Ch7. Negotiable Instruments — Promissory Notes & Bills of Exchange

What Is a Negotiable Instrument?

Negotiable Instrument (UCC Article 3):
An unconditional written promise or order to pay a fixed amount
of money, with or without interest, at a definite time or on demand.

Key characteristics:
① Written and signed: must be a written, signed document
② Unconditional promise or order: no conditions may attach
③ Fixed amount of money: sum certain (interest may be specified)
④ Payable to bearer or to order
⑤ Freely transferable by indorsement and delivery

Principal types:
Promissory Note: maker promises to pay (2-party instrument)
Bill of Exchange / Draft: drawer orders drawee to pay (3-party)
Check: a draft drawn on a bank, payable on demand

Promissory Note

Parties:
Maker (promisor): unconditionally promises to pay on the due date
Payee: entitled to receive payment

Required elements (UCC § 3-104):
① The word "note" or equivalent
② Unconditional promise to pay a fixed sum
③ Payable to order or to bearer
④ Payable on demand or at a definite time
⑤ Signed by the maker

Maturity / due-date options:
Demand note:          payable whenever the payee presents it
Fixed-date note:      payable on a specified calendar date
Time note:            payable a fixed period after issuance
                      (e.g., "90 days after date")
Installment note:     series of scheduled payments

Bill of Exchange (Draft)

Parties:
Drawer: issues the draft and orders payment
Drawee: ordered to pay (has no obligation until acceptance)
Payee: entitled to receive payment

Acceptance:
The drawee's signed agreement to pay the draft.
Before acceptance: payee cannot demand payment from drawee
After acceptance: drawee becomes primarily liable (acceptor)

Dishonor / Refusal to Accept:
Holder may exercise recourse against the drawer and
any indorsers (secondary liability).

Draft vs. Note:
Note = 2 parties (maker = the direct obligor)
Draft = 3 parties (drawer issues the order; drawee becomes
  the primary obligor upon acceptance)

Indorsement & Transfer

Indorsement:
The method by which a negotiable instrument is transferred.
Indorser signs on the back; may name the indorsee.

Effects of Indorsement:
Transfer effect:       passes all rights in the instrument
Warranty liability:    indorser warrants that the instrument
                       is genuine and they have good title
Secondary liability:   indorser is liable if the maker/acceptor
                       dishonors (subject to proper presentment
                       and notice of dishonor)

Chain of Indorsements:
Original payee → 1st indorsee → 2nd indorsee → current holder
The chain must be unbroken for a holder to qualify as HDC.

Restrictive Indorsement:
"For deposit only" → limits further transfer; instrument
  must be collected through a bank account.

Blank Indorsement:
Indorser signs without naming an indorsee → becomes bearer paper.

Holder in Due Course (HDC) & Personal Defenses

Holder in Due Course (UCC § 3-302):
A holder who takes the instrument:
① For value
② In good faith
③ Without notice of dishonor, defenses, or claims

HDC Status cuts off Personal Defenses:
Personal (personal) defenses — e.g., failure of consideration,
fraud in the inducement, prior payment, breach of contract —
CANNOT be asserted against an HDC.

Real Defenses (assert against anyone, including HDC):
Forgery / material alteration
Fraud in the factum (deceived as to the nature of the document)
Discharge in bankruptcy
Infancy (minority) as a defense
Illegality, duress, or incapacity that makes the obligation void

Defense Cut-Off Rationale:
Promotes the free flow of commercial paper in commerce
by protecting good-faith purchasers from hidden disputes
between original parties.

Note vs. Draft ★★★★★ : Note = maker promises to pay directly (2 parties). Draft = drawer orders drawee to pay (3 parties; drawee must accept). Memory hook: note = direct promise; draft = third-party order

Indorser’s Secondary Liability ★★★★★ : Every unqualified indorser guarantees payment if the primary obligor dishonors. Chain of indorsements must be unbroken. Memory hook: indorsement = transfer + guarantee

HDC Cuts Off Personal Defenses ★★★★☆ : An HDC takes free of personal defenses between original parties. Real defenses (forgery, fraud in factum, bankruptcy) remain available against all holders. Memory hook: HDC = personal defenses gone; real defenses survive

Practice Questions

Q. What happens when a drawee refuses to accept a draft?

Dishonor (refusal to accept) triggers the holder’s right of recourse against the drawer and any prior indorsers. The holder must give timely notice of dishonor. The drawer and indorsers become secondarily liable and must reimburse the holder if properly notified.

Q. What is the personal-defense cut-off rule and why does it exist?

A holder who qualifies as an HDC takes the instrument free of personal defenses that would otherwise allow the maker or drawer to refuse payment (e.g., failure of consideration, fraud in the inducement). The rule exists to make negotiable instruments reliable and freely tradable: if buyers of instruments could always be subjected to remote parties’ disputes, the commercial paper market would break down.