ULC

UCC Article 3, Negotiable Instruments (1990) Summary

In 1896, four years after the Uniform Law Commissioners (ULC) first organized, they promulgated the Negotiable Instru­ments Law (NIL).  It was adopted in every state in the United States, and was the first successful Uniform Act.  When the Uniform Commercial Code (UCC) was promulgated initially in 1951, the old, venerable NIL was polished up a bit and offered as Article 3 of the new UCC.  The old NIL in either its independent form or as part of the UCC has gov­erned negotiable instruments in the United States for about 80 years, as its first major revisions are prepared for promulga­tion by the ULC in the year 1989.  Another 80 or so years of service is expected for the revisions.

 

Negotiable instruments make the economy go around.  That is why the law on negotiable instruments is important and why the work of the Uniform Law Commissioners has been lasting and uniformly adopted on this subject.  What is a negotiable instru­ment?  It is either a “draft,” of which the most common sub­category is the “check,” or a “note.”  A “draft” is merely an order from one person to another to pay money to a third person.  A check, as a species of draft, illustrates.  A person writes checks on a bank account which the bank maintains on that person's behalf.  A check, as a kind of draft, is an order from the person/depositor as “drawer” to the bank/drawee for payment of money to a third person named on the check as “payee.”

 

A “note” is evidence of a debt between the “maker,” who promises to pay, and another person.  A traditional promissory note is an example.  One person borrows money from another person.  The borrower signs a piece of paper that obligates him to pay the money back at a certain time.  That piece of paper, which evidences the debt, is a “note.”

 

Both notes and drafts can be negotiable or nonnegotiable, but negotiability is the issue that makes Article 3 essential.  Drafts and notes represent money and have value, based upon that representation.  It has long been accepted that drafts and notes can be passed from person to person, well beyond the persons who are parties to the initial transactions represented, almost as easily as money itself is passed from hand to hand.   The ability to transfer drafts and notes from person to person, from hand to hand, to “negotiate” them is important to overall economic activity.

 

That becomes readily apparent when we think about that most common draft, the “check.” A “check” is but a draft drawn on a bank.  Checks are used to pay for everything, because of their convenience and security.  A check has to be negotiable or it simply could not be used for the purposes of paying for nearly everything. 

 

Also, “notes” are bought and sold daily in large quantities on the commercial paper markets in the United States.  A person may buy a car or refrigerator on time and sign a note.  The dealer will generally negotiate that note to another person in the market for commercial paper, thereby realizing his or her profit and obtaining funds to purchase more inventory to sell.  The ability to negotiate these notes, again, is the key to making the market for commercial paper work.  The economy needs negotiable instru­ments, specifically “drafts” and “notes” under Article 3 of the UCC.

 

 “Drafts” and “notes” are “instruments” under Article 3.  Besides being orders or promises to pay, they have to have three other characteristics to be instruments subject to Article 3.  They must be unconditional orders or promises to pay money on demand or at a time certain.  They must be payable to “bearer” or to “order.”  A bearer instrument simply states that it is payable to bearer—no specific payee.  Order instruments state the specific person or entity to which payment is to be made.  Last, they must promise or order the payment of a fixed amount of money, although this characteristic changes between original and revised Article 3, and that change is described a little later on in this summary.

 

A negotiable instrument (note or draft) is simply one that a person, called a “holder in due course,” who is not one of the persons who created the instrument originally, may negotiate or transfer to another person without difficulty, and who has the power, also, to enforce the instrument according to its terms.  If the instrument is a draft, the holder in due course can present it for payment and expect to be paid.  If the instrument is a note, a holder in due course can expect to receive payment when the debt is due.  The holder in due course can do these things even when the relationship between the original parties to the instrument would preclude their enforcement of the instrument for payment.  The holder in due course is the essence of negotia­ble instruments.  Free alienability of these instruments is their important charac­teristic, and holders in due course are the agents of free alienability. 

 

How does a person become a holder in due course?  He or she does so by taking the instrument in good faith from a prior holder for value without knowledge of any defects in the instru­ment, of any claims against the instrument, or of any defenses that may be asserted against its payment.  The holder in due course, therefore, honestly receives the instrument, has paid for it, and can claim innocence with respect to any transactions which may have involved the instrument prior to its coming into his or her possession.  The characteristic of innocence is, perhaps, primary.

 

Negotiation involves a specific sequence of acts that make up the transfer to a holder, and from one holder to another.  There are two elements, depending upon the kind of instrument involved.  If the instrument is a bearer instrument, delivery of the instru­ment from one person to another constitutes negotia­tion.  If the instrument is an order instrument, it is negotiated by indorsement of the instrument by the current payee and physical delivery to another person, who becomes a holder.

 

Some kinds of drafts are bearer instruments, and they are passed from holder to holder just as money is passed.  The common check, although it can be made out to bearer, is usually made out to a specific person.  That check is an order instrument, and to negotiate it, the payee must indorse it and pass it on to the next holder.  If the indorsement is to bearer, the check can be negotiated further simply by delivery to another person who becomes the next holder.  If the indorsement is to a specific person, it remains an order instrument, and negotiation requires a further indorsement and physical delivery to another holder.  Most of us are familiar with checks and how the rules of negotiable instru­ments apply to them, so they make good examples for illustrating these rules.  It should be recognized that there are other instruments used in varieties of business transactions that are subject to the same general rules.

 

If negotiable instruments are used handily under current Article 3, why revise it?  The basic reason for a revision is the accumulation of decisions based upon current Article 3, some of which have identified problems.  It is possible after these many years to respond to these cases in statutory language, correcting the problems that some of the cases reflect.  Also, the transac­tional environment has changed for negotiable instruments.  Institutions such as banks, which are heavily engaged in transac­tions involving negotiable instruments, operate a little different­ly than they did when the UCC was first promulgated.  Technology is a primary factor, along with an imperative need to use it.  Check processing is an example of the need to modernize the law of negotiable instruments.  Banks need to process checks faster in volume numbers that have grown astronomically.  They need to be able to use electronic communications, computers, and visual scanners to process checks.  The law of negotiable instruments, and bank deposits must accommodate these kinds of changes.

 

It is not possible in the context of a short summary to cover every aspect of the revision of Article 3.  Remembering that the viability of negotiable instruments was and remains the reason for Article 3, a few of the improvements can be described as examples of the overall revision. 

 

The scope of Article 3 narrows to a degree in the revision.  It answers the question of what is a negotiable instrument by admitting, in theory, fewer instruments.  Original Article 3 states that it applies to instruments that have certain charac­teristics of negotiable instruments, except that they are not made out “to order or bearer.”  Such instruments fall under original Article 3, but no holder of such instruments can be a “holder in due course.”

 

This provision has been viewed as injecting considerable ambiguity into Article 3.  Some contracts may have characteris­tics that make it a question as to whether Article 3 would apply.  There may be unanticipated outcomes for parties to such contracts if Article 3 does apply.  In revised Article 3, the ambiguity is removed.  The only instrument to which Article 3 would apply that is not a bearer or order instrument is a check -an instrument payable at a bank.  Checks, whether made out to order to bearer, ought to be treated as negotiable instruments.  Holders of such instruments can be holders in due course, also.

 

Original Article 3 requires that a negotiable instrument state a “sum certain.”  The requirement of a sum certain is completely eliminated in revised Article 3.  Rather than a sum certain, an instrument must show a “readily ascertainable amount of money, with or without interest or other charges described in the promise or order . . .”  Rates of interest may be stated as “fixed or variable.”

 

There is a very specific reason for eliminating the old “sum certain” requirement.  Variable rates of interest, pegged to some sort of fluctuating standard rate of interest, are common as they were not in the time Article 3 was originally promulgated.  Instruments with variable rates of interest cannot be negotiable instruments with the sum certain requirement, and such instru­ments should be negotiable instruments.  Revised Article 3 assures that variable rate instruments will be negotiable.

           

Another example of improvements in Article 3 in the new revision is the statement of contribution rules for multiple parties to a draft or notes.  If more than one person signs an instrument in the same capacity, Article 3 has always provided that they are jointly and severally liable in that capacity.  But revised Article 3 provides further that a party who satisfies an instrument has a right of contribution from co-parties signing the instrument in the same capacity.  Further, it deals with contribu­tion when a co-party is insolvent.  Contribution is divided between parties who are solvent.

 

An example for the above rule could involve three persons who co-sign a promissory note as makers.  If one of them satisfies the note when it is due, revised Article 3 would permit that person to collect one-third of the payment from each of the co-makers  If one of them is found to be insolvent, the other solvent co-maker would be liable for one-half.  The issue of contribution is not addressed in original Article 3.

 

Original Article 3 provides rules for determining when a cause of action arises or accrues under Article 3.  Revised Article 3 adds a statute of limitations.  It simply states the time periods within which any action under Article 3 must be brought, as an ordinary statute of limitations provision does. 

 

When an instrument is an order instrument, it requires an indorsement for negotiation.  An indorsement is exactly what might be expected, the person to whom payment is ordered signs his or her name on the instrument in the expected place.  An indorsed check is a kind of order draft familiar to most people and is an appropriate example. 

 

But endorsements may come with more than the signature.  Endorsements that condition negotiation or payment are called restrictive endorsements in original Article 3, because they are intended to restrict the right to negotiate the instrument or to obtain payment.  Article 3 has always erred on the side of negotiation.  For that reason, an indorsement that purports to prohibit further transfer or negotiation has been always treated as ineffective. 

 

Certain restrictive endorsements were given effect under original Article 3, however.  “The first taker under an indorse­ment . . . had to apply any value . . . consistently with the indorse­ment . . . ,” for example.  Revised Article 3 goes much further in limiting the effect of restrictive endorsements on the right to receive payment.  Conditional language does not make an indorse­ment “restrictive” in revised Article 3.  An indorsement conditioning the right to receive payment “does not affect the right of the indorsee to enforce the instrument.”  A person paying the instru­ment or taking it for value or collection may disregard the condition and the rights and liabilities of that person are not affected by whether the conditions have been fulfilled.  Revised Article 3 errs even further on the side of effective negotiation.

 

Revised Article 3 follows original Article 3 by honoring certain restrictive endorsements such as “for deposit,” “for collection,” “pay any bank,” and the like.  These are restrictive endorsements applicable to instruments that are collected within the banking system.  They are endorsements that must be honored, except in the case of intermediary banks or the non-depositary payor bank.  While all others who wrongfully pay over such a restrictive indorsement are held for conversion of the instru­ment, intermediary banks and the non-depositary payor bank are not.  Their role as mere conduits to the depositary bank would be impaired if there was liability.  Revised Article 3, however, explicitly makes a non-depositary payor bank exempt from liability with intermediary banks, clarifying the position of the non-depositary payor bank as original Article 3 does not.

 

Revised Article 3 adds indicia of a regularly executed instrument to the other requirements for a holder in due course in original Article 3.  If there is “apparent evidence of forgery or alteration” a holder cannot become a holder in due course.  To this extent, the notion of holder in due course is a little more limited than in original Article 3, and the notion of innocence is given a little more specificity. However, if an instrument is clearly forged or altered, it is proper to charge the holder with knowledge of that obvious defect, and revised Article 3 does so.

 

These are examples of the kinds of improvements of Article 3 made in Revised Article 3.  Revised Article 3 covers a great many other topics, including liability of parties to instruments, what happens when a negotiable instrument is dishonored, and discharge of instruments.  Some of the older mechanical rules pertaining to such matters as presentment of an instrument as a condition to payment are relaxed.  But the basic negotiable instrument remains as it was under original Article 3, and under the NIL.  The changes in Revised Article 3 are adjustments to the existing act that make it a better one.  Revised Article 3 will guarantee the effective­ness of negotiable instruments for the next century.