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Negotiable Instruments - Module 1 of 6

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Module 1: Negotiable Instruments


Traveling with large amounts of cash can be risky.  In the early days of commerce, merchants did not want to carry gold and silver for fear of being robbed so they started accepting paper as payment.  This paper served as evidence of a merchant’s debt that a creditor could, in turn, use as money.  These debts were part of a system developed in the Middle Ages called the “law merchant,” which was a collection of rules by which merchants could separate money from the obligation entitling them to collection.  Merchants began to carry this substitute money item that allowed them to use debts owed to them as a form of payment.[1]  

Today, this substitute money item is called commercial paper.  Both federal consumer law and state law, along with private industry arrangements and international agreements, govern the modern commercial payments system. All states have adopted a model law called the Uniform Commercial Code to regulate business transactions, albeit not all in precisely the same forms and iterations. We’ll refer to this as the “UCC” or the “Code.”  Article Three of the UCC regulates negotiable instruments, which are widely-used types of commercial paper.[2]

Negotiable instruments include drafts and notes.[3]  A draft is an order for third parties to pay a person. The personal check is a commonly used draft. A note is a promise to pay. Loan obligation agreements and “I owe you” notes are examples of notes.  Article Four of the UCC regulates the payments system itself, including check collection, credit and debit cards and electronic funds transfers.[4]  Article Five addresses letters of credit, which are typically used in large international transactions.[5]    

Parties to Drafts and Notes

In law, there are many designations people can have at any given time and a person’s designation may define her rights and responsibilities.  For example, a motorist has a set of rights and responsibilities when operating a motor vehicle which are separate from the rights and responsibilities of pedestrians or cyclists.  In commercial payments, a person may be a drawer of a check. The drawer writes the check that directs a drawee, usually a bank, to pay it.[6]  An issuer[7] or maker is someone who issues or creates a note, and is typically a borrower in the transactions. The note is made in favor of the holder, who is in possession of the note.

A draft or note may be payable to a specific person or to the “bearer,” who is in possession of a note at any given time.  Anyone can be a bearer and paper payable to “bearer” is comparable to a check made out to “cash.”  When a maker or drawer first transfers an instrument, the first person is said to be issuing the instrument and the initial recipient is the holder.[8]

For example, assume that Roy wants to buy a car from Susan. He goes to his bank and gets a check that the bank draws on his own account, called a cashier’s check, made payable to Susan.  Roy is in possession of the check, but since the check is payable to Susan, Roy cannot be a holder of the check.  Susan is not a holder either until Roy gives her the check.  Once Roy gives Susan the check, she becomes a holder because she is in possession of the check and it is payable to her.  Note the same would be true if the check was payable to “bearer.”

In this transaction, by issuing the cashier’s check, the bank has entered into an agreement to pay the check when it is ultimately presented (probably by Susan or her bank). Note that simply writing a check to someone who accepts payment is not accepting the check in the very narrow meaning of the Code’s use of that term.[9]

Another designation a person may have in a commercial payment is holder-in-due-course, or “HDC.”[10]  HDC status is one of the most remarkable aspects of Article 3,[11] as such status protects its holder from most claims and defenses against an instrument’s enforcement.  A holder in due course receives an instrument in a commercial transaction and satisfies additional criteria that we’ll discuss a bit later.[12]  At this point, we’ll start with a note’s negotiability, which is a prerequisite for holder in due course status and a trigger for many commercial paper rules.[13]    


An instrument is negotiable if it is a signed writing that contains an unconditional promise or order to pay a fixed amount of money at a definite time.[14]

The signature requirement dictates that the person must show an intention to be bound. This can be conveyed by a written signature, an “x,” a computer graphic, or even a thumbprint.[15]  Interestingly, a person who forges another person’s signature does not bind the forged person but does satisfy the negotiability requirement of having a signature (it would count as his own signature to whatever extent that would help).[16] 

The writing requirement can be satisfied if the obligation is handwritten, typewritten or otherwise manifested in any tangible medium.[17] The Uniform Electronic Transactions Act allows for “paperless” electronic records transactions. Moreover, in 2001, Congress enacted the Electronic Signatures in Global and National Commerce Act, abbreviated as E-Sign.[18]  The 2004 “Check 21” Act[19] further allows paper checks to be represented digitally. Note, though, that none of these rules allow negotiable instruments to be created or transacted orally.  Everything must be committed to at least some form of tangible medium.   

To be negotiable, the instrument must also be unconditional.[20]  It may refer to another document, but it cannot be subject to or governed by another writing. A negotiable instrument also must be free of any non-monetary instruction or contingency (such as “payable only if it snows on January 1” or “payable only of the issuer is still employed by July 15”).  Payment also cannot be contingent on contracts outside of the instrument (such as “payable only if the bearer mows the issuer’s lawn on Saturday”).

The Code does, though, allow reference to certain standard commercial practices without destroying negotiability.  These include prepayment terms on a loan promissory note and acceleration clauses that make the entire debt due at once in the event of late or nonpayment.  Moreover, the requirement that a negotiable instrument may only be paid from a particular source or fund does not destroy negotiability.  References to collateral and countersignature requirements on traveler’s checks are also allowed.  

A negotiable instrument must assert an unambiguous promise or order to pay.  A mere “I owe you” or authorization for someone to pay money is not a negotiable instrument.  Also, the drawer (the person making the order or promise) and the drawee (the person ordered to pay) must be clearly identified on the instrument. 

To be negotiable, the amount must be fixed. However, repayment terms may feature variable rates of interest that are tied to financial indexes such as those paid on U.S. Treasury bills.[21]  If the note specifies that it is payable with interest- with no rate specified- then the rate is the default rate under state law, which is called the judgment rate.

The negotiability requirement that an obligation be payable in money includes foreign currency (so, for example, a check for 500 Euros can be a negotiable instrument) but excludes commodities (so, a check written for “50 barrels of oil” or “a 12-pack of beer” is not a negotiable instrument).

A blank check is nonnegotiable, but is allowable under the Code to allow a holder to complete a blank check in the amount authorized.[22] Once properly completed by the holder later, the check can now be negotiable.  

For example, Alan writes a check to Doris for a shipment of soybeans but the amount to be paid is set by whatever the soybean price is on a given day in the future according to an independent financial monitor of soybean prices.  Accordingly, he authorizes Doris to complete the check herself by reference to that future price on a given date.  The check is negotiable.

For an instrument to be negotiable it must state that it is payable to the order of an identifiable person or to bearer. Note that the Code requires the use of the actual words - payable “to the order of.” In the case of bearer instruments, it may be payable to bearer, to cash, to the order of bearer or to the order of cash.”[23]  However, bank checks constitute an exception.  They may safely omit the words “order” or “bearer” and still retain their property of negotiability.[24]  For example, a check may be “payable to Sam” instead of “payable to the order of Sam” and still be negotiable.

Note that if an instrument fails to name the payee, it is still negotiable as bearer paper and any legal holder may cash it.

An instrument may be also payable to two or more persons individually or jointly.[25] 

For example, Hugo writes a check payable to Alice OR Barney.  Either Alice or Barney may cash the check.  However, if Hugo writes a check payable to Alice AND Barney then they both must participate in the negotiation of the check, which means they must both indorse the check for it to be cashed.

The Code permits an instrument to indicate that it is non-negotiable. For example, a bank may wish to use a sample or symbolic check in its advertisements that is non-negotiable.

Another requirement for negotiability is that an instrument must be payable on demand or at a definite time.[26]  A draft payable on demand is a sight draft payable at the will of the holder. A draft payable at a definite time may be payable at a fixed date or starting on a fixed date.[27]  Note that acceleration and prepayment clauses do not affect negotiability; neither do automatic time extensions or instruments payable at a closing date.   

The Holder of a Negotiable Instrument

Negotiability is important because it allows commercial paper to function as a substitute for money.  However, negotiability is critically important for another reason: it’s required for someone to acquire the coveted status of a holder-in-due course.[28] 

For example, Mark’s used car dealership sells a truck to Diane on credit.  She promises to pay Mark for the truck in several installment payments.  Mark then sells the note, and along with it the right to receive payments from Diane, to First Finance Company.  Unfortunately, the truck is in poor condition to the extent that Diane claims that contractual warranty provisions were violated. She therefore stops payment on the truck. First Finance seeks to collect on the note.  Diane’s defense is breach of the sales contract. If First Finance took the note as a holder-in-due-course, it would not be subject to that claim. First Finance would still be able to collect from Diane, and Diane would have to seek a judgment for indemnification against Mark!       

Negotiation of an instrument means giving it to another “holder,” [29] which means a “person entitled to enforce the instrument.” When the negotiation to another person is done with the intent to allow the recipient to enforce the instrument, then that act is called a transfer.[30]  Depositing a check in a bank account is a transfer of the check.  

A negotiation of a bearer instrument (such as a check made out to cash) only requires delivery, while a negotiation of an order instrument additionally requires a signature, called an “indorsement.”[31]  The indorsement is typically done by signing the back of the check. Once indorsed, the check is effectively a bearer instrument as the indorsed check can now be negotiated to another person through simple delivery and this subsequent transferee would also be a holder.  This type of indorsement, consisting of a mere signature, is called a “blank indorsement.”

Alternatively, the holder can indorse the check for payment to another identified person, in which case, the instrument is still an order instrument.  An indorsement may be restrictive such as “for deposit only” or to a lawyer “as attorney” for a client, which must be held in an attorney’s escrow or client account. Banks can incur liability for mishandling a check with a restrictive indorsement, so banks will usually require deposit (rather than cashing) of a check with a restrictive indorsement.  

For example, assume Alan is a landscaper who does work on Lisa’s house.  After Alan completes his work, Lisa writes a check to him.  Alan indorses the check by signing the back and he writes nothing more than his signature.  Alan is now a holder of a bearer instrument.   He then uses that check as a money substitute to pay for some truck repairs and negotiates the check to Linda of Linda’s Repair Service who is now the holder of the check.  Linda takes the check and writes a restrictive indorsement on the back of the check “for deposit only, Linda’s bank account at First Bank, account #123456789.”  She deposits the check in her savings account at First Bank. Now, First Bank is the holder.


To be considered a holder-in-due-course (which, for the sake of brevity, we’ll refer to as an “HDC”), a person must be a holder of a negotiable instrument who has given value for the instrument and does not have any notice of any problems with its enforcement.[32]  The instrument must be complete.  A person in possession of a check missing the amount, for example, cannot be a holder-in-due-course. 

A person has “knowledge” of a defect under the Code (thus depriving HDC status) if she has received notice through the mail or other mode of communication or has reason to know of a problem with the instrument.  If a person has notice that an instrument is overdue, been dishonored or is in default the person cannot be an HDC.[33] An instrument that contains visible indications of forgery, alteration, irregularity or incompleteness also effectively deprives the possessor of HDC status.

Holders of “stale” checks, which means checks written more than 90 days ago under the UCC (or shorter, if stated on the instrument) or checks that have been dishonored or not paid after presentment for a reasonable time cannot be holders-in-due-course.[34] 

Even if the instrument itself is sound, if the recipient has knowledge of a fiduciary violation that went into the check’s creation, such as if the recipient knows that the trustee in charge of the trust account who wrote the check had no rights to spend the trust’s money for this purpose, he is likewise not an HDC.  

To be an HDC, the recipient must take the instrument for “value,” which generally means fair market value.  The UCC formerly required “honesty in fact in the conduct or transaction concerned,” which means the deal must have been done in good faith. This requirement was expanded under the 1990 revisions to “honesty in fact and the observance of reasonable standards of fair dealing.”  This addition of an objective component was adopted by some states but rejected by others.[35]

Certain types of transactions do not confer HDC status, meaning that these recipients are not protected. These include creditors’ proceedings (as when a note is seized to satisfy the debts of the holder), bulk sales (as when many instruments are packaged as a security and sold by investment banks) and inheritances or successors to an interest in an estate.[36] Executory promises, which are promises yet to be performed, are also excluded from the meaning of “value” for HDC status.[37] So, if Adam gives a $500 instrument to Barbara in exchange for Barbara’s promise to paint Alan’s car, until Barbara paints the car, she cannot be a holder-in-due-course.

A transferee to whom an instrument is properly negotiated gains the rights of the transferor.  At common law this was called the “doctrine of derivative title.”[38]  Thus if an HDC gives her note to another person, the transferee retains HDC status even when the transfer is not normally the type to confer HDC status.  This is called the “shelter doctrine.”[39]  For example, if Jane gives Don a $10,000 promissory note in exchange for Don’s car, Don is an HDC. If Don gifts the note to his friend, Betty, then Betty benefits from being an HDC even though HDC status is not generally available for gift transfers. Don can convey his HDC status to Betty.

Benefits of Being a Holder-in-Due-Course

Against an HDC seeking payment, the Code allows some defenses but disallows others. Those few defenses that will work against an HDC are referred to as real defenses, while defenses against which the HDC is immune are referred to as personal defenses. Typically, real defenses indicate severe issues with the instrument to the extent that its enforcement would be problematic. 

“Real” defenses include:

-       Infancy, which means that the note-maker was a minor, rendering the transactions void or voidable; 

-       Duress, meaning that the note-maker was forced by wrongful threats to sign the note;

-       Incapacity, as in the case where the note-maker is so mentally ill as to not be considered responsible for his agreements;

-       Illegality of the transaction, when the illegality is of such severe nature that the law considered the transaction automatically void;

-       Fraud, which must be of such a severe character that it “induced the obligor to sign the instrument with neither knowledge nor reasonable opportunity to learn of its character or essential terms.” 

-       Discharge of the obligation in insolvency proceedings.[40]

“Personal” defenses, which are NOT available against an HDC seeking to enforce an instrument, include breach of contract, lack of consideration, fraud and illegality that don’t rise to the levels we described earlier, and that the note was already paid.[41]

A “claim in recoupment” which means an offset, is also not available against an HDC.[42] For example, If Joan has $1,000 in her account at National Bank but owes $200 in bank fees, the bank can offset the debt by deducting $200 from her account. But if a holder-in-due-course presents a $1,000 check written by Joan and the account has the requisite $1,000 in it, the bank must honor the check and try to collect its fees from Joan in another way.

In the following modules we will examine the liability issues surrounding negotiable instruments and the check collection process.


[1] Stephen C. Veltri, The ABCs of the UCC: Article 3: Negotiable Instruments; Article 4: Bank Deposits and Collections and Other Modern Payment Systems, 1-4. (3d ed. 2015).

[2] Michael D. Floyd. Mastering Negotiable Instruments: UCC Articles 3 and 4 and Other Payment Systems, 3-15. (2d ed. 2018).

[3] Unif. Comm. Code § 3-104.

[4] Unif. Comm. Code, art. IV - Bank Deposits and Collections.

[5] Unif. Comm. Code, art. V - Letters of Credit.

[6] Unif. Comm. Code § 3-103.

[7] Unif. Comm. Code § 3-105.

[8] Unif. Comm. Code § 1-201(b)(21)(A).

[9] Floyd, supra note 2, at 29.

[10] Unif. Comm. Code § 3-302.

[11] Floyd, supra note 2, at 54.

[12] Unif. Comm. Code §§ 3-305, 3-306.

[13] "Negotiation" means “a transfer of possession, whether voluntary or involuntary, of an instrument by a person other than the issuer to a person who thereby becomes its holder.” Unif. Comm. Code § 3-201(a).

[14] Unif. Comm. Code § 3-104; Regent Corp., USA v. Azmat Bangladesh, Ltd., 686 N.Y.S.2d 24, 28 (App. Div. 1st Dep’t. 1999) (reference to a bill of lading date for payments did not impair negotiability); Ameritrust Co., N.A. v. White, 73 F.3d 1553, 1559 (11th Cir. 1996) (Note containing forfeiture clause ruled non-negotiable).

[15] Unif. Comm. Code § 1-201(b)(37); Veltri, supra note 1, at 11.

[16] Unif. Comm. Code § 3-403.

[17] Unif. Comm. Code § 1-201(b)(43).

[18] Electronic Signatures in Global and National Commerce Act of 2000 (ESign), Pub. L. No. 106-229, 114 Stat. 464 (15 U.S.C. §§ 7001-7031).

[19] Check Clearing for the 21st Century Act, (Check 21 Act), Pub L. No. 108-100, 117 Stat. 1177.

[20] Unif. Comm. Code § 3-104; § 3-106.

[21] Veltri, supra note 1, at 17-18; Floyd, supra note 2, at 39.

[22] Unif. Comm. Code § 3-115.

[23] Unif. Comm. Code § 3-109.

[24] Unif. Comm. Code § 3-104(c); State of Mexico v. Herarra, 130 N.M. 85, 88 (App. 2001). (Payee on a check adds his name to the payee line on a check payable to “cash” was found to be not guilty of forgery.)

[25] Unif. Comm. Code § 3-110(d); Coregis Insurance Company v. Fleet National Bank, 68 Conn. App. 716, 721 (2002) (cited in Veltri, supra note 1, at 19).

[26] Unif. Comm. Code § 3-104.

[27] Unif. Comm. Code § 3-108. Messing v. Bank of America, 373 Md. 672, 692-93 (App. 2003) (Bank refused to pay a presenter until he placed thumbprint on a check; court ruled that until acceptance by the bank there is no liability and the bank had not accepted the check).

[28] All Lease Co. v. Bowen, 1975 WL 22864 at *791 (Md. Cir. Ct. 1975)  (Several other promises in an instrument rendered the instrument non-negotiable, effectively depriving the plaintiff holder in due course status).

[29] Unif. Comm. Code § 3-201(a).

[30] Unif. Comm. Code § 3-203(a).

[31] Unif. Comm. Code § 3-204; § 3-205; § 3-206.

[32] Unif. Comm. Code § 3-302(a)(2).

[33] Unif. Comm. Code § 3-302(a)(2).

[34] Unif. Comm. Code § 3-304(a)(2).

[35] Floyd, supra note 2, at 64-65.

[36] Unif. Comm. Code § 3-302.

[37] Unif. Comm. Code § 3-303.

[38] Veltri, supra note 1, at 38.

[39] Unif. Comm. Code § 3-203(b).

[40] Unif. Comm. Code § 3-305.

[41] See Fed. Deposit Ins. Corp. v. World Univ., Inc., 978 F.2d 10, 16 (1st Cir. 1992)

[42] Unif. Comm. Code § 3-305.