negotiable instruments, credit, and bankruptcy

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NEGOTIABLE INSTRUMENTS, CREDIT, AND BANKRUPTCY

Chapter 13

Meiners, Ringleb & EdwardsThe Legal Environment of Business, 12th Edition


CHAPTER ISSUES

Negotiable Instruments Credit Bankruptcy


NEGOTIABLE INSTRUMENTS Functions of Negotiable Instruments

Substitute for cash (checks for example)Provides way to extend credit (promissory note)

Types of Negotiable Instruments3 party instruments used instead of cash and as credit

device Orders to Pay: Drafts Orders to Pay: Checks

2 party instruments used as credit device Promises to Pay: Notes Promises to Pay: Certificates of Deposit


THE CONCEPT OF NEGOTIABILITY Can be transferred to another party

Assigned - Assignee has same rights and responsibilities as assignor

Transferred by negotiation - Transferee takes instruments free of transferor’s responsibilities

Transfer order instrument by: Payee endorses and Delivers instrument to third party

Bearer instruments Drawer my create “to bearer”; “to the order of bearer”, payable

to bearer,” “to cash” or “pay to the order of cash” Risky – if lost, can be cashed by finder Transfer bearer instrument by delivery


REQUIREMENTS FOR NEGOTIABLE INSTRUMENTS

Only negotiable instruments fall under the UCC If nonnegotiable, the common law applies To be negotiable it must:

Be writtenBe an unconditional order or promise to payBe signed by the maker or drawerBe payable on demand or at a specified timeBe made out “payable to order” (order paper) or “to

bearer” (bearer paper)Must state a certain sum of money


REQUIREMENTS FOR HOLDERS IN DUE COURSE

Person in possession of negotiable instrument may be ordinary holder or holder in due course

Ordinary holder has same contract responsibilities as assignee – holder in due course does not

To be holder in due course, transferee must: Give value for instrument Take instrument without knowledge it is overdue or defective Take instrument in good faith


INTERNATIONAL PERSPECTIVE“MIXING RELIGION AND FINANCE”

In U.S. laws limiting high interest rates (usury) can be traced to Christian views that the practice is sinful.

Islamic limits on interest are even more stringent. Some Islamic countries prohibit “banking as usual”, such as

charging interest on loans & paying interest to depositors. Many believers in the Koran hold this to be haram or banned by

Islam. In Malaysia and other countries, banks consult with advisers on

Shariah (Islamic law) about what forms of loans and repayments are acceptable.

Modern financial instruments are now more widely available – but the presentation is different.

(Continued)


Example: Conventional finance company may borrow $100 million and pay 6% ($6 million/year) on 10-year note.

Then repay principal. Under rules permitted (halal) by some Islamists, the borrowing

company transfers assets, like buildings to a legal entity like a trust (ijara sukuk).

Company leases assets back for payments of $6 million/year. Borrower also pledges to buy back assets at the end of 10 years

for $100 million. Not all Islamists agree this is acceptable. However, many banks using this method have seen explosion of

growth.

INTERNATIONAL PERSPECTIVE“MIXING RELIGION AND FINANCE”


MAJOR TYPES OF NEGOTIABLE INSTRUMENTS

Draftso Unconditional written promise

to pay• Drawer orders drawee to

pay $$ to payee• Time draft says at a

specified time• Sight draft gets paid upon

presentationo Sales draft – for sale of goodso In international, called a bill of

exchangeo Bankers acceptance creates a

guarantee by a bank that draft is good.

Checkso “Draft drawn on a bank and

payable on demand”o Checks used to be a major

method of paymento Now credit & debit cards have

largely replaced checkso On a cashier’s check the bank

is both drawer and draweeo See Exhibit 13.1


CASEASSOCIATED HOME AND RV SALES V. BANK OF

BELEN Plaintiff sells recreation vehicles under trade name

Enchantment. Hired Ramos to assist with bookkeeping

In 20 months, Ramos forged 211 checks payable to herself or “to cash”; $283,547 stolen from Enchantment

Managers discovered forgeries and notified bank. Bank refused to cover loses

Said it sent monthly statement Included photocopies of cancelled checks

Enchantment sued Bank of Belen for common law fraud and negligence and for negligence under the UCC.

Trial court granted summary judgment to bank. Enchantment appealed.

(Continued)


UCC states that usually common law principles are not preserved “in an area which is thoroughly covered by the UCC”.

Art. 4 of UCC: sets up a liability scheme & defenses between payor-bank and customers

A forged or altered check is not properly payable; Bank is strictly liable for resulting losses to its customer

UCC 4-406 Bank may seek “safe harbor” from that strict liability if it makes statements available to the customer. Customer can then ID forgery & must be reasonably prompt in notifying it to

bank. This is within 30 days of receiving the statement – then bank is strictly liable for loss.

After 30-day period, bank is liable only if customer proved bank failed to exercise “ordinary care” in passing the forged item and bank “substantially contributed” to the loss. Loss is then apportioned between customer & bank based on comparative negligence.

Regardless, if a year or more has passed since customer receives statement and ID’s forgery, customer cannot bring a claim under the UCC – then customer bears the loss.

In this case, UCC 4-406 provides scheme for liability and defenses.

CASEASSOCIATED HOME AND RV SALES V. BANK OF

BELEN


CASEASSOCIATED HOME AND RV SALES V. BANK OF BELEN

HELD: Therefore common law claims by Enchantment are precluded.

Enchantment, however, was entitled to try to prove a lack of ordinary care by the Bank within 1 year of Enchantment alerting Bank of the forgeries.

If bank sent statements directly to Ramos, an employee, this is “a reasonable manner” of notification to Enchantment.

HELD: Summary Judgment reversed re: UCC negligence issue.

Enchantment did minimum necessary to raise issues of fact that jury may view. Jury can then determine whether Bank breached its duty of ordinary care to Enchantment.


PROMISES TO PAY

Notes Promise by the maker to

pay certain $ to payee Usually called promissory

notes But also have

Collateral noteReal estate mortgage

note Installment noteBalloon note

See Exhibit 13.2

Certificates of Deposit Bank is maker of

certificate & promises to repay customer payee

Most large certificates are negotiable which allows them to be sold, used to pay debts or used as collateral


Creditor: Lends money Debtor: To whom money is lent Principal: The sum of the debt owed Equity financing: Sale of stock in company or sale of

negotiable instruments subject to securities regulation Debt financing: Borrowing money evidenced by contract Credit Policy focuses on characteristics such as:

Capacity (the debtor’s ability to pay)Capital (the debtor’s financial condition)Character (the debtor’s reputation)Collateral (the debtor’s assets to secure the debt)Conditions (the economic situation affecting the

debtor’s business)

CREDIT


CREDIT ACCOUNTS

Open AccountMust pay within fixed time period

Installment AccountRepay through regular (usually monthly) payments

Revolving AccountMake minimum payment & can add new debt – i.e.

credit card See Exhibit 13.4


COLLECTIONS POLICY

Needed for debtors who fail to make timely payments Starts with a past-due letter Followed by telephone call or 2nd letter Letters may be followed by a personal visit. Additional action may be necessary – depends on

whether a creditor is unsecured or secured. If debtor is insolvent, creditor will receive nothing.


CREDIT WITH SECURITY When creditor can take property of debtor to satisfy debt – can

happen by agreement or by operation of law By Agreement - Depends if property is real or personal Suretyship - Promise by a third party to pay debt if debtor doesn’t Guarantor – Provides a guarantee of payment to creditor should

principal debtor fail to pay Defenses of Sureties - Since debt falls under contract law, there

are the same defenses that the principal (debtor) has – including, impossibility, illegality, duress, fraud

Surety’s Rights Against the Principal If borrower could pay creditor but refuses to, surety is entitled

to exoneration (court order for principal to pay) Subrogation – Surety is entitled to rights of the creditor against

the debtor


CASEGE BUSINESS FINANCIAL SERVICES V.

SILVERMAN

Warren Park Partners, Ltd. borrowed $34.8 million from GE Financial. Bought land in Frisco, Texas.

When loan was made, Silverman & partners signed a guaranty “absolutely, unconditionally” guaranteeing full payment.

Warren Park defaulted; went into bankruptcy. GE demanded payment from Silverman. Silverman didn’t pay; GE sued.

Silverman & parties claimed affirmative defenses of (1) fraud, (2) extortion, (3) theft & (4) economic duress.

Said hours before signing the documents, GE notified them changes in terms of the agreement. They had no time to contest, as loan was needed immediately. He signed agreement because he was trapped.

Claimed GE employee told him new terms would not be enforced. GE moved for summary judgment.

(Continued)


HELD: Summary judgment for GE. GE offered evidence of both claims that defendants did not

contest. Instead defendants asserted the 4 affirmative defenses (above). GE argued even if affirmative defenses are true, allegations are barred by the Credit Agreement Act (ICAA).

ICAA bars all actions or defenses by a debtor based on an oral agreement (similar to Statute of Frauds).

Defendants didn’t dispute that they made “credit agreements”. Defendants say ICAA does not bar their affirmative defenses. They also argue “unclean hands” of the plaintiff, GE.

The court was not swayed, because – Oral promises by GE contradict the terms of Counts I and II;

therefore the ICAA bars defendant’s affirmative defenses. Silverman loses.

CASEGE BUSINESS FINANCIAL SERVICES V.

SILVERMAN


SECURED TRANSACTIONS Product may secure debt Commercial sale of goods - UCC Article 9 (not real estate) Must create security interest - be sure it is:

1. Attached (Attachment) Signed by customer Seller provided value Customer has legal, transferable rights in collateral

2. Perfected (Perfection) Filing w/proper official

Interests in Inventory As collateral, equipment, inventory, raw materials (tangible

property) are used as security “Floating Lien” Inventory

Goods held for sale as well as raw materials Inventory is constantly changing


DEFAULT BY DEBTOR

Some property my be exempt, i.e. homestead exemption (when personal assets have been placed as collateral

Default is when the buyer doesn’t repay Creditor can take back property and keep or may resell

it (in a “commercially reasonable manner”) Any excess from sale of repossessed property over

debt owed must be returned to debtor See Fordyce Bank & Trust Co. v. Bean Timberland, Inc. See Exhibit 13.5


CASEFORDYCE BANK & TRUST V. BEAN TIMBERLAND, INC.

Fordyce Bank made series of loans to Bean Timberland so it could buy timber from landowners. Bean would cut timber and sell logs to Potlatch and Idaho Timber (P&I) – it would then mill logs into timber. Bean’s proceeds from timber sales would repay loans.

Bank perfected its interest by filing UCC Financing Statement with the Secretary of State’s Office of Arkansas. Bean sold timber but failed to repay loans; went bankrupt.

Bank sued P&I because it had a priority interest in the timber sale proceeds. Bank said P&I was negligent in its dealings for failing to do a lien search and did not “exercise good faith” required under the UCC.

Trial court held for P&I, ruling they were not negligent. Trial court said that P&I was not required to perform a security interest

search in the “ordinary course of business.” The bank appealed.

(Continued)


Under Arkansas UCC 4-9-320, a buyer in the ordinary course of business (P&I) “takes free of a security interest created by the buyer’s seller [Bean], even if the security interest is perfected [by the bank] and buyer knows of its existence.”

If P&I were buyers in “ordinary course of business”, they had no duty to perform a lien search. Even if they know of bank’s security interest, P&I can take free of Bank’s security interest.

HELD: Affirmed. P&I won. Clear evidence that purchasing gatewood (lumber brought to the

mill’s front gate, and if meets mills specs, then mill purchases it) without performing a lien search is standard timber industry practice.

P&I’s actions were “usual or customary practices” in the timber industry, and they were therefore “buyers in the ordinary course of business.”

Owed no duty to the bank to conduct a lien search.

CASEFORDYCE BANK & TRUST V. BEAN TIMBERLAND, INC.


REAL ESTATE FINANCING Mortgage: Real estate is used to secure a debt obligation evidence by a

mortgage Debtor is the mortgagor Creditor is the mortgagee Mortgage is a lien in most states In case of default, the mortgagee has the right to foreclose on property Deficiency judgment: If proceeds from foreclosure not sufficient, a

separate legal action against debtor is maintained Most mortgages are non-recourse debt – Lender can seize

collateral/property but not seek a deficiency judgment for money owed not covered by sale of property

Statutory redemption: Period of time mortgagor has the right to redeem the property by paying the debt (normally within 6 months after default) Most states have this procedure


LIENS Nonconsensual lien

• Obtained by Operation of Law No Need for Debtor’s Consent Procedures of using liens under state statutes; Must be removed before

property is sold Mechanic’s Lien

Party that furnished material, labor, or services for construction or repair of building or other real property places the lien

Possessory or Artisan’s Lien Party that added value to or cared for personal property puts on lien

Court-Decreed Liens Attachment lien is court-ordered seizure of goods through writ of

attachment Judgment lien occurs when creditor has successful action against

debtor; If debtor doesn’t pay judgment, creditor asks court for writ of execution


CASESUMMERS GROUP, INC. V. TEMPE

MECHANICAL, LLC Summers Group d/b/a Rexel, sold electrical materials for construction on

property owned by Metro Lofts. Rexel was not paid on June 26, 2008 and recorded a mechanic’s lien on Metro Lots property. Other contractors on the work including Tempe Mechanical, also filed liens against Metro Loft.

No payment received – Rexel brought suit on December 24, 2008 against Metro Lots and all other lienholders. Some of lienholders (contractors) did not respond – had default judgments.

Tempe, answered Rexel’s complaint Metro was in bankruptcy & under control of bankruptcy trustee ML

Manager. All parties agreed bankruptcy court would determine priority of payment of

liens. ML Manager argued that it stood first to receive payment, since it should

not be challenged and that Rexel should pay all attorney fees related to litigation.

Trial Court agreed. Rexel appealed.

(Continued)


Arizona law establishes lien procedures, including naming of all other mechanics’ lien claimants if those others fail to file a lien themselves. Remaining Lien Claimants asserted their lien priorities.

The bankruptcy court’s decision also affected their claims. Therefore ML Manager had to defend its lien priority. Statute requires that when sale is ordered in mechanics’ lien foreclosure action, proceeds are prorated over all lienholders that have equal footing with the foreclosing lien. Attorneys fees are apportioned between successful and unsuccessful efforts.

HELD: Reversed and Remanded. Trial court erred in holding Rexel solely responsible for payment of

ML Manager’s attorney fees. These fees should be prorated among lien claimants.

Intent of statute is to create an even playing field for all who provided services and materials, regardless of date work was performed.

All Remaining Lien Claimants will be liable for ML Manager’s attorney fees in proportion to their claims.

CASESUMMERS GROUP, INC. V. TEMPE

MECHANICAL, LLC


Purpose: Orderly resolution where debtor owes more

than can be paid. Federal Bankruptcy Code has been amended – most

recent revision was The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.

Most bankruptcies involve individuals. A person must take credit counseling before filing

bankruptcy. After filing bankruptcy, there must be debtor education

about budgeting, use of credit, etc. Key feature: fair treatment of creditors

BANKRUPTCY


PERSONAL BANKRUPTCY Most bankruptcies involve individuals. Creditors usually do not get paid. Before filing, person must complete a debtor education course. Dept. of Justice’s U.S. Trustee Program approves organization s to

provide mandatory credit counseling & debtor education. Credit counseling is taken before filing bankruptcy. Debtor education is taken after filing. Income and Means Testing

Income test determines if person files under Chapter 7 (liquidation) or Chapter 13 (reorganization of debts).

People with higher income less likely to have debts extinguished.

There is a test of income against expenditures – to see if person is living above average for a given income level.


CHAPTER 7 Most bankruptcies are voluntary, but creditors may force

an involuntary proceeding. Some assets, such as car, clothing, appliances, some

home equity and pension are exempt. Upon filing, there is a freeze on actions against the

debtor and the debtor’s property. Trustee is appointed to administer the debtor’s estate. Assets are liquidated and proceeds distributed to

creditors. After discharge, debtor is not liable for debts covered by

proceeding. Liquidation and fair distribution of debtor’s non-exempt

assets to creditors.


CHAPTER 13 Available only to individuals; only voluntary option. Sole

proprietorship owned by an individual may file under Chapter 13. Debtor files plan for payment of creditors over time. Usually over 5

years. Debtor keeps property and shares administration of the bankrupt

estate with court-appointed trustee. Trustee makes sure payments are made and that creditors don’t try

to “go around” fixed payment schedule. Court protected debt repayment plan. Confirmation Plan that was

approved makes these payments. Debts of those bankrupt not discharged. Long-term secured debt (i.e. house mortgage) treated differently. IF plan fails, possible to shift to Chapter 7 for hardship discharge.


PRIORITY CLASSES OF CREDITORS

Secured creditors Costs of preserving and administering debtor’s estate Unpaid wage claims Certain claims of farmers and fishermen Refund of security deposits Alimony and child support Taxes Unsecured creditors All creditors of a particular class must be paid before

going to next class


CASEIN RE DARBY

After Darby filed Chapter 13 bankruptcy, Time Warner canceled cable service. Darby filed motion with bankruptcy court to compel Time Warner to reinstate his service, with his assurances of future payment.

Bankruptcy Court and District Court ruled that cable service was not a “utility” that must be provided as a “necessity” under law. Darby appealed.

HELD: Affirmed. Cable service is not a “necessity”. Bankruptcy laws give protections to debtors from cut-off of service

by a utility after they file for bankruptcy. Utilities are “necessities” and must be provided to debtors. Includes

electric company, gas supplier or telephone company that is a monopoly in the area.

Cable service is not a “necessity”, and bankruptcy court need not require its reinstatement to Darby.


CHAPTER 11 Allows businesses to keep operating, without

liquidation of assets “Prepackaged” bankruptcy filings: debtor & creditors

settle issues before debtor files, and court then approves

ReorganizationStays further action by creditorsDebtor acts as trustee, called debtor in possession,

to run business for benefit of all partiesCreditors are satisfied by class in order of priority of

claims


CASEIN THE MATTER OF KMART

CORPORATION Kmart consists of parent company and 37 affiliates and

subsidiaries. Kmart, requested to pay, in full, claims of “critical

vendors.” Kmart said that if it didn’t pay these vendors, they would not do business in the future and were necessary for Kmart to stay in operation.

Bankruptcy judge agreed – granted order. No notice to disfavored creditors.

Kmart determined the critical vendors, paying 2330 suppliers $300 million.

Other 2000 vendors not paid, and 43,000 additional unsecured creditors received 10 cents on the dollar (mostly in stock of reorganized company).

(Continued)


Some of creditors appealed. District court reversed order of payments to critical vendors.

Decision was appealed. HELD: Affirmed. Kmart argued that the District Court’s reversal order was too late –

money had already changed hands. To order payment of critical vendors, it is necessary to show

(1) Disfavored creditors will be as well off with reorganization as with liquidation (this was never demonstrated), and

(2) That critical vendors would cease deliveries if old debts were left unpaid during litigation. This was not always true, i.e. some of the critical vendors must continue business due to have long-term contracts

CASEIN THE MATTER OF KMART

CORPORATION

negotiable instruments, credit, and bankruptcy

Documents

accessible website

order of bearer

edition2015 cengage

delivery2015 cengage

bearer bearer papermust

defectivetake instrument

instrumenttake instrument

assignee holder