later presented to Payors, who paid the checks. iii. Employer sues in negligence against Bank (depositary). c. Court i. Pre-1990, courts would say that the forged check trumps the forged indorsement—the forged check was the principal infirmity. Therefore, courts would impose the loss on the payor bank. ii. Current Law, 3-404(b) If the person forging the check does not intend the named payee to have any interest in the check (which applies to these facts), the person’s indorsement is effective in favor of persons who in good faith pay the instrument or take it for value or collection. 1. Even for a person who forges a check, his signature determines the intent of who the payee will be. Here, the Employee clearly did not intend to give the listed payees (creditors) rights under the instrument. 2. Therefore, the indorsement is effective. Still, it is a forged check—so the loss falls upon the payor bank. iii. 3-404(d) states that if the person taking the check fails to exercise ordinary care, the person bearing the loss may recover from the taker, to the extent that the negligence contributed to the loss. 1. Thus the drawer can sue the depositary in a double forgery case. 2. But why does drawer need to sue depositary? Because the payor is liable on this forged check. 3. The comments indicate that the payor bears the loss, and if the depositary is negligent, payor may be able to shift loss to the depositary. But it doesn’t make sense to allow the drawer to bypass the payor and sue the depositary. d. Summary: For double forgery, treat as forged check, not forged indorsement. i. Yes, the indorsement is “effective” as that of the payee, protecting depositary/collecting banks from liability for transfer/presentment warranties. ii. But, the payor bank is still liable because it is still a forged check. iii. Note, that under 3-404(d), the payor may be able to shift some of the loss back to the depositary bank under a comparative negligence analysis. vii. Allocation of Loss by Contract 1. Statute, 4-103 a. Provisions of this chapter may be varied by agreement, but agreement cannot disclaim bank’s responsibility for its lack of good faith or failure to exercise ordinary care or limit the measure of damages for lack of failure 2. Jefferson Parish School Board v. First Commerce Corp. a. Facts i. Unknown person counterfeited checks. ii. The Bank had drafted an agreement purporting to absolve it of liability for checks bearing signatures that appeared to resemble facsimile specimens on file with the bank. iii. The signatures at issue did resemble the specimens on file with the bank. iv. No employee of the school board was implicated. b. Court i. Held: The agreement between bank and school board was valid under 4-103 to vary the terms of the statute. 1. 4-103 allows freedom of contract between bank and its customer. ii. This is perhaps the most looming issue in forgery law—how can far can a bank go in overturning the UCC’s provisions of who bears the loss in forgery cases? iii. Here the court says that the drawee can contract out of the Price v. Neal rule that the drawee/payor bank is liable for forgeries. c. Freedom of Contract i. Arguably, parties should be able to adapt in this way. ii. However, how is the customer to protect itself from forgeries, if the customer agrees to absolve the payor bank from responsibility for any check whose signatures resembles the one on file? 1. If customer does not sign an agreement, the bank will refuse to do business with him. 2. Such an agreement is a massive reallocation of losses. 3. The banks have won most of these cases under the freedom of contract banner. 4. However, one case has held that banks should not be allowed to alter the basic structure of Articles 3 and 4. 3. Nondisclosure a. Courts might recognize that banks at least have a duty to disclose—that when there is a boilerplate clause in the contract, the bank must bring it to customer’s attention that customer will be liable for forgeries b. For example (and by analogy), in one case, bank said that it did not have to stop payment unless customer on stop payment order reported the exact amount of the check. Held: if the bank wanted to enforce this provision, bank should have explained the provision to the customer. b. Alteration i. Complete Instruments 1. Generally a. **Common errors on the exam in this subject matter. b. Alteration is far less common than forgery, but still exists. 2. HSBC Bank v. F&M a. Facts i. Authorized employee delivered check payable to payee. Payee altered the amount of the check without authorization of drawer. ii. Check was deposited at payee’s account with depositary; payor paid the altered amount. Draweremployer’s account debited for the higher-thanauthorized amount. b. Statute, 3-407 i. (a) Alteration means (i) an unauthorized change in an instrument purporting to modify a party’s obligation, or (ii) an unauthorized addition of words or numbers or other change to an incomplete instrument relating to the obligation of a party. ii. (b) Except as in (c), an alteration fraudulently made discharges a party whose obligation is affected by the alteration unless that party assents or is precluded from asserting the alteration. No other alteration discharges a party, and the instrument may be enforced according to its original terms. 1. Routinely misread by students. iii. (c) A payor/drawee paying a fraudulently altered instrument or a person taking it for value in good faith and without notice of alteration, may enforce rights with respect to the instrument (i) according to its original terms, or (ii) in the case of an incomplete instrument altered by unauthorized completion, according to its terms as completed. c. Analysis i. Absent negligence on drawer’s part, payor can charge the drawer’s account only for the original amount and may recover the over-amount from depositary bank on basis of its breach of presentment warranty under 3-417: breached the warranty that the instrument has not been altered. ii. Depositary can then turn and recover the same amount from the payee, who altered the instrument, on basis of payee’s breach of transfer warranty under 3-416, of the warranty that instrument has not been altered. iii. The alteration cannot change the obligation of the issuer/drawer, unless the lack of ordinary care contributed to the alteration, or the drawer has not reported the alteration in a timely fashion. iv. 3-407(b) is the key: where an alteration is made with fraudulent intent, it discharges the drawer’s obligation entirely, but subject to (c). (c) tells us that the discharge is not effective against a payor or drawee or one who pays the instrument in good faith, or transfers for value, in good faith, and without notice of the alteration. 1. The discharge can only be raised against the alterer, or other persons who did not give value, were in bad faith, or had notice of the alteration. 2. Therefore, the drawer will still have to pay the original, unaltered amount, to a person who takes the instrument in good faith, for value, and without notice of the alteration. d. Application i. Payor can charge drawer’s account on the original amount on the instrument. ii. But because presenter of check warrants that check has not been altered, payor can recover its loss under 3-417(b) (interest and expenses--business losses) from the depositary, who will then sue for same amount from the payee for breach of transfer warranty. 3. Alteration involving added numbers/words a. Sometimes drawer might leave extra spaces for a fraudster to add extra zeroes. And leave extra space on word line for fraudster to add extra words like “thousand”! b. 3-406 may apply in this case—lack of care contributing to an alteration. c. Then payor bank may be able to raise this defense against its customer, with the possibility of comparative negligence on payor bank’s part. 4. Alteration of Certified Checks a. Pre-certification alteration i. Payor certifies the check after there has been an alteration ii. 3-413(a): Accepter of draft is obliged to pay according to terms at time of acceptance, even though the acceptance states that the draft is payable as originally drawn. iii. Therefore, a payor bank’s stipulation that it accepts the check to pay it only in the value at time of original issuance—this stipulation is ineffective. The payor’s acceptance discharges the drawer. The payor must pay the amount at time of acceptance. b. Post-certification alteration i. This is alteration after the payor accepts the check. ii. 3-413(b): If certification/acceptance states the amount accepted, the obligation of acceptor is that amount. If amount is not stated, if the amount is thereafter altered to a higher amount and HIDC takes the instrument, the obligation of acceptor is the amount of the instrument at time taken by the HIDC. 1. So basically if the payor accepts and puts the accepted amount, and thereafter there is alteration, payor will only have to pay the accepted amount. 2. However, if the payor’s acceptance does not state the amount of acceptance, this is negligent, and the payor will have to pay the amount thereafter altered. a. However, this higher amount must only be paid to a HIDC. Therefore, there would have to be no apparent evidence of the alteration for the subsequent taker to be a HIDC. ii. Incomplete Instruments 1. Statute, 3-115 a. Incomplete Instrument defined: (a) A signed writing whose contents show that signer intends for the instrument to be later completed by words or numbers. i. Example, person preparing check for company leaves some space on the check. This does not mean the check is incomplete!!! Because the instrument is only incomplete if there is evidence that the contents of the signed writing show an intention that the signer wanted the instrument to be later completed. 2. Hypo a. A owes B money. A sends check payable to B, but leaving the amount blank. A tells B to fill in the amount of debt that is owed. b. If B determines that $10 is owed, and B writes in “$10,” this is fine. Done with A’s authorization. B was A’s agent, for purpose of adding the amount of the check to the instrument that A provided. This is not an alteration. Alteration requires an unauthorized addition to an instrument. c. However, if B writes in $10,000, this is not authorized. This is an alteration under 3-115 and 3-407. d. 3-407(c): The instrument can be enforced according to its terms as completed, as long as it’s a payor or person taking for value in good faith and without notice of the alteration. 3. Why the difference in rules for complete v. incomplete instruments? a. For a complete instrument, the issuer is liable only for the original amount, unless the issuer is negligent. b. For an incomplete instrument, the same result is reached without addressing actual negligence. The check is left completely empty, making an alteration easy. The loss should be imposed on the party that foolishly created an incomplete instrument. The issuer is treated as conclusively bound for the entire amount. c. Restrictive Indorsements i. Generally 1. The purpose of a restrictive indorsement is to restrict payment of the instrument 2. Some restrictive indorsements are enforceable, such as “for deposit only” or listing a certain account to which the funds must be deposited. 3. Others are not enforceable: 3-206(a) indorsements restricting payment to a particular person (e.g. “Pay to John Doe only”), and 3-206(b) indorsements that attempt to prohibit payment unless a stated condition is satisfied. ii. Statute, 3-206 1. (a) An indorsement that purports to limit payment to a particular person or otherwise prohibiting further transfer or negotiation of the instrument is not effective to prevent further transfer or negotiation of the instrument. 2. (b) An indorsement stating a condition to the right of the indorsee to receive payment does not affect the right of indorsee to enforce. 3. (c) An instrument bearing an indorsement (i) to “pay any bank”, or (ii) indorsed in blank or to a particular bank using words such as “for deposit,” “for collection,” or other words indicating a purpose of having the instrument collected by a bank for the indorser or for a particular account, the following rules apply: a. (1) A person, other than a bank, who purchases the instrument when so indorsed converts the instrument unless the amount paid for the instrument is received by the indorser or applied consistently with the indorsement. b. (2) A depositary bank that purchases the instrument or takes it for collection when so indorsed converts the instrument unless the amount paid by the bank with respect to the instrument is received by the indorser or applied consistently with the indorsement. c. (3) A payor bank that is also the depositary bank or that takes the instrument for immediate payment over the counter from a person other than a collecting bank converts the instrument unless the proceeds of the instrument are received by the indorser or applied consistently with the indorsement. d. (4) Except as otherwise provided in Paragraph (3), a payor bank or intermediary bank may disregard the indorsement and is not liable if the proceeds of the instrument are not received by the indorser or applied consistently with the indorsement. 4. Problem, page 294 a. Peter, payee of 10k check indorsed and mailed to Bank One where he had an account. Thief stole and indorsed Peter’s name, depositing in his account at Bank Two. Payor pays the check. What are Peter’s rights against Bank Two and Payor Bank if Peter’s indorsements were as follows: b. #1 - For deposit only Peter Thief i. Peter has action against Bank2, depositary, for conversion. Bank2 was put on notice by the restrictive indorsement that the check could only be deposited in an account of Peter’s. ii. The proceeds were made not available to Peter. iii. The payor is not liable because it is not an “on us” check. c. #2 – Pay to Bank One for Account No. xyzabc Peter Thief i. Special indorsement but also restrictive. ii. Same result. The indorsement specifies that it is to go into that account. Therefore, depositary bank is liable for conversion because proceeds were paid neither to Peter nor to the specified account. d. #3 – Peter For deposit only Thief i. Here is it unclear whether “for deposit only” was written by Peter or Thief. ii. If it is ambiguous and depositary cannot tell which person indorsed, then depositary might argue that it has the right to treat this as an indorsement by Thief and therefore is not liable for conversion. iii. Majority Rule: depositary must deposit the check in account of payee. If depositary deposits funds in account of anyone other than payee, depositary does this at its peril—the customary assumption is that restrictive indorsements are for the benefit of payee. iv. 3-206(c)(2) states that the depositary bank must make the payment available to the indorser or apply the payment consistently with the indorsement. 1. This does not clearly state that in this situation, the payment must be made available to the payee. 2. However, the majority rule (e.g. State of Qatar v. First American Bank) interprets the statute as requiring payment to the payee. 3. However, there are some courts that find if a particular account is not specified, the check may be deposited in anyone’s account—the check just must be deposited, as opposed to cashed. 4. Schulingkamp v. Carter—Louisiana case recently addressed case just like this one. Louisiana First Circuit sided with the majority rule. However, case went up to LASC, who reversed without opinion. The case has been remanded by the trial court. 5. Problem, page 298 a. Situation in which the indorsement indicates that the instrument is being negotiated to the indorsee. b. Peter, payee of check of 10k drawn on Payor, gave check to Faith, legal guardian of Ward. Peter told Faith that the check was a contribution to defray Ward’s nursing home expenses. Peter indorsed: Pay to Faith as Guardian for Ward Peter Faith indorses by signing her name and deposits the check in her personal account in Depositary. Faith also had a fiduciary account as guardian for Ward in the same bank. Pursuant to her instructions, Depositary credited Faith’s personal account for 10k and obtained payment from Payor. Faith withdrew the 10k. Ward sues Faith for breach of fiduciary duty, and he also sues Depositary and Payor. c. 3-206(d)—Except for an indorsement covered by (c), if the indorsement bears words to the effect that payment is to be made to the indorsee as agent, trustee, or fiduciary for the benefit of the indorser or another person, the following rules apply: i. (1) Unless there is notice of breach of fiduciary duty as provided in 3-307, a person who purchase the instrument from indorsee or takes the instrument for collection or payment for value may do so without regard to whether the indorsee violates a fiduciary duty to the indorser. ii. (2) A subsequent transferee of the instrument or person who pays the instrument is neither given notice nor otherwise affected by the restriction in the indorsement unless the transferee or payor knows that the fiduciary dealt with the instrument or its proceeds in breach of fiduciary duty. d. The Payor is not liable; the Depositary bank is liable. i. Where the Depositary had knowledge of Faith’s fiduciary status, because the proceeds were deposited in the account of someone other than the represented person, Depositary is liable. e. Peter’s indorsement is restrictive under 3-206 because it gives notice that the proceeds should be paid to Faith in her fiduciary capacity, on behalf of Ward. i. By paying Faith, Depositary is doing what the indorsement instructs it to do. Depositary has no duty to monitor what Faith does with the funds. ii. But here, Depositary seemingly has notice of Faith’s breach of fiduciary duty. Because the check was deposited in a personal account, Depositary was on notice of the breach of fiduciary duty, and is therefore liable to Ward. VII. iii. Payor is not liable because it had no knowledge of Faith’s breach of fiduciary duty. The Bank-Customer Relationship a. Introduction i. 4-401 et seq. 1. 4-401(a) defines what makes a check properly payable. a. A bank may charge against an account of a customer an item that is properly payable from that account, even though the charge creates an overdraft. An item is properly payable if it is authorized by the customer and is in accordance with any agreement between the customer and the bank. b. The comments address a common cause for customer dissatisfaction with banks: imposition of fees for stopping payment. i. A forged check or check bearing forged indorsement is not properly payable. Therefore, if customer advises the bank that such a check should not be paid because of forgery, then the bank is not entitled to demand payment from its customer for stopping payment. ii. Comment says that it is inappropriate for a bank to require a stop payment fee in such a circumstance. iii. Remember Holmes’ war story that if you advise the bank that this is the law, they probably won’t charge you a fee to stop payment order for potential forged instrument. 2. 4-402(a)—A payor bank wrongfully dishonors an item if it dishonors an item that is properly payable, but a bank may dishonor an item that would create an overdraft unless it has agreed to pay the overdraft. 3. 4-404—A bank is under no obligation to a customer having a checking account to pay a check, other than a certified check, which is presented more than 6 months after its date, but it may charge its customer’s account for a payment made thereafter in good faith. a. Addresses “stale” checks. b. If a check is presented that is more than 6 months old, the payor bank has the discretion to dishonor. c. This is different from what makes a check overdue—90 days after its date. This is the separate issue of “irregularity” that would prevent a taker from becoming a HIDC of an instrument. 4. Additionally, federal regulations have the effect of creating agreements between banks and customers, even if banks and customers do not actually include these provisions in their agreements. 5. 4-103(a) provides that the provisions of Article 4 may be changed by agreements between the parties. Except that the bank cannot disclaim its duty of good faith, or limit liability or damages for failing to exercise ordinary care. b. Stop-Payment Orders i. Proving Loss Under 4-403(c) 1. Statute, 4-403 a. (a) A customer or any person authorized to draw on the account may stop payment on any item drawn on the account, or close the account, by an order to the bank describing the item or account with reasonable certainty received at a time and in a manner that affords the bank a reasonable opportunity to act on it before any action by the bank with respect to the item. If the signature of more than one person is required to draw on an account, any of these persons may stop payment or close the account. b. Problems, page 301 i. #1—Remitter of cashier’s check asks Bank to stop payment because remitter believes she has been defrauded by Payee of the check. 1. Bank does not have to stop payment because the check is not drawn on the remitter’s account. ii. #2—Payee learns that paycheck has been stolen from his wallet. 1. Bank does not have to stop payment because the check is not drawn on the payee’s account. It is drawn on the drawer’s account. Payee should ask drawer to stop payment. iii. #3—Baker and Able are partners, but their agreement with the bank is that both signatures are required to sign any partnership check. Both signed a check payable to Payton. Now, Baker wants to stop payment. 1. Bank must stop payment because where the signature of more than one person is required, any person who may draw upon the account can stop payment. iv. #4—Husband and Wife have joint account in Bank. Wife disapproved of some checks that Husband wrote on the account and ordered Bank to close the account. 1. Bank must stop payment because the statute says that any person authorized to draw on the account may order a stopping of payment or cancel the account. 2. 4-403(c) a. The burden of establishing the fact and amount of loss resulting from the payment of an item contrary to a stoppayment order or order to close an account is on the customer… i. Comment says that a stop payment order is a service that customers expect from banks. This is inconvenient for banks, but banks must bear this expense as a cost of banking. ii. Another comment states that a payment in violation of an effective stop payment order is an improper payment, even if made by mistake or inadvertence. iii. It is difficult to reconcile these comments with 4403(c)’s placing the burden of establishing loss from wrongful payment upon the customer. b. Minority Rule: Loss under subsection (c) means nothing other than the debiting of the account. Bank is absolutely obliged to re-credit customer’s account, without the need for an inquiry into the underlying transaction. Bank could then subrogate to customer’s right to recover payment from the non-customer party to the transaction, if customer has such a right to which bank could subrogate. c. Majority Rule: Loss is more than just the debiting of the account. The customer must prove that he did not owe the money. Burden of establishing that customer had a defense to payment of the check. i. No Louisiana cases have addressed this. ii. In such a state, the bank will force the customer to sue it. As long as the bank knows that the law will place the burden of proof on the customer, the bank will not re-credit the account. iii. This viewpoint is based on the fact that most stoppayment orders result from buyer’s remorse and not a legitimate defense to payment. iv. Dunnigan v. First Bank 1. Facts a. Overpayment by wire transfer. Payment for coins. Then another payment by two checks for gold coins. Drawer then instructs stop payment. b. Bank fails to stop payment on one of the checks. 2. Court a. No loss was proven because there was no defense to payment of the check. The drawer merely having a counterclaim did not constitute loss. b. The customer must prove that he was not liable to payee on the check. 3. Dissent: Even though there was technically no defense to payment of the check itself, there was a claim in recoupment, a claim against the payee. Thus drawer should have been able to recover damages for failure to stop payment. a. Prof. thinks this is correct. b. Under the statute (subsection (c)), subsequent transactions can be taken into effect—what happens after the issuance of the check is relevant. Thus transactions occurring prior to issuance of the check should also be relevant. 3. Last sentence of (c): The loss from payment can also include damages for dishonor of subsequent checks. a. Thus if bank fails to stop payment and as a result, subsequent checks bounce, the damages recoverable can include damages for dishonor. ii. Operational Issues 1. Generally a. 4-403(b) makes it clear that customer can stop payment orally. 2. Problems, page 310 a. #1—Customers ordered stop payment on check #292 for 1k. Order was given in time, but customer ordered payment on the wrong check number, #293. Therefore, bank paid the check because its computer did not recognize the check number supplied by the customer. i. Held: Bank was liable for wrongful payment. ii. Bank could have programmed its computer to stop payment on the basis of either amount or check number. If bank can do this, this is what it is required to do. iii. Generally, customers win these cases even if they supplied an error, but only if the order reasonably identifies the check. iv. The comment indicates that it is not appropriate for the statute to set in stone a set of information that the customer must provide. Banks have to be flexible and adapt to changes in technology. b. #2—Same as previous, except on bank’s stop payment order form, there is a clause saying that the customer must inform of the exact amount of the item, the number of the check, and the account number. Clause then says that if this information is not provided, the bank will not be responsible for failure to stop payment. i. The cases are split as to whether such a provision is enforceable. ii. White & Summers say that the clause should be in conspicuous text and should explain why adequate information is needed. c. #3—Bank induces customer to sign stop-payment order form, with a clause in which the customer agrees to hold the bank harmless for all expenses and costs incurred by the customer on account of refusing payment; and further agreeing not to hold the bank liable on account of payment through inadvertence, accident or oversight; or if by reason of payment other items drawn by the customer are returned insufficient. i. The first part is okay; the customer may be required to indemnify the bank for stopping payment. ii. The second part is not okay: 4-103 does not allow the bank to disclaim its liability for negligence, which this clause attempts to do. iii. The third clause is also an attempt to disclaim liability for negligence, which the bank may not do. d. #4—It would seem that the drawee may charge a fee for processing a stop-payment order. But some courts have held that this is not allowed. But Professor says that bank should be allowed to charge stop payment fee—because customer just has buyer’s remorse. 3. Postdated Checks a. 4-401(c) allows a customer to postdate a check. The customer has to file a notice of postdating similar to a stop payment order. This is because the bank’s machines cannot read a notation that says the check should not be paid till a later date. c. Wrongful Dishonor i. 4-402 1. (a) A bank wrongfully dishonors an item that is properly payable. 2. (b) a. UCC: A payor bank is liable to its customer for damages proximately caused by the wrongful dishonor of an item. Liability is limited to actual damages proved and may include damages for an arrest or prosecution of the customer or other consequential damages. Whether any consequential damages are proximately caused by the wrongful dishonor is a question of fact to be determined in each case i. Loucks v. Albuquerque National Bank 1. Facts a. Partnership opened an account with the bank. One of the partners was in default, so bank set off this amount against deposited funds. This resulted in checks bouncing. b. Partners sued the payor bank. 2. Court a. Held in favor of compensatory belief, but not punitive. 3. Wrongful Dishonor: A creditor is not entitled to partnership’s assets—only entitled to partner’s share of profits. The checks were properly payable. ii. The customer must establish some actual loss. 1. The common law rule was that if a bank dishonors a business’ check, the business is entitled to damages automatically, without having to prove anything more than the dishonor of the check. A strict liability rule. The “trader rule.” The trader has been defamed, and therefore substantial damages may be awarded based on defamation per se. 2. The Revision: the trader rule is dead. The customer must offer evidence of actual loss. But they don’t have to be quantified necessarily. 3. More than mere nominal damages are awardable. They must be compensatory and cannot be harsh. 4. Evidence of malice on wanton disregard was not enough in this case to allow punitive damages. b. Louisiana Version: A payor bank is liable to its customer for damages proximately caused by the wrongful dishonor of an item. i. The damages are not limited to actual loss in our statute. ii. Louisiana originally had the trader rule. 1. The legislative comments to our statute indicated that the extra language of 4-402 was not adopted because the Legislature intended to maintain the trader rule, under CC Art. 2315. iii. However, in our adoption of the Revision, the Legislature initially adopted the full uniform text, but then one year later amended the statute to shorten it to its present form. However, no commentary was provided as to why the Legislature made this deletion. iv. Given the history, Professor thinks that the Legislature intended to keep the trader rule. 3. The person having an account with the bank is the customer. Only the person with the account is allowed to recover damages for wrongful dishonor. ii. Liability to Customer 1. Question of whether shareholders, officers, or directors should be allowed to sue where the corporation’s check is dishonored. 2. Some courts under a veil-piercing theory have allowed the organization’s constituents to recover for wrongful dishonor. 3. The furthest extension has been one court holding that a guarantor of an obligation of the organization may have a right to sue for wrongful dishonor. 4. However, some cases have held that insiders have no right of action. 5. One Louisiana case: shareholders of corporation had no right of action. iii. Damages Recoverable 1. The cases have divided over whether emotional distress damages are awardable. Courts are reluctant. 2. Whether punitive damages are recoverable is a matter of extrinsic state law.