Negotiable Instruments, Credit and Bankruptcy

Chapter 12

Negotiable Instruments• Functions of Negotiable Instruments

– substitute for cash (checks for example)

– provides way to extend credit (promissory note) • Types of Negotiable Instruments

– 3 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

Negotiable Instruments and 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 & delivers instrument to third party• Bearer instruments

– drawer may create “to bearer”; “to the order of bearer”, “payable to bearer,” “to cash” etc.

– risky – if lost, finder can be cashed by finder– transfer bearer instrument by delivery

UCC Requirements for Negotiable Instruments

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

– be written– be an unconditional order or promise to pay– be signed by the maker or drawer– be payable on demand or at a specified time– be 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

Major Types of Negotiable Instruments

• Drafts– unconditional written promise to pay

• drawer orders drawee to pay $$ to payee

• time draft says at a specified time• sight draft gets paid upon

presentation– sales draft – for sale of goods– In international, called a bill of

exchange– Bankers acceptance creates a

guarantee by a bank that draft is good.

• Checks– draft drawn on a bank

and payable on demand– Checks used to be a

major method of payment– Now credit & debit cards

have largely replaced checks

– on a cashier’s check the bank is both drawer and drawee

Lor-Mar/Toto, Inc. v. 1st Constitution Bank

• Lor-Mar had a business checking account at 1st Constitution Bank.• Resolution between Lor-Mar & bank allowed checks to be paid if they

had a signature of either Van Middlesworth or Toto.• Bank given samples of their stamped signatures.• Five bogus checks for $24,350 were written against the account; paid

by bank. Lor-Mar saw problem in monthly statement.• Bad checks had all correct information, but on different paper stock

and color used by Lor-Mar.• Checks had different “security features” from standard checks.• Had signatures that looked like Van Middlesworth’s stamped

signature.• Bank allowed customers to use checks not provided by bank.• Bank thought the signature appeared the same, so it held the

payment proper.• Lor-Mar sued.• Trial court held for Lor-Mar. Bank appealed.

Lor-Mar/Toto, Inc. v. 1st Constitution Bank, cont.

• ISSUE: Whether the fraudulent checks were authorized by Lor-Mar and were they in accordance with the agreement between Lor-Mar and the Bank?

• In New Jersey, strict liability of bank can be shifted to the customer as long as the bank lives up to its statutory duty of good faith.

• Parties can agree for bank to honor checks bearing a facsimile signature that resembles the specimen on file, BUT must have clear and unambiguous language of shifting the risk to the customer for a forged facsimile signature resembling the specimen on file – didn’t happen here.

• Lor-Mar did not expressly know and assume all risks in the unauthorized use of its officer’s facsimile signature.

• No meeting of the minds modifying the customer’s rights.• HELD: Affirmed. Bank paid improperly.

Promises to Pay

• Notes– promise by the maker

to pay certain $ to payee

• usually called promissory notes

• but also have

– collateral note

– real estate mortgage note

– installment note

– balloon note

• 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

Credit• Creditor: lends money• Debtor: to whom money is lent• Principal: the sum of the debt owed• Equity financing: sale of stock in company or 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 Accounts• Open Account

– must pay within fixed time period

• Installment Account– repay through regular

(usually monthly) payments• Revolving Account

– make minimum payment & can add new debt – credit cards work this way

Credit with Security

• By Agreement - depends if property is real or personal

• Suretyship - promise by a third party to pay debt if debtor doesn’t

• Defenses of Sureties - since debt falls under contract law, there are the same defenses that the principal (debtor) has – including, impossibility, illegality, duress, fraud

When creditor can take property of debtor to satisfy debt – can happen by agreement or

by operation of law

General Electric Business Financial Services v. Silverman

• Warren Park Partners, Ltd. borrowed $34.8 million from GE Financial.• Bought land in Frisco, Texas. Silverman & partners signed a guaranty “absolutely,

unconditionally” guaranteeing full payment.• Silverman also signed “Limited Joinder” guaranteeing full repayment of loan even if

Warren Park went bankrupt.• Warren Park defaulted; went into bankruptcy.• GE demanded payment from Silverman; he did not 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 .

General Electric Business Financial Services v. Silverman

• HELD: Summary judgment for GE.• Breach of limited joinder (a contract claim) and breach of guaranty.• 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 would contradict the terms of the contract;

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

Credit with SecurityPerfected Security Interest

• Secured Transactions– product may secure debt– commercial sale of goods - UCC Article 9– 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 state official (online)• Interests in Inventory

– As collateral, equipment, inventory, raw materials (tangible property) are used as security

• “Floating Lien” Inventory– Goods held for sale and 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

Fordyce Bank & Trust v. Bean Timberland

• Bank made 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). Revenue from sales would repay loans.

• Bank perfected its interest by filing UCC Financing Statement with the Arkansas Secretary of State Office.

• Bean sold timber but failed to repay loans; went bankrupt.• Bank sued P&I because Bank had a priority interest in 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.” Bank appealed.

Fordyce Bank & Trust v. Bean Timberland

• Under Arkansas UCC 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.” No duty to perform a lien search. Even if they knew of bank’s security interest, P&I can take free of Bank’s interest.

• HELD: Affirmed. Evidence that purchasing timber brought to the mill’s front gate 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.” No duty to the bank to conduct a lien search.

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

the property• Deficiency judgment: If proceeds from foreclosure not

sufficient, a separate legal action against debtor is maintained• Statutory redemption: Period of time mortgagor has the right

to redeem the property by paying the debt (normally within 6 months after default)

Liens (Nonconsensual Lien)

• Should 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

places the 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 a writ of execution

Obtained by operation of law.

Bankruptcy

• Purpose: orderly resolution when 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.• Chapter 7 (Liquidation)• Chapter 13 (Reorganization of debts)• Chapter 11 (Business wishes to remain in operation

and not be liquidated.)

Personal Bankruptcy• Most bankruptcies involve individuals• Means businesses do not get paid• Dept. of Justice’s U.S. Trustee Program approves

organizations to provide mandatory credit counseling• Credit counseling must be taken before filing bankruptcy• Debtor education is taken after filing• Income and Means Testing

– Income test determines if person files under Chapter 7 or Chapter 13

– People with higher income less likely to have debts liquidated

– Test of income against expenditures – to see if person has above average income for a given area

Bankruptcy : Chapter 7 Proceedings

• Most bankruptcies are voluntary, but creditors may force an involuntary proceeding

• 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.

• Liquidation and fair distribution of debtor’s non-exempt assets to creditors

Bankruptcy Chapter 7

• Used to be the most commonly used (now about half)• Since 2005 reforms, many people forced into Chapter 13• Chapter 7 means liquidation of debts and fair distribution

of debtor’s non-exempt assets• Liquidating bankruptcy available for businesses under

Ch. 7, but only individuals can be discharged under Ch 7.• Bankruptcy petition provides

– Statement of the financial affairs of debtor– List of all creditors & addresses, with amounts owed– List of properties owned by debtor– Statement of current income & expenses of debtor– Priority of creditors

Bankruptcy - Chapter 13• Available only to individuals.• Sole proprietorship may file under Chapter 13.• Debtor files plan for payment of creditors over time

(installment repayment plan).• Debtor keeps property and shares administration of the

bankrupt estate with court-appointed trustee.• Trustee collects income from debtor; pays creditors.• Payments made under approved Confirmation Plan • Debts of those bankrupt not discharged.• Plan usually is accomplished within 5 years.• Long-term secured debt (i.e. house mortgage) treated

differently.• If plan fails, possible to shift to Ch 7 for total discharge.

Bankruptcy - Chapter 7• Priority of classes of creditors

– secured creditors– costs of preserving and

administering debtor’s estate– unpaid wage claims– refund of security deposits– alimony and child support– taxes– unsecured creditors

• All creditors of particular class must be paid before going to next class

In re Darby• After Darby filed Chapter 13 bankruptcy, Time Warner

canceled his 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. – Include electric company, gas supplier or telephone

company.• Cable service not a “necessity” and bankruptcy court

need not require its reinstatement to Darby.

Bankruptcy 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

• Reorganization– stays further action by creditors– debtor acts as trustee, called debtor in

possession, to run business for benefit of all parties

– creditors are satisfied by class in order of priority of claims

In the Matter of Kmart Corporation

• Kmart, in Chapter 11 bankruptcy, 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. Changed the order of unpaid creditors (vendors).

• Bankruptcy judge agreed – granted order. • Kmart determined the critical vendors, paying 2330

suppliers $300 million.• 2000 unpaid vendors, and 43,000 additional unsecured

creditors received 10 cents on the dollar (mostly in stock of reorganized company).

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

In the Matter of Kmart Corporation

• HELD: Affirmed.• Kmart argued that the District Court’s reversal order was

too late – money had already changed hands.• Too bad. 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.

• #2 was not always true, i.e. some of the critical vendors must continue business due to long-term contracts