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NEGOTIABLE INSTRUMENTS LAW

Atty. Rene Alexis P. Villarente, MBA


Ateneo de Davao University

INTERNATIONAL AND LOCAL TERMINOLOGIES


I. SECTION 1 and allied Sections
1. Extension Clauses. The reverse of an acceleration clause is an extension
clause, which allows the date of maturity to be extended into the future. To keep
the instrument negotiable, the interval of the extension must be specified if the
right to extend is given to the maker of the instrument. If, on the other hand, the
holder of the instrument can extend it, the maturity date does not have to be
specified. (1)
Extension Clauses. The reverse of an acceleration clause is an extension
clause, which allows the date of maturity to be extended into the future. To
keep the instrument negotiable, the interval of the extension must be
specified if maker or drawer of the instrument is given the right to extend it.
If, however, the holder of the instrument can extend it, the maturity date
does not have to be specified. (4)
2. Drafts. A draft, which is a three-party instrument, is an unconditional written
order by one party (the drawer) that orders a second party (the drawee) to pay
money to a third party (the payee). A draft can be either a time draft or a sight
draft. A time draft is payable to a designated future date. A sight draft is
payable on sight. A sight draft is also called a demand draft. (2)
Bank Drafts. A bank draft is a check drawn by one bank on another bank.
Banks customarily keep a portion of their funds on deposit with other banks.
A bank, then, may draw a check on these funds as freely as any corporation
may draw checks. (3)
Draft Usage. Businesses often use drafts to pay for merchandise ordered,
especially when the buyer and the seller are in different states. Drafts may
be payable at sight (i.e., on demand), or they may be time drafts (i.e.,
they are payable at a future date). (6)
3. Trade acceptance. A trade acceptance is a sight draft that arises when credit
is extended with the sale of goods. In this type of draft, the seller is both the
drawer and payee. The buyer to whom credit is extended is the drawee. Even
though only two actual parties are involved, it is considered a three-party
instrument because three legal positions are involved. (2)

Trade Acceptances. A trade acceptance is a type of draft that is frequently


used in the sale of goods. In a trade acceptance, the seller of the goods is
both the drawer and the payee. (4)
Often, a seller of goods will send a draft to the buyer for acceptance. If the
buyer accepts, he or she has agreed to pay any holder who makes proper
presentation. Such a draft is called a trade acceptance. (6)
4. Certificates of Deposit. A certificate of deposit is a special form of note that
is created when a depositor deposits money at a financial institution in exchange for
the institutions promise to pay back the amount of the deposit plus an agreed-upon
rate of interest upon the expiration of a set time period agreed upon by the parties.
(2)
The UCC defines a certificate of deposit (DC) as an acknowledgment by a
bank that a sum of money has been received by the bank and a promise by
the bank to repay the sum of money. Normally the money is repaid with
interest. The UCC classifies a certificate of deposit as a note even though it
does not contain the word promise. A CD is to a draft because it does not
contain an order to pay. (3)
A certificate of deposit is an instrument used by a bank evidencing a debt
owed to a depositor. These instruments commonly call for the bank to pay to
a proper presenter the amount deposited plus interest at a stated future
date. Although regularly thought of as a type of special savings account,
certificates of deposit are really credit instruments. They recognize money
borrowed by the bank from its depositor (6)
A certificate of deposit is a promise made by a bank to pay a payee a
certain amount of money at a future time. The UCC defines a certificate of
deposit as an instrument containing an acknowledgment by a bank that a
sum of money has been received by the bank and a promise by the bank to
repay the sum of money. A certificate of deposit is a note of the bank. (7)
5. Permanency and portable. Permanency requirement is a requirement of
negotiable instruments that says they must be in a permanent state, such as
written on ordinary paper. Portability requirement is a requirement of negotiable
instruments that says they must be able to be easily transported between areas. (2)
6. Nonnegotiable Contract. If a promise or order to pay does not meet one of the
previously discussed requirements of negotiability, it is a nonnegotiable contract.
As such, it is not subject to the provisions of UCC Article 3 (NIL). The contract,
however, is not rendered either nontransferable or nonenforceable.
A
nonnegotiable contract can be enforced under normal contract law. If the maker or
drawer of a nonnegotiable contract fails to pay it, the holder of the contract can sue
the nonperforming party for breach of contract. (2)
7. Law Merchant. In England prior to about A.D. 1400, all disputes between
merchants were settled on the spot by special courts set up by the merchants. The
rules applied by these courts became known as the law merchant. (3)
8. Bond. A bond is a written contractual obligation, usually under seal, generally
issued by a corporation, a municipality, or a government, that contains a promise to
pay a sum certain at a fixed or determinable future time. In addition to the promise
to pay, it will generally contain certain other conditions and stipulations. A bond
issued by a corporation is generally secured by a deed of trust on the property of
the corporation. A bond may be a coupon bond or a registered bond. (3)

9. Coupon Bond. A coupon bond is so called because the interest payments that
will become due on the bond are represented by detachable individual coupons to
be presented for payment when due. Coupon bonds and the individual coupons are
usually payable to the bearer, as a result, they can be negotiated by delivery. There
is no registration of the original purchaser or any subsequent holder of the bond. (3)
10. Registered bond. A registered bond is a bond payable to a named person.
The bond is recorded under that name by the organization issuing it to guard
against its loss or destruction. When a registered bond is sold, a record of the
transfer to the new bondholder must be made under the name of the new holder of
the bond. (3)
11. Collateral Note. A collateral note is a note secured by personal property.
The collateral usually consists of stock, bonds, or other written evidences of debt, or
a security interest in tangible personal property given by the debtor to the payeecreditor. (3)
12. Debentures. An unsecured bond or note issued by a business firm is called
debentures. A debenture, like any other bond, is nothing more or less than a
promissory note, usually under seal. It may be embellished with gold-colored edges,
but this does not in any way indicate its value. A debenture is usually negotiable in
form. (3)
13. Certified check. A certified check is an ordinary check accepted by an
official of the drawee bank. The official accepts it by writing across the face of the
check the word certified, or some similar word, and signing it. Either the drawer or
the holder may have a check certified. The certification of the check by the bank
has the same effect as an acceptance. It makes the bank liable for the payment of
the check and binds it by the warranties made by an acceptor. A certification
obtained by a holder releases the drawer from liability. (3)
A certified check is a check that has been drawn by a depositor and then
accepted by the bank on which it is drawn. (4)
A certified check is one that has been accepted by the drawee bank. In
other words, the bank has assumed primary liability and agreed to pay the
check upon a later presentment. (6)
Certified check: A check accepted by the bank on which it is drawn (7)
14. Cashiers Check. A check that a bank draws on its won funds and that the
cashier or some other responsible official of the bank signs is called a cashiers
check. It is accepted for payment when issued and delivered. Such a check may
be used by a bank in paying its own obligations, or it may be used by anyone else
who wishes to remit money in some form other than cash or a personal check. (3)
When a bank draws a check on itself, the check is called a cashiers check
and is a negotiable instrument on issue. (4)
Cashiers check means a draft with respect to which a drawer and drawee
are the same bank or branches of the same bank. (6)

Cashiers check means a draft with respect to which a drawer and drawee
are the same bank or branches of the same bank. (7)
15. Voucher Checks. A voucher check is a check with a voucher attached. The
voucher lists the items of an invoice for which the check is the means of payment.
In business the drawer of the check customarily writes on the check such words as
In full of account, For invoice NO. 1622, or similar notations. These notations make
the checks excellent receipts when the returned to the drawer. (3)
16. Bad Check. A bad check is a check that the holder sends to the drawee bank
and the bank refuses to pay, normally for insufficient funds. Usually these statutes
state that if the check is not made good within a specific period, such as ten days, a
presumption arises that the drawer originally issued the check with the intent to
defraud. (3)
17. Stale Check. A check that is presented more than six months after its date is
commonly called stale check. A bank acts in good faith may pay it. However,
unless the check is certified, the bank is not required to pay it. (3)
Stale Check. If a check is not presented to a bank within six months of its
date, the check is considered a stale check. (7)
18. Tellers Check is usually drawn by a bank on another bank; when drawn on a
nonblank, it is payable at or through a bank. (4)
Tellers check means a draft drawn by a bank (i) on another bank, or (ii)
payable at or through a bank. (6)
Tellers check is similar to a cashiers check in that both the drawer and the
drawee are banks. However, a tellers check is different because it is a check
that is drawn by one bank and usually drawn on another bank. In other
words, bank A is the drawer while bank B is the drawee. (7)
19. Travelers Check is an instrument that is payable on demand, drawn on or
payable at a bank and designated as a travelers check. (4)
Travelers Check means an instrument that (i) is payable on demand, (ii) is
drawn on or payable at or through a bank, (iii) is designated by the term
travelers check or by a substantially similar term, and (iv) requires as a
condition to payment, a countersignature by a person whose specimen
signature appears on the instrument. (6)

Travelers Check An instrument that (i) is payable on demand, (ii) is drawn


on or payable at or through a bank, (iii) is designated by the term travelers
check or by a substantially similar term, and (iv) requires as a condition to
payment, a countersignature by a person whose specimen signature appears
on the instrument. (7)
20. Fixed Amount of Money Requirement. A holder of a negotiable instrument
must know how much money is to be received when the instrument is paid. The
amount is commonly specified exactly, which makes the determination simple, but
this is not necessary to satisfy the fixed amount of money requirement. (6)
Sum certain in money. Negotiable instruments must promise or order that
payment be made in a national currency. For example, US dollars, English
pounds, euros, and Japanese yen all satisfy the currency requirement.
Bushels of apples, gold, shares of stock, diamonds and rare gems, and the lie,
are not currencies. While promises to pay in apples or gold or stock may
form a perfectly enforceable contract, the resulting instrument is not a
negotiable instrument. (7)
21. Demand Instruments. The payee (or subsequent holder) can demand actual
payment at any time. The UCC defines an instrument payable on demand as one
that (i) states that it is payable on demand or at sight, or otherwise indicates that it
is payable at the will of the holder, or (ii) does not state any time of payment. With
a time instrument, payment can be made only at a specific time designated in the
future. The UCC requires that an instrument payable at a definite time have a
time easily determined from the document itself. (7)
22. Discharge of liability on instrument.
When a partys liability for a
negotiable instrument is terminated, this partys liability has been discharged. In
other words, the party is released from liability. Discharged can occur through a
variety of ways. (7)
Discharge through payment and tender payment, discharged by cancellation
or renunciation, discharge by reacquisition, discharge by impairment of
recourse, discharge by impairment of collateral. (7)
Discharge by impairment of recourse. A right to recourse is the ability of
a party to seek reimbursement. If the holder has in some way impaired the
endorsers ability to seek recourse from any of these parties, the endorser is
not liable on the instrument. (7)
Discharge by impairment of collateral. If a party posts collateral to
ensure his performance of the negotiable instrument and the holder of the
collateral impairs the value of the collateral, the party to the instrument is
discharged from the instrument to the extent of the damage to the collateral.
(7)
23. The Truth-In-Savings Act. In an effort to allow consumers to be better
informed, Congress (US) passed the Truth-in-Savings Act (TISA) in 1991. TISA
requires that depositary institutions disclose, in great detail, the terms and
conditions of their accounts. Depositary institutions include commercial banks,
savings banks, credit unions and savings and loan associations. (7)

II. SECTIONS 14, 15 and 16/INDORSEMENT


1. Unqualified indorsement. An indorsement whereby the indorser promises to
pay the holder or any subsequent indorser the amount of the instrument if the
maker, drawer, or acceptor defaults on it. (2)

2. Red Light Doctrine. A holder cannot qualify as a holder in due course if he or


she has notice that the instrument contains an unauthorized signature or has been
altered or that there is any adverse claim against or defense to its payment. This
rule is common referred to as the red light doctrine. (2)
3. Trailing Edge. Banks required that an indorsement on a check be on the back
and within one and a half inches of the trailing edge. The trailing edge is the left
side of a check when looking at it from the front. If the indorsers signature appears
elsewhere and it cannot be determined in what capacity the signature is made, it
will be considered an indorsement. (3)
4. Allonge. An allonge is a paper so firmly attached to an instrument as to become
a part of it. If a party does not wish to be liable as an indorser, the instrument can
be assigned by a written assignment on a separate piece of paper. (3)
If there is no room on the instrument, the indorsement can be written on a
separate piece of paper, called an allonge (pronounced uh-lohnj). The
allonge must be so firmly affixed (to the instrument) as to become a part
thereof. Pins or paper clips will not suffice. Most courts hold that staples are
sufficient. (4)
If there is no room on the instrument or if all the room has been taken by
previous endorsements, an allonge may be attached. An allonge is simply
an additional piece of paper with the endorsements. It must be firmly
attached. (7)
5. Blank Indorsement. As the name indicates, a blank indorsement is one
having no words other than the name of the indorser. If the instrument is a bearer
paper, it remains bearer paper when a blank indorsement is made. (3)
A blank indorsement specifies no particular indorsee and can consist of a
mere signature. (4)
A blank indorsement does not specify the party to whom the instrument is
to be paid. The normal form of a blank indorsement is a mere signature by
the holder. Such an indorsement makes the instrument bearer paper. (6)
A blank endorsement is simply the payees or last endorsees signature,
nothing else. The effect of this unqualified, blank endorsement is that it turns
the previous order paper into bearer paper.
An instrument with an
unqualified, blank endorsement may now be negotiated by delivery only. (7)
6. Special Indorsement. A special indorsement designates the particular
person to whom payment should be made. After making such an indorsement, the
paper is order paper, whether or not it was originally so payable or was originally
payable to bearer (Warning! This is contrary to our law [section 40] read this part
with caution see Plate II). (3)

A special indorsement identifies the person to whom the indorser intends


to make the instrument payable. (4)
A special indorsement specifies the party to whom the instrument is to be
paid or to whose order it is to be paid. This means that a special indorsement
makes (or leaves) the instrument payable to order. (6)
A special endorsement is the endorsers signature along with a name
endorsee. Note that in an endorsement, the words of negotiability, to order
of, are not needed. The instrument remains negotiable. The effect of this
kind of endorsement is that it keeps order paper as order paper and thus
continues to require an endorsement and delivery for further negotiation. (7)
7. Qualified Indorsement. A qualified indorsement has the effect of qualifying,
thus limiting, the liability of the indorser. This type of indorsement is usually used
when the payee of an instrument is merely collecting the funds of another. (3)
An indorser who does not wish to be liable on an instrument can use a
qualified indorsement to disclaim this liability. The notation without
recourse is commonly used to create a qualified indorsement. (4)
Qualified endorsements. As with unqualified endorsements, there are two
versions of qualified endorsements: blank qualified endorsements and
special qualified endorsements.
What makes them qualified is the
addition of the words without recourse. When negotiable instruments are
passed from one party to another, the person transferring the instrument is
guaranteeing certain aspects of the instrument by virtue of his or her
signature. Endorsing the instrument with the restrictive endorsement without
recourse states that the endorser does not intend to be bound to this
guarantee. (7)
8. Restrictive Indorsement. A restrictive indorsement is an indorsement that
attempts to prevent the use of the instrument for anything except the stated use.
The indorsement may state that the indorsee holds the paper for a special purpose
or as an agent or trustee for another or it may impose a condition that must occur
before payment. (3)
A restrictive indorsement requires the indorsee to comply with certain
instructions regarding the funds involved but does not prohibit further
negotiation of the instrument. (Warning! This is contrary to our law [section
37] and Natividad Gempesaw vs. Court of Appeals G.R. No. 92244, February
9, 1993 read this part with caution) (4)
A restrictive indorsement purports to prohibit any further negotiation of
the instrument, contains a condition restricting any further negotiation,
contains words that indicate it is to be deposited or collected, such as for
deposit, for collection, or pay any bank, or it has some other restriction
specified as to its use. (6)
Restrictive endorsements attempt to either limit the transferability of the
instrument or control the manner of payment under the instrument. Such an
endorsement does not succeed in its attempt. No type of endorsement can
prohibit further transfer; in other words, once an instrument is negotiable, it
remains negotiable. (Warning! This is contrary to our law [section 37] and
Natividad Gempesaw vs. Court of Appeals G.R. No. 92244, February 9, 1993
read this part with caution) (7)
Conditional Indorsements. When payment depends on the occurrence of
some event specified in the indorsement, the instrument has a conditional
indorsement. (4)

Conditional endorsement. The endorser can put a condition on


payment (one that if it were on face of the instrument would destroy
negotiability, but it does not affect negotiability here). However, it
does not affect the ability of the instrument to be further negotiated.
(7)
Indorsement for Deposit or Collection. A common type of restrictive
indorsement make the indorsee (almost always a bank) a collecting agent of
the indorser. (4)
The most comment restrictive endorsement is the endorsement for
deposit or collection only. Signing the back of a check with an
unqualified blank endorsement and the adding for deposit only turns
that endorsement into a blank restrictive endorsement. The check
cannot be cashed; it can only be deposited into an account any
account. (7)
Trust Indorsement. Indorsements to person who are to hold or use the
funds for the benefit of the indorser or a third party are called trust
indorsements (also known as agency indorsements). (4)
Trust Indorsement. This kind of endorsement is used when the
instrument is being transferred to an agent or trustee for the benefit of
either the endorser or a third party. (7)
9. Incomplete or inchoate bill. This is a bill lacking in some material particular.
(5)
10. Bills in a set. It is common for bills from abroad to be drawn in sets of two,
three or more parts (copies), three being the most usual number. The object is to
avoid delays which would arise, say from the loss of the sole copy of the bill. The
rules relating to these bills, labeled as a rule, First of Exchange (second and third of
same tenor being unpaid), which avoids duplication of liability, of payment, and so
on. (5)
11. Transfer.
Negotiable instruments are intended to flow through the
commercial world. In order to flow, the instrument needs to be transferred from
person to person. The form these transfers take determines the rights that can be
asserted by each person gaining possession of the negotiable instrument. (6)
12. Negotiation. Obviously, something more is needed to protect the possessor of
the commercial paper and to facilitate the free flow of commercial paper through
commercial channels. That something more is provided by the UCC, and it is
known as negotiation. (6)
Negotiation. When the rights to a negotiable instrument are transferred
from one party to another, such a transfer is called negotiation. In
understanding the rules on negotiation, it is important to understand that the
rules are slightly different depending on whether the instrument is an order
instrument or a bearer instrument. Bearer paper requires only delivery of
the instrument to the holder by the payee. In contrasts, order paper requires
delivery and an endorsement. (7)

III. FORGERY AND MATERIAL ALTERATION


1. Unauthorized Signatures. People are not normally liable to pay on negotiable
instruments unless their signatures appear on the instrument.
Hence, an
unauthorized signature is wholly inoperative and will not bind he person whose
name is forged. There are exceptions to this rule. If the person whose unauthorized
signature was used ratifies that signature or is in some way precluded from denying
it, then the unauthorized signature is operative. (1)
An unauthorized signature is one made without any authority, expressed
or implied, and it includes a forgery. An unauthorized signature is wholly
inoperative against the person whose name was signed unless that person
later ratifies the signing. (6)
2. Imposter Rule. An imposter is one who, by use of the mails, telephone, or
personal appearance, induces a maker or drawer to issue an instrument in the
name of an impersonated payee. The maker or drawer honestly believes that the
imposter is actually the named payee and issues the instrument to the imposter.
Since the maker or drawer did issue and intend the imposter to receive the
instrument, the indorsement by the imposter is not treated as unauthorized when
the instrument is transferred to an innocent party. (1)
For purposes of the imposter rule, an imposter is one who impersonates a
payee and induces the maker or drawer to issue an instrument in the payees
name and give the instrument to the imposter. If the imposter forges the
indorsement of the named payee, the drawer or maker is liable on the
instrument to any person who, in good faith, pays the instrument or takes it
for value or for collection. This rule is called the imposter rule. (2)
An imposter is one who, by her or his personal appearance or use of the
mail, telephone, or other communication, induces a maker or drawer to issue
an instrument in the name of impersonated payee. If the drawer or maker
believes the imposter to be the named payee at the time of issue, the
indorsement of the imposter is not treated as unauthorized when the
instrument is transferred to an innocent party. (4)
Under the UCCs imposter rule, if a maker or drawer issues a negotiable
instrument to an imposter, the imposters endorsement will be effective. The
court considers the intent of the drawer or maker when issuing the
instrument. (7)
3. Fictitious Payee Rule. The so-called fictitious payee rule deals with an
instrument issued in the name of a payee with intention that the payee have no
interest in the instrument. The payee need not be fictitious (that is, the payee may
be a real person). The determining factor is that the maker or drawer, or another
party who has supplied the payees name to the maker or drawer, intends that the
payee not be the party to receive the proceeds when payment is made on the
instrument. (1) (Also PNB vs. Rodriguez, G.R. No. 170325, September 26, 2008)
A drawer or maker is liable on a forged or unauthorized indorsement under
the fictitious payee rule. This rule applies when a person signing as or on
behalf of a drawer or maker intends the named payee to have no interest in
the instrument or the person identified as the payee is a fictitious person. (2)
An unauthorized indorsement will also be effective when a person causes an
instrument to be used to a payee who will have no interest in the instrument.
In this situation, the payee is referred to as a fictitious payee. (4)

4. Material Alteration. The UCC defines a material alteration as an unauthorized


change in an instrument that purports to modify in any respect the obligation of a
party, or an unauthorized addition of words or numbers or other change to an
incomplete instrument relating to the obligation of a party (UCC, 3-407)

IV. RIGHTS AND LIABILITIES OF PARTIES


1. Shelter Principle. A person who does not qualify as a holder in due course but
who derives his or her title through a holder in due course can acquire the rights
and privileges of a holder in due course. If a holder was a party to fraud or illegality
affecting the instrument, or if, as a prior holder, he or she had notice of a claim or
defense against an instrument, that holder is not allowed to improve his or her
status by repurchasing from a later holder in due course. (1)
Holder Through a Holder in Due Course. The first holder in due course
brings into operation all the protections that the law has placed around
negotiable instruments. When these protections once accrue, they are not
easily lost. Consequently a subsequent holder, known as a holder through
a holder in due course, may benefit from them even though not a holder in
due course. (3)
Holder by Due Negotiation. When a document is negotiated to a person
who purchases the instrument in good faith and the purchaser takes the
document without notice of any defense against or claims to the goods or the
document, the instrument has been duly negotiated. This makes the recipient
of the document a holder by due negotiation (HDN), a preferred and
protected status in the area of documents of title. (6)
Generally, if an item is transferred from one person to another, the transferee
acquires all the rights that the transferor had in the item. This idea is called
the shelter principle. Therefore, following the shelter principle, even if a
holder cannot attain holder in due course status, the holder can acquire the
rights and privileges of a holder in due course if the item is being transferred
from a holder in due course. (7)
Shelter Rule. It is basic rule at common law that whenever property is
transferred, the transferee acquires at least whatever rights the transferor
had in that property. Because a negotiable instrument is a type of property,
this principle applies to the transfer of an instrument. Thus, it is possible to
acquire the rights of a holder in due course without actually becoming one.
This can be done by taking shelter in the holder in due course rights of
ones transferor. The rights one acquires by the shelter rule are no different
from true holder in due course rights. The shelter rule assures the holder in
due course of a free market for the instrument. (8)
Party to the Fraud Exception. There is an important exception to
the shelter rule.
This rule cannot confer holder in due course
protection to one who is involved in any fraud or illegality with respect
to the instrument. (8)
2. Wrongful Dishonor. If the bank doe not honor a check when there are
sufficient funds in a drawers account to pay a properly payable check, it is liable for
wrongful dishonor.
The payer bank is liable to the drawer for damages
proximately caused by the wrongful dishonor as well as for consequential damages,
damages caused by criminal prosecution, and such. (2)

10

If a bank wrongfully fails to pay a check wrongfully dishonoring the


check the bank may be liable to the customer for damages. The UCC
clearly states that banks can be held liable, but it does not cite a specific
theory for recovery. Therefore, someone whose check was dishonored need
prove only that the dishonoring was wrongful, and he or she will be entitled to
recovery. (7)
Under the properly payable rule, a bank has a duty to pay checks from
customers account as long as the check is properly payable. In other
words, the check must be authorized by the drawer and must not violate the
agreement between the bank and the customer. (7)
Duties of the bank. Remember that the drawee bank makes no promise to
third parties to pay items. The promise to pay a check is in the contract
between the customer-drawer and the bank. As part of this contract the bank
promises to pay items that are properly payable. Most of the controversies
in this regard arise either from the bank paying an item that is not properly
payable or failing to pay an item that is properly payable. (8)
3. Jus Tertii. The contract of the obligor is to pay the holder. The doctrine of jus
tertii concerns claims and defenses of a person other than the obligor. Under the
doctrine, the rights of a third party cannot be used even against a mere holder. (8)
4. The Collection Process. Payor bank, the bank where the drawer has a
checking account and on which the check is drawn. Depositary bank, the bank
where the payee or holder has an account. Collecting bank, the depositary bank
and other banks in the collection process (other than the payor bank).
Intermediary bank, a bank in the collection process that is not the depositary
bank.(2)
Designation of Banks Involved in the Collection Process. The first bank
to receive a check for payment is the depositary bank. The bank on which
the check is drawn (the drawee bank) is called the payor bank. Any bank
except the payor bank that handles a check during some phase of the
collection process is a collecting bank. Any bank except the payor bank or
the depository bank to which an item is transferred in the course of this
collection process is called an intermediary bank. (4)
Types of Banks Involved in Check Collection. The check collection
process is established by Article 4 of the UCC. Section 4-105 of the UCC
defines the four types of banks that may be involved in the check collection
process. Depository bank the first bank accepting a check for payment.
Payor bank the bank ultimately responsible for granting funds for the check.
Collecting bank a bank, other than the payor bank, handling the check at
any point from the time the check is deposited to the time it reaches the
payor bank. Intermediary bank, a bank receiving a transferred check
during the collection process [excluding the first bank (depositary) and the
last bank (payor)]. (7)
Presenting bank is any bank presenting an item. (8)
5. Good Faith. Good faith is defined as honesty in fact in the transaction. This
requirement is actually measured by a negative test. The holder acted with good
faith if bad faith is not present. (6)

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Taking Instrument in Good Faith. Historically there has some debate


about whether good faith had an objective or subjective definition. Looking
at good faith in an objective sense means considering what the reasonable
holder would have done. However, other courts look at good faith in a
subjective sense by asking whether the holder acted honestly when taking
the instrument. To look at good faith in a subjective sense means considering
the holders actual behavior. (7)
The UCCs definition of good faith is somewhere in the middle of the
subjective and objective standard. The UCC defines good faith as honesty
in fact and the observance of reasonable commercial standards of
fair dealing [UCC, 3-103(a)(4)] (7)
6. On Us checks. If the drawer and the payer or holder have accounts at the
same bank, the depositary bank is also the payer bank. The check is called an on
us item it is presented for payment by the payee or holder. In this case, the bank
has until the opening of business on the second banking day following the receipt of
the check to dishonor it. If it fails to do so, the check is considered paid. The payee
or holder can withdraw the funds at this time [UCC, 4-215(e) (2), note no parallel
provision in the NIL]. (2)
7. On Them checks. If the drawer and the payee or holder have accounts at
different banks, the payor and depository bank are not the same bank. In this case,
the check is called an on them item. (2)
8. Electronic fund transfer system (EFTS). Electronic fund transfer is a transfer
of money made with the use of an electronic terminal, a telephone, a computer, or
magnetic tape. Automatic payments, direct deposits, and other fund transfers are
now made electronically; no physical transfers of cash, checks, or other negotiable
instruments are involved. Electronic fund transfer transactions eliminate the float
time that the drawer of a check currently enjoys by retaining the use of funds
during the period between the checks issuance and final payment. (1)
Electronic payment and collection system that are facilitated by computers
and other electronic technology. (2)
An electronic fund transfer (EFT) is a transfer of money made by the use
of an electronic terminal, a telephone, a computer, or magnetic tape. (4)
Recent technological advances have provided banking with a new method of
doing business and with a new type of service. This new method of doing
business is the electronic funds transfer (EFT), which allows for
computerization of checking accounts and for theoretically faster, more
accurate banking transactions. (6)
9. Automated Teller Machines. A major Electronic Fund Transfer Systems
development involved the automated teller machine (ATM), also called a
customer-bank communications terminal or remote service unit.(1)
An electronic fund transfer system at a convenient location that is connected
on-line to the banks computers; customers use ATMs to withdraw cash from
bank accounts, cash checks, make deposits, and make payments owned to
the bank. (2)
Automated Teller Machines (ATMs), machines connected to a banks
computer, are located in convenient places so that customers may conduct
banking transactions without actually going into a bank. Customers may
withdraw and deposit money, as well as check the balance of their savings
and checking accounts. (7)

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10. Point-of-Sale Systems. Point-of-sale systems allow consumers to transfer


funds to merchants to pay for purchases. On-line terminals are located at checkout
counters in, for example, grocery stores. Instead of receiving cash or a check from
the customer, the checkout person inserts the customers card into a terminal,
which reads the data encoded on the card. The computer at the customers bank
verifies that card and that there are enough funds in the customers account to
cover the purchase. After the payment is made, the customers account is debited
for the amount of the purchase. (1)
Point-of-sale (POS) terminal is a terminal at a merchants checkout
counter that is connected on-line to the banks computers; a debit card or
credit card ca be used to make purchases at POS terminals. (2)
Point of Sale (POS) Transactions. The first method is the point-of-sale
(POS) transaction, involving the use of a POS terminal and a debit card. In
a POS transaction, the customer presents the merchant with a debit card, the
merchant imprints the card and has the customer sign, and the funds are
transferred from the customers account to the merchants account. The
transaction is similar in format to the use of a credit card, but there should be
no delay in receiving the money from the sale for the merchant. (6)
A point of sale system allows customers to directly transfer funds from a
banking account to a merchant.
11. Pay-by-Telephone System.
This allows the customer to access the
institutions computer system by telephone and direct a transfer of funds. (1)
Payment-by-Telephone or Pay-by-Computer System.
Many banks
permit customers to pay bills from their bank accounts by use of a telephone
or a personal computer. (2)
Telephonic Transactions. If the bank is a participant in a network, the
customer may be able to authorize payments to predetermined accounts by
phone. Here, the customer calls the bank and, using the buttons or a touchtone phone, can designate preselected payees who will be paid an amount
determined by punching in the amount of the electronic check so that the
funds are automatically transferred. (6)
12. The Bank Statement Rule. The customer must exercise reasonable care in
examining the bank statement or items to discover an unauthorized signature or
alteration and must notify the bank promptly of any irregularities. This duty, called
the bank statement duty, arises when the bank complies with its duty to send or
make the bank statement available to the customer. The bank must either return or
make the item paid available to the customer or provide information to allow the
customer to reasonably identify the items paid. (8)
Check Truncation. A system of shortening the trip a check makes from the
payee to the drawee bank and then to the drawer is called check
truncation.
Many banks no longer return canceled checks to their
customers with the monthly statement. Instead, the form of the statement to
customers has been revised to list the check numbers. As before, the dollar
amount of the checks is shown, but the transactions are now printed in
numerical order. The customer can easily reconcile the amount without
having the canceled checks. However, banks must be able to supply legible
copies of the checks at the customers request for seven years. This is a
type of check truncation. (3)

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Substitute checks. To further facilitate electronic presentment, in 2004


Congress passed the Check Clearing for the 21st Century Act (also known as
Check 21 or the Check Truncation Act). Check 21 allows banks to forgo
sending original checks as part of the collection or return process and instead
send a truncated version. In place of the original paper check, a bank may
send (1) a substitute check or (2), by agreement, an electronic image of
the check along with data from the magnetic ink character recognition (MICR)
line on the original check. (7)
13. Uncured Default. A purchaser who has reason to know that any part of the
principal is overdue, that an uncured default exists in payment of an instrument in
the same series, or that acceleration of the instrument has been made has notice
that the instrument is overdue. (3)
14. Digital Cash. New forms of electronic payments (e-payments) have the
potential to replace physical cash coins and paper currency with virtual cash in
the form of electronic impulses. This is the unique promise of digital cash, which
consists of funds stored on microchips and other computer devices. (4)
15. E-money. Today, various forms of electronic money, or e-money, are
emerging. The simplest kind of e-money system uses stored-value cards. These are
plastic cards embossed with magnetic strips containing magnetically encoded data.
(4)
E-Money and Online Banking. Digital cash: Money stored electronically on
microchips, magnetic strips, or other computer media. Stored-value cards:
Plastic cards that contain magnetic strips, similar to those on credit cards or
ATM cards, containing data regarding the value of the card. (7)
16. Smart cards. Another form of e-money is the smart card. Smart cards are
plastic cards containing computer microchips that can hold more information than a
magnetic strip. (4)
Smart cards: Cards that are the same size as regular check and ATM cards
but that contain microchips, instead of a magnetic strip, for storing larger
amounts of data. (7)
17. Clearing house. An association of banks and financial institutions that
clears items between banks. (6)
18. Debit/ATM Cards. The bank customer inserts his or her card in the machine,
enters his or per personal identification number (PIN), and selects a transaction.
The customer can make a deposit, a withdrawal, a transfer from one account to
another, a payment, or a number of other banking transactions. (6)
19. Preauthorized Transactions. There are preauthorized automatic payments
and preauthorized direct deposits. In both cases, regular amounts are deducted
from, or added to, customers account balance on designated dates to ensure that
payment (or credit) is received without any worries about forgetting to send in the
check or drive to the bank to make the deposit. (6)
Direct deposits and withdrawals. A direct deposit or withdrawal is a
preauthorized action performed on a customers account through an
electronic terminal. (7)
20. Money Laudering. The false reporting of income from criminal activity as
income from legitimate business. (9)

Sources (citations and quotations omitted):

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(1) Kenneth W. Clarkson, Roger LeRoy Miller, Gaylord A. Jentz, Franck B. Cross
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(4) Kenneth W. Clarkson, Roger LeRoy Miller, Gaylord A. Jentz, Franck B. Cross
(2004). Wests Business Law Text Cases Legal, Ethical, International, and ECommerce Environment, 9th Edition.
(5) R B Vermeesch, K E Lindgren (1984).
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Linda Barkacs, Lucien Dhooge, Carrie Williamson (2009). Dynamic Business Law.
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of the Americas, New York, NY, 10020.
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Concepts, Analysis, Perspective. IRWIN Burr Ridge, Illinois; Boston, Massachusetts;
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