Liability and Negotiable Instruments - Module 2 of 6

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Module 2: Liability and Negotiable Instruments

Signatures and Parties

Along with providing a clear framework for the negotiability of drafts and notes, the UCC provides rules to address situations where problems cause multiple and possibly conflicting claims.  The Code envisions many situations where the parties to an instrument may encounter errors or omissions from oversight or malicious acts, such as forgery or theft of an instrument. In these cases, the Code assigns and apportions liability among the parties. The goals of these provisions include allocating responsibility to the party in the best position to detect and correct the problems. In this way, the Code encourages people to be vigilant in their commercial transactions to prevent costly errors and possible criminal activity.

According to one commentator, determining liability on a negotiable instrument involves three questions.[1]  First, are the required signatures present and valid?  Second, what is the liability of each party?  And finally, have any of the parties been discharged?   

With respect to the first question, the issue of signatures is ordinarily straightforward.  No one can incur liability unless that person’s signature appears on the instrument.[2]  However, the Code allows for signatures by authorized representatives, which can result in interpretive issues.[3]  The Code defers to agency law for this determination.  If it is evident from the instrument that a duly-appointed agent intended to bind the principal, then the principal is bound, but not the agent.[4]   

For example, assume Arthur is the president of Acme Manufacturing and he signs his company checks as “Arthur, President,” which indicates he has the authority to bind Acme Manufacturing.  While Acme is liable for the check, Arthur does not incur personal liability.

An agent who fails to clearly indicate he is signing as an agent may be personally liable on the instrument when it’s enforced by a holder in due course, assuming that the holder in due course has no notice of the agency arrangement. When confronted with a claim by anyone other than a holder in due course, the agent is not liable as long as he can show that the parties did not intend for him to be liable.[5]   

If a person signs as an agent even though she does not possess the proper authority to do so, then the agent is bound by the signature, but the principal is not.[6]  Similarly, a forged signature only binds the forger, not the person whose name was forged on the instrument. 

A bank never assumes liability for an instrument unless it is a certified check, cashier’s check or teller’s check.  In those cases, the bank “accepts” the check before it is cashed and agrees to pay the check when it is presented for payment.[7]

For these purposes, an “accepted” check is a check a bank draws on itself while a “certified check” indicates on the face of the instrument that a bank has accepted the check.  A “teller’s check” is a draft drawn on a bank or payable through another bank.  Once a check is accepted, the drawer’s liability is discharged on the instrument, but may still be liable on the underlying obligation.[8] This means that if Buyer owes Seller $5,000 for a car, once he presents the check and the check is accepted, he is not liable on the check itself. But if the check fails for whatever reason, he may still be liable to pay the $5,000.  

Effect on The Underlying Obligation

In the case of a check that is not subject to prior acceptance by a bank, the underlying obligation merges into the instrument and, until liability on the instrument is discharged or the instrument is dishonored, the underlying obligation is suspended.[9]

Sometimes a person to whom payment is owed will accept less than full payment for the underlying obligation.  The issue then arises as to whether the creditor can later sue to recover the balance of what was originally owed. The Code allows a person to satisfy an entire debt with a negotiable instrument with a reduced payment if the settlement was mutually agreed to by the parties.  This agreement, called an “accord and satisfaction,” is valid so long as the reduced payment was made as part of a bona fide, good faith, dispute.  However, the recipient of the “in full payment” check can return the funds within ninety days of the payment and seek to recover the amount in dispute.[10]           

The parties to an instrument may also agree to terminate the liability of a person on the instrument by various means including destroying the instrument, crossing out a person’s signature, by agreeing not to pursue a claim or renouncing a right to do so by a signed record.[11]

Payment on Notes of Transferred or Uncertain Ownership

The Code requires that payment must be made to a person entitled to enforce the instrument.[12]  Thus, if a note is transferred without proper notice to other parties, this causes the danger that another person might make payments to the transferor of the note instead of the transferee.[13] 

If the transfer was made without adequate notification to the payor, the payments made by the person would be effective and that person could be discharged once payment is made in full.  However, if the person continues to pay the transferor of the note after receiving effective notification that the note was transferred to someone else, then the person may still be required to pay the transferee.[14]

For example, assume First Bank issues a loan to Patrick in exchange for a promissory note requiring Patrick to repay at the rate of $1,000 per month, for two years.  After eleven months, First Bank sells the note to Second Bank but does not notify Patrick, who keeps making his payments to First Bank.  The payments are still effective because Patrick did not receive notification of the sale of the note to Second Bank. If Patrick finishes all 24 payments to First Bank, his debt will be discharged. Second Bank should have notified Patrick of the transfer and so its only remedy is to seek indemnification from First Bank.

However, assume Patrick did receive notification of the transfer of the note from First Bank to Second Bank, but he kept paying First Bank anyway. Under the Code, he might be required to pay Second Bank because he ignored the notice and made payments to the wrong bank. 

Sometimes the person obligated on the note may be uncertain as to whom to make payment if the transfer of the note is in question.  Under the 2002 revision to the Code, if the transferee is claiming a right to payment and the transferor is denying a transfer took place, then the obligor can require the transferee to furnish reasonable proof of the transfer.  If the transferee does not comply, then payments to the transferor, who was the original holder of the note, are effective.  However, this is a minority rule.  The majority rule requires payment to the person in possession of the instrument.[15]    

Even if the bank knows that an instrument is disputed, the bank’s paying the holder is normally sufficient to discharge its liability.[16]  However, if the bank knows that a court has issued an order against payment on the check, then payment is not effective.  Also, if the bank knows that the holder of the check stole it or otherwise obtained it fraudulently, paying it would not discharge liability to the rightful holder.[17]

Liability for Fraudulent or Altered Notes

An issuer of a promissory note is not normally bound by unauthorized alterations made by a forger. However, if he leaves a blank area that’s later filled in, he’s liable for those filled-in terms.[18] So, if the note issuer wrote $1,000 and a forger stuck in an extra zero to make it look like $10,000, the issuer is not liable. But, if he left the amount blank with the understanding that $1,000 would be filled in and someone else wrote “$10,000” instead, he can be liable. Thus, instrument provisions should not be left blank for later completion if at all avoidable. 

If a draft (such as a check) is dishonored, which means that it is refused for payment, the drawer (writer of the instrument) is liable to the drawee (the person who received the instrument) unless he writes the words “without recourse”[19] on the draft (though this limitation does not work for bank checks). This is apart from any underlying obligation that was not satisfied by the “bounced” draft.

A recipient of a draft can “indorse” the check to transfer it to another party or to allow anyone to cash the instrument. Any signature by the recipient of the draft will be construed as an indorsement unless it specifies otherwise.[20] An indorsement can also restrict the recipient’s ability to use the draft, such as specifying “for deposit by John Smith only” or “can be deposited only after work is completed on this project,” etc.[21]  

If the recipient indorses the draft to another party and the check is dishonored by the bank, the third party recipient from the indorser may enforce the instrument against the indorser. However, if a check is not entered into the bank collection process within 30 days after the indorsement, then the indorser is discharged from liability.[22]  Additionally, if an indorser of a draft was entitled to a notice of dishonor and was not so notified then the indorser is discharged.[23]         

A person who has the right to enforce an instrument may enforce one that has been lost, stolen, or destroyed if the person can prove the terms of the agreement, such as amount, due date, and interest rate.[24]  A court can require a bond to protect the one obligated on the instrument, which is posted by the one claiming to have lost the instrument. 

In the cases of cashier’s, teller’s and certified checks, the claimant can give a bank a sworn declaration of loss.  Under the Code, the bank benefits from a ninety-day period, starting from the check’s issuance or acceptance, during which it need not resolve the claim. After the expiration of the ninety days, the bank must pay the check and it will then be relieved of further liability.[25]      

A person who issues an incomplete instrument takes the risk that the instrument may be improperly completed; therefore, the issuer bears the loss.  According to the Code, a person who takes an instrument for value, in good faith, and without notice has a claim against the issuer of an altered instrument.[26]  Typically, a fraudulent alteration will involve the amount of the check.  If the bank honors the check for an increased, but fraudulent amount, then the parties must find a way to apportion the loss of monies taken by the criminal.[27]  Note that any indorsers here incur no liability because the check was not dishonored and indorsers only incur liability upon dishonor.

Guarantors on Promissory Notes

The law recognizes that creditors may want to seek assurance they will be paid beyond the mere promise of the debtor.  One way a creditor can recover when a debtor defaults is to seek compensation by seizing and selling collateral the debtor may have pledged for the loan.  Article Nine of the Code addresses situations where a borrower gives a security interest to a lender in personal property.[28]  A second way that lenders can protect their extension of credit is to have a secondary party sign the note and agree to be liable should the borrower not pay the outstanding amount due on the note.  A borrower may, for example, entice a lender to extend credit when a secondary party is willing to guarantee the debt will be paid.  

If the borrower and the guarantor both sign the note, they are “co-makers” and so are jointly and severally liable on the note. If it is dishonored, the claimant suffering a loss may demand payment from either party in full. The guarantor in this case is known as an “accommodation party.” However, if the guarantor merely signs as part of the “negotiation” (or it guarantees anything other than “payment”), the claimant has to proceed first against the principal obligor, then, and only if the principal obligor fails to make payment, against the guarantor.[29] 

An accommodation party may sign with words indicating a guarantee of payment, such as, "Lisa, as guarantor."   Alternatively, the accommodation party may sign as an "anomalous endorser," which is defined in the Code as an endorsement by a person other than the holder of an instrument.[30]  Alternatively, the accommodation party may sign as a co-maker.  Note that a maker is any "person who signs or is identified in a note as a person undertaking to pay."  

For example, say that Arlene applies for a loan at First Bank to buy a used car.  However, Arlene’s credit rating is insufficient to support the loan, so the bank asks for a co-signer.  Arlene’s friend Byron signs the note “Byron, as guarantor.” Arlene defaults on the note and First Bank has its choice under joint and several liability to pursue either Arlene or Byron for the outstanding amount.  It is likely Arlene does not have the funds to pay the note since she defaulted so First Bank elects to bring a claim against Byron as co-maker.  Note that First Bank would be required to bring a claim against Arlene first in the event Byron signed as an accommodation party guaranteeing only collection, though this would have to be stated explicitly on the note.         

If more than one jointly liable party is responsible under a note but one party was forced to pay because the drawee brought an action against him alone, he is entitled to “contribution” from co-obligors where they have agreed to share the obligation.  In the case where an accommodation party has paid an instrument, that accommodation party may recover from the original obligor (assuming the obligor has the money to indemnify the accommodation party. [31]

Assume a debtor and creditor agree to modify the terms of a note.  The secondary obligor may be bound to this new arrangement and may not have had any influence or even knowledge that a modification occurred.  For this reason, the Code and courts have sought to protect secondary obligors from the possible adverse consequences of modification of the note.[32]  Thus, if the secondary obligor (the guarantor) does not agree to the change and the modification affects the terms or risk in the transaction, then the accommodation party may be released. 

Some modifications that can hurt the guarantor include the release of the principal obligor, extension of time for payment modification of the obligation for reasons other than a release and impairment of collateral.  Collectively, these releases operate as defenses to liability and are called suretyship defenses.[33]  Sometimes a creditor will require a separate guaranty agreement in which the obligor agrees to waive some of these suretyship defenses.[34]

In our next module, we will focus on check collection and the mechanisms by which banks process and discharge checks and other drafts.



[1] Michael D. Floyd, Mastering Negotiable Instruments: UCC Articles 3 and 4 and Other Payment Systems 71 (2d ed. 2018).

[2] Unif. Comm. Code § 3-401(a).

[3] Unif. Comm. Code § 3-402.

[4] For the Code’s treatment of the signatures of agents, see Unif. Comm. Code § 3-402.

[5] Floyd, supra note 1, at 73.

[6] Unif. Comm. Code § 3-403.

[7] Unif. Comm. Code § 3-408; § 3-409.

[8] Unif. Comm. Code § 3-409-412.

[9] Unif. Comm. Code § 3-604(a).

[10] Unif. Comm. Code § 3-311.

[11] Unif. Comm. Code § 3-604.

[12] Unif. Comm. Code § 3-602(a).

[13] For a discussion of general payment issues, see Floyd, supra note 1, at 64-65.

[14] Unif. Comm. Code § 3-602(b).

[15] Unif. Comm. Code § 3-602(b).

[16] Unif. Comm. Code § 3-602(a), (c)

[17] Unif. Comm. Code § 3-602(e).

[18] Unif. Comm. Code § 3-115.

[19] Unif. Comm. Code § 3-414(e).

[20] Floyd, supra note 1, at 77; Unif. Comm. Code § 3-204(a).

[21] Unif. Comm. Code § 3-204.

[22] Unif. Comm. Code § 3-415(e).

[23] Unif. Comm. Code § 3-415(c).

[24] Unif. Comm. Code § 3-309.

[25] Unif. Comm. Code § 3-312.

[26] Unif. Comm. Code § 3-407(c).

[27] This involves a complex analysis; see generally, Floyd, supra note 1, at 79.

[28] Uniform Commercial Code-Secured Transactions.

[29] Unif. Comm. Code § 3-419(d).

[30] Unif. Comm. Code § 3-205.

[31] Floyd, supra note 1, at 92-96.

[32] Unif. Comm. Code § 3-605.

[33] Unif. Comm. Code § 3-605.

[34] For a discussion of waiver and the complexities of § 3-605 see Floyd, supra note 1, at 96-102.