CHAPTER 40 LIABILITY OF PARTIES Outline I. Introduction A.

Liability in General Liability on negotiable instruments flows from signatures as well as actions concerning them. Contractual Liability A. Contractual liability on the instrument depends on the capacity in which the person signed. Article 3 of the UCC provides the terms of the contract. B. Primary and Secondary Liability The person who has agreed to pay the negotiable instrument is primarily liable. A guarantor is secondary liable. Obligation of a Maker A. General Information The maker of a promissory note is primarily liable for payment of it. The makers obligation is owed to a person entitled to enforce the instrument. Revised Article 3 provides that the drawer of a cashiers check has the same obligation as the maker or issuer of a note. Example: American Federal Bank, FSB v. Parker: The court found that Parker was liable for the entire amount of the note even though he only verbally agreed to pay for a portion. Parker signed the blank note obligating himself to whatever amount Kirkman included on the document. B. Obligation of a Drawee or an Acceptor The acceptor of a draft is obligated to pay the drafter according to the terms at the time of acceptance. At the time a check or draft is written, no party is primarily liable. If the drawee bank certifies the check, it becomes primarily liable. C. Obligation of a Drawer The drawer of a check is secondarily liable unless she disclaims liability by drawing "without recourse." D. Obligation of an Indorser A person who indorses a negotiable instrument is usually secondarily liable unless the indorsement is qualified. E. Obligation of an Accommodation Party An accommodation party is a person who signs a negotiable instrument for the purposes of lending her credit to another party to the instrument. F. Signing an Instrument No person is contractually liable unless his signature appears on the instrument. G. Signature of an Authorized Agent An authorized agent can sign the instrument. Example: Marion T, LLC v. Northwest Metals Processors, Inc.: An individual who signs a check drawn on a corporate account without indicating he is signing in a representative capacity is not personally liable on the instrument. H. Unauthorized Signature If a person's signature was unauthorized, the person is not bound. Contractual Liability in Operation

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A. Presentment of a Note The instrument must be presented. A note is presented to the maker when due. B. Presentment of a Check or a Draft A check or draft is presented to the drawee. C. Time of Presentment When an instrument is payable at a definite time the holder should present it for payment on the due date. Depending on the nature of the instrument, demand instruments should be presented within a reasonable time. V. Warranty Liability A. A person who transfers an instrument or presents it may incur liability on the basis of certain implied warranties, called transferors warranties and presentment warranties. B. Transfer Warranties A person who transfers a negotiable instrument to someone else and for consideration makes 5 warranties. 1. The warrantor is entitled to enforce the instrument. 2. All signatures are authentic and authorized. 3. The instrument has not been altered. 4. The instrument is not subject to a defense or claim. 5. The warrantor has no knowledge of any insolvency. Example: Bank One, N.A. v. Streeter: The court held that Streeter is liable to Bank One on the grounds that he breached the transfer warranties when he transferred the instrument with the names of the payees altered. C. Presentment Warranties Persons who present negotiable instruments for payment make differing warranties than those of transferors. D. Payment or Acceptance by Mistake If the drawee bank mistakenly paid a check, the bank cannot recover if it paid the check to a presenter who had taken the instrument in good faith and for value. E. Operation of Warranties The transfer and presentment warranties shift the liability back to a wrongdoer or to the person who dealt immediately with a wrongdoer in some situations. VI. Other Liability Rules A. Negligence If a person has been negligent, Article 3 precludes her from using the alteration or lack of authorization as a reason for not paying a negotiable instrument. B. Imposter Rule The imposter rule puts the responsibility for determining the true identity of the payee on the drawer or maker of a negotiable instrument. C. Fictitious Payee Rule If a dishonest employee forges checks, the employer is responsible for bearing the immediate loss. VII. Comparative Negligence Rule re Imposters and Fictitious Payees A. General Information Revised Article 3 establishes a comparative negligence rule for imposters and fictitious payees. Example: Victory Clothing Co.,Inc. v. Wachovia Bank, N.A.: The court applied comparative 40-2

B.

C.

VIII. A. B. C. D.

E.

negligence principles to split the loss between the company whose employee forged checks and a depository bank which allowed the forger to deposit the checks into her personal account. Fraudulent Indorsements by Employees Revised Article 3 specifically addresses employer responsibility for fraudulent indorsements by employees. Conversion A bank that pays a check that contains a forged indorsement may become liable for conversion. Example: Lawyers Fund for Client Protection of the State of New York v. Bank Leumi Trust Co. of New York: A payee has a claim for conversion when an instrument is paid to someone else with his indorsement. Discharge of Negotiable Instruments Discharge of Liability There are several ways to discharge liability Discharge by Payment Payment by the person primarily liable discharges all parties to the instrument. Discharge by Cancellation Discharge may also occur through cancellation. Altered Instruments; Discharge by Alteration Alteration of the instrument generally discharges any party whose obligation is affected by the alteration. Discharge of Indorses and Accommodation Parties A person entitled to enforce an instrument may agree to a material modification of the obligation of a party to the instrument.

Learning Objectives 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. You should understand the liability a person assumes when she indorses a check. You should understand the warranties made when a check is presented to a drawee bank for payment. You should understand the liability of a drawee bank to its customer if the check contains a forged signature. You should know whether the drawee bank bears the loss if an imposter presented a check for payment. You should understand the affect of materially altering a negotiable instrument. You should be familiar with the ways that liability on a negotiable instrument may be discharged. You should be able to distinguish primary liability from secondary liability. You should know the effects of the certification of a check. You should be able to determine the contractual liability of an accommodation party. You should know what is meant by presentment, dishonor, and notice of dishonor. You should know who makes which transferor's warranties, and to whom. You should know who makes which presentment warranties, and to whom. You should know the effect of a maker or drawer's negligent execution of a negotiable instrument. You should be familiar with fictitious payees. You should know the special rule concerning forged indorsements when an imposter or fictitious payee exists.

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You should know the extent of a drawee bank's liability for conversion when it pays a check with a forged indorsement.

Learning Hints 1. This chapter examines how a person becomes liable on a negotiable instrument and the nature of the liability incurred. Basically, liability may be based on the fact a person signed the instrument. In such cases, liability depends on the capacity in which the person signed the instrument. Liability on a negotiable instrument can also be based on breach of warranty, improper payment, negligence, or conversion. When a person signs a negotiable instrument, he generally becomes contractually liable on the instrument. That liability may be primary or secondary. Note that the only way a person may become contractually liable on a negotiable instrument is to sign it. This explains why the forgery of your signature on a check does not make you liable, but makes the forger liable. Of course, your agent may sign for you and make you liable. To aid your understanding of contractual liability, address each type of negotiable instrument separately. For example, a note has a maker, payee, indorser, and perhaps accommodation parties. What is the contractual liability of each? An uncertified check has a drawer, drawee, payee, indorser, and perhaps accommodation parties. What is the contractual liability of each? Do the same for certified checks, drafts, and accepted drafts. Note that "accommodation" means help. This is why an accommodation maker has the liability of a maker, because the accommodation maker has helped the maker obtain credit. Note that an accommodation maker is primarily liable. This means that the holder of the note can obtain payment from the accommodation maker before trying to obtain payment from the maker. As far as the holder is concerned, the accommodation maker is like any other maker. That a person is an accommodation maker is important only between the accommodation maker and the maker. If the accommodation maker pays, she can recover the payment from the maker. The above analysis also applies to accommodation drawers and indorser, except that in these situations, the liability is secondary. Note that no one is primarily liable on an uncertified check or unaccepted draft. The drawee has no contractual liability, because the drawee has not signed the check or draft. The drawer has only secondary liability, because the drawer promises to pay only if the drawee does not pay. Transferor's warranties arise because a person transfers an instrument. A person may have no contractual liability, yet have a transferor's warranty liability. A person may have both contractual liability and transferor's liability. Transferor's warranties are based upon reasonable expectations. A person who receives a negotiable instrument expects five things to be true, because he expects to receive something very much like money. These five things are the five transferor's warranties. You must memorize them. To help you understand transferor's warranties, make a chart setting forth the transferor's warranties made by the nonindorsing transferor, the indorser, and the qualified indorser, and to whom each of these parties makes transferor's warranties. Presentment warranties are also based upon the reasonable expectations of the person who pays for the instrument. It is easier to understand how contractual and warranty liability operate if you make a diagram of the transfer of the instrument. These schematics help you to see who held the instrument, and in what order. You can put notes next to each person's name indicating whether, for instance, he was a thief and whether he signed the instrument. Schematics also illustrate how the instrument eventually returns to its issuer.

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The liability rules regarding negligence, impostors, and fictitious payees make good sense. The negligence rule places liability on the person who was negligent. Good examples of negligence are leaving unfilled spaces on the payee and amount lines of a check. A dishonest person could easily and skillfully raise the amount of the check and change the payee's name. The imposter rule places liability on the maker or drawer who failed to ascertain the true identity of the person to whom the instrument was written. It is fairer to impose liability on the drawer who dealt with the imposter than to impose it upon a holder who never met the imposter. The fictitious payee rule places liability upon the employer who should have better supervised the employee who made out the payroll checks to the fictitious payee. It is fairer to impose liability on the employer whose unsupervised employee did the wrong than to impose it upon a holder who was not aware of the fiction.

True-False In the blank provided, put "T" if the statement is True or "F" if the statement is False. _____ 1. The drawee bank has primary liability on a normal check. _____ 2. When a maker dishonors a note, the holder should give timely notice to any indorsers. _____ 3. A person who indorses a negotiable instrument usually is secondarily liable. _____ 4. The maker of a note is secondarily liable on the note. _____ 5. Maker makes a note payable to payee's order; payee indorses and negotiates the note to First, who in turn indorses and negotiates the note to Second. If Second cannot recover from maker, he can successfully sue either Payee, or First on their secondary indorser's liability. _____ 6. Sheila issues a promissory note to Tim. Tim indorses it over to Carl. Carl indorses it over to Rodney. Tim makes a warranty to Rodney that all signatures on the instrument are genuine. _____ 7. In question # 6, Rodney makes a warranty to Sheila that all signatures are genuine. _____ 8. The drawer of a forged check is liable for the check if the fictitious payee rule applies. _____ 9. An accommodation maker is secondarily liable. _____ 10. Notice of dishonor may be made orally or in writing to hold a drawer liable on a draft. Multiple Choice Circle the best answer. 1. The party who is primarily liable on a check or a draft is called: a. The drawee. b. The acceptor. c. The payee. d. The maker. 2. Who is primarily liable on a check at the time it is written? a. The payee. b. The drawer. c. The drawee bank. d. No one. 3. Which of the following always blocks recovery on any transfer warranty? a. That the instrument has not been negotiated to the transferee. b. That the transferor did not indorse the instrument. c. That the transferor is a holder in due course. d. That the transferor received no consideration for the transfer.

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Which of the following may avoid the indorsers secondary liability on a dishonored instrument? a. A qualified indorsement. b. A restrictive indorsement. c. A blank indorsement. d. A special indorsement. Which of the following is not a reasonable request of a maker upon presentment of the instrument? a. Ask to see the note. b. Ask for a signed receipt. c. Require surrender of the note. d. None of the above. Liz writes a check drawn on 1st State Bank to pay Phil for mowing her lawn. Which of the following statements is true? a. 1St State Bank is primarily liable on the check. b. Liz is primarily liable on the check. c. 1st State Bank is primarily liable on the check if the bank certifies the check. d. Liz has no liability on the instrument. How should Abby Alston, president of Astra Corporation, sign checks on behalf of Astra, if her signature as an agent is required on the checks? a. Astra Corporation by Abby Alston, President. b. Abby Alston, President. c. Astra Corporation. d. Abby Alston. Tad issues a promissory note to Ann, who indorses it to Steve. Steve negotiates it to Gail without indorsing it. Gail indorses it to Henry, who presents the instrument to Tad for payment. Which of the following is not true? a. Henry makes a warranty to Tad that he had no knowledge of Tads signature being unauthorized. b. Steve makes a warranty to Henry that the instrument is not altered. c. Steve makes a warranty to Gail that all signatures are authentic. d. Ann makes a warranty to Steve that she has no knowledge of any insolvency proceedings against Tad. Arnie issues a note to Carol for $1,000. Arnie was negligent in making the note and allowed a lot of blank spaces on it. Carol was able to alter the instrument to $10,000 and sold it to Frank, who qualifies as a holder in due course. Frank presents the note to Arnie. Which of the following is true? a. Arnie will not be required to pay on the note due to the alteration. b. Arnie will only be required to pay the original amount of $1,000. c. Arnie will be required to pay $10,000 due to his negligence in drafting the note. d. Arnie is not allowed to seek damages from Carol. Milt works in the accounting department for Franks, Inc. Milt creates a false invoice to Smith Co. A check is drawn on Fidelity Bank. Milt forges Smiths indorsement and cashes the check. Which of the following is true? a. The bank is liable for paying on a forged instrument. b. Franks is not liable on the check due to the forgery. c. Milt is not liable for the forgery. d. Franks is liable on the check under the fictitious payee rule. 40-6

Short Essay 1. Amy issued his negotiable promissory note payable to the order of Buddy. Buddy indorsed the note, "Without recourse, Buddy," and negotiated it to Second Bank. At the time Buddy negotiated the note, Amy was insolvent but this was unknown to Buddy. The note was not paid. Is Buddy liable to the Bank on his indorsement?

2.

Rose is the president of ABC Beverage and has the authority to sign negotiable instruments for ABC. Rose common signs the checks "Rose Red" on the signature line below where "ABC" is printed. Supply Company takes a check signed as above by Rose. The drawee bank dishonored the check because there were insufficient funds in the account. If Supply Company sues ABC and Rose to make the check good, is Rose personally liable to Supply Company?

3.

Ernie steals a car from Al. Ernie takes the car to Honest Hollies Used Cars and sells it to Hollie. Hollie writes a check drawn on Peoples Bank to Al, thinking that Ernie is Al. Ernie then forges the check and cashes it. Who is liable for this forged check? Why?

4.

Valerie steals some checks from Roni. She then buys some goods from Dollar Mart by forging Ronis signature on a check. The checks are drawn on State Bank. Who is liable for the forged checks?

5.

Laura applies for a loan at Farmers Bank. Lauras credit history is a bit weak, so the bank asks for

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an accommodation party to sign with Laura. What type of accommodation party is the bank likely to require for Lauras loan? Why?

6.

Describe the liability of the parties involved in a check. Distinguish an ordinary check from a certified check.

7.

Tom pays his 60-day note plus interest to April on time. Greg issued a promissory note to Gina. Gina negotiated the note by indorsement to Buddy. Buddy decides to forgive Gregs debt and destroys the note. Describe the liabilities in each of these situations.

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Helen is vice president of finance for Coffee Enterprises, Inc. She does all the bookkeeping and check distribution for the company. One of their suppliers is Margaux Caf Products. Helen has set up an account at her companys bank named Margaux Coffee, with Helen as its sole proprietor. Over a period of time, Helen signed a number of company checks made out to Margaux and proceeded to direct them into her own account. Coffee Enterprises finds out about this embezzlement and sues its own bank for wrongfully honoring the checks that went to Margaux Coffee. Is the bank liable?

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