Chapter 16 Liability and Discharge

The General Rule

Section 3-402(a) of the UCC provides that a person acting (or purporting to act) as an agent who signs an instrument binds the principal to the same extent that the principal would be bound if the signature were on a simple contract. The drafters of the UCC here punt to the common law of agency: if, under agency law, the principal would be bound by the act of the agent, the signature is the authorized signature of the principal. And the general rule in agency law is that the agent is not liable if he signs his own name and makes clear he is doing so as an agent. In our example, Igor should sign as follows: “Frank N. Stein, Inc., by Igor, Agent.” Now it is clear under agency law that the corporation is liable and Igor is not.Uniform Commercial Code, Section 4-402(b)(1). Good job, Igor.

Incorrect Signatures

The problems arise where the agent, although authorized, signs in an incorrect way. There are three possibilities: (1) the agent signs only his own name—“Igor”; (2) the agent signs both names but without indication of any agency—“Frank N. Stein, Inc., / Igor” (the signature is ambiguous—are both parties to be liable, or is Igor merely an agent?); (3) the agent signs as agent but doesn’t identify the principal—“Igor, Agent.”

The UCC provides that in each case, the agent is liable to a holder in due course (HDC) who took the instrument without notice that the agent wasn’t intended to be liable on the instrument. As to any other person (holder or transferee), the agent is liable unless she proves that the original parties to the instrument did not intend her to be liable on it. Section 3-402(c) says that, as to a check, if an agent signs his name without indicating agency status but the check has the principal’s identification on it (that would be in the upper left corner), the authorized agent is not liable.

The General Rule

An unauthorized signature is not binding; it is—as the UCC puts it—“ineffective except as the signature of the unauthorized signer.”Uniform Commercial Code, Section 3-403. So if Crook signs a Frank N. Stein, Inc., check with the name “Igor,” the only person liable on the check is Crook.

The Exceptions

There are two exceptions. Section 4-403(a) of the UCC provides that an unauthorized signature may be ratified by the principal, and Section 3-406 says that if negligence contributed to an instrument’s alteration or forgery, the negligent person cannot assert lack of authority against an HDC or a person who in good faith pays or takes the instrument for value or for collection. This is the situation where Principal leaves the rubber signature stamp lying about and Crook makes mischief with it, making out a check to Payee using the stamp. But if Payee herself failed to exercise reasonable care in taking a suspicious instrument, both Principal and Payee could be liable, based on comparative negligence principles.Uniform Commercial Code, Section 3-406(b).

Maker

By signing a promissory note, the maker promises to pay the instrument—that’s the maker’s contract and, of course, the whole point to a note. The obligation is owed to a person entitled to enforce the note or to an indorser that paid the note.Uniform Commercial Code, Section 3-412.

Acceptor

Recall that acceptance is the drawee’s signed engagement to honor a draft as presented. The drawee’s signature on the draft is necessary and sufficient to accept, and if that happens, the drawee as acceptor is primarily liable. The acceptance must be written on the draft by some means—any means is good. The signature is usually accompanied by some wording, such as “accepted,” “good,” “I accept.” When a bank certifies a check, that is the drawee bank’s acceptance, and the bank as acceptor becomes liable to the holder; the drawer and all indorsers prior to the bank’s acceptance are discharged. So the holder—whether a payee or an indorsee—can look only to the bank, not to the drawer, for payment.Uniform Commercial Code, Section 3-414(b). If the drawee varies the terms when accepting the draft, it is liable according to the terms as varied.Uniform Commercial Code, Section 3-413(a)(iii).

Drawer’s Liability

If Carlos writes (more properly “draws”) a check to his landlord for $700, Carlos does not expect the landlord to turn around and approach him for the money: Carlos’s bank—the drawee—is supposed to pay from Carlos’s account. But if the bank dishonors the check—most commonly because of insufficient funds to pay it—then Carlos is liable to pay according to the instrument’s terms when he wrote the check or, if it was incomplete when he wrote it, according to its terms when completed (subject to some limitations).Uniform Commercial Code, Section 3-414. Under the pre-1997 UCC, Carlos’s liability was conditioned not only upon dishonor but also upon notice of dishonor; however, under the revised UCC, notice is not required for the drawer to be liable unless the draft has been accepted and the acceptor is not a bank. Most commonly, if a check bounces, the person who wrote it is liable to make it good.

The drawer of a noncheck draft may disclaim her contractual liability on the instrument by drawing “without recourse.”Uniform Commercial Code, Section 3-414(d).

Indorser’s Liability

Under UCC Section 3-415, an indorser promises to pay on the instrument according to its terms if it is dishonored or, if it was incomplete when indorsed, according to its terms when completed. The liability here is conditioned upon the indorser’s receipt of notice of dishonor (with some exceptions, noted in Section 16.2 "Contract Liability of Parties" on contract liability of parties. Indorsers may disclaim contractual liability by indorsing “without recourse.”Uniform Commercial Code, Section 3-415(b).

Conditions for Liability in General

The conditions are slightly different for two classes of instruments. For an unaccepted draft, the drawer’s liability is conditioned on (1) presentment and (2) dishonor. For an accepted draft on a nonbank, or for an indorser, the conditions are (1) presentment, (2) dishonor, and (3) notice of dishonor.

Presentment

PresentmentA holder’s demand for payment from a payor. occurs when a person entitled to enforce the instrument (creditor) demands payment from the maker, drawee, or acceptor, or when a person entitled to enforce the instrument (again, the creditor) demands acceptance of a draft from the drawee.Uniform Commercial Code, Section 3-501.

The common-law tort that makes a person who wrongfully takes another’s property liable for that taking is conversionWrongful possession or disposition of another’s property as if it were one’s own.—it’s the civil equivalent of theft. The UCC provides that “the law applicable to conversion of personal property applies to instruments.”Uniform Commercial Code, Section 3-420. Conversion is relevant here because if an instrument is presented for payment or acceptance and the person to whom it is presented refuses to pay, accept, or return it, the instrument is converted. An instrument is also converted if a person pays an instrument on a forged indorsement: a bank that pays a check on a forged indorsement has converted the instrument and is liable to the person whose indorsement was forged. There are various permutations on the theme of conversion; here is one example from the Official Comment:

Dishonor

DishonorRefusal to pay or accept an instrument when it is presented. generally means failure by the obligor to pay on the instrument when presentment for payment is made (but return of an instrument because it has not been properly indorsed does not constitute dishonor). The UCC at Section 3-502 has (laborious) rules governing what constitutes dishonor and when dishonor occurs for a note, an unaccepted draft, and an unaccepted documentary draft. (A documentary draft is a draft to be presented for acceptance or payment if specified documents, certificates, statements, or the like are to be received by the drawee or other payor before acceptance or payment of the draft.)

Notice of Dishonor

Again, when acceptance or payment is refused after presentment, the instrument is said to be dishonored. The holder has a right of recourse against the drawers and indorsers, but he is usually supposed to give notice of the dishonor. Section 3-503(a) of the UCC requires the holder to give notice to a party before the party can be charged with liability, unless such notice is excused, but the UCC exempts notice in a number of circumstances (Section 3-504, discussed in Section 16.2 "Contract Liability of Parties" on contract liability). The UCC makes giving notice pretty easy: it permits any party who may be compelled to pay the instrument to notify any party who may be liable on it (but each person who is to be charged with liability must actually be notified); notice of dishonor may “be given by any commercially reasonable means including an oral, written, or electronic communication”; and no specific form of notice is required—it is “sufficient if it reasonably identifies the instrument and indicates that the instrument has been dishonored or has not been paid or accepted.”Uniform Commercial Code, Section 3-503(b). Section 3-503(c) sets out time limits when notice of dishonor must be given for collecting banks and for other persons. An oral notice is unwise because it might be difficult to prove. Usually, notice of dishonor is given when the instrument is returned with a stamp (“NSF”—the dreaded “nonsufficient funds”), a ticket, or a memo.

Suppose—you’ll want to graph this out—Ann signs a note payable to Betty, who indorses it to Carl, who in turn indorses it to Darlene. Darlene indorses it to Earl, who presents it to Ann for payment. Ann refuses. Ann is the only primary party, so if Earl is to be paid he must give notice of dishonor to one or more of the secondary parties, in this case, the indorsers. He knows that Darlene is rich, so he notifies only Darlene. He may collect from Darlene but not from the others. If Darlene wishes to be reimbursed, she may notify Betty (the payee) and Carl (a prior indorser). If she fails to notify either of them, she will have no recourse. If she notifies both, she may recover from either. Carl in turn may collect from Betty, because Betty already will have been notified. If Darlene notifies only Carl, then she may collect only from him, but he must notify Betty or he cannot be reimbursed. Suppose Earl notified only Betty. Then Carl and Darlene are discharged. Why? Earl cannot proceed against them because he did not notify them. Betty cannot proceed against them because they indorsed subsequent to her and therefore were not contractually obligated to her. However, if, mistakenly believing that she could collect from either Carl or Darlene, Betty gave each notice within the time allowed to Earl, then he would be entitled to collect from one of them if Betty failed to pay, because they would have received notice. It is not necessary to receive notice from one to whom you are liable; Section 3-503(b) says that notice may be given by any person, so that notice operates for the benefit of all others who have rights against the obligor.

There are some deadlines for giving notice: on an instrument taken for collection, a bank must give notice before midnight on the next banking day following the day on which it receives notice of dishonor; a nonbank must give notice within thirty days after the day it received notice; and in all other situations, the deadline is thirty days after the day dishonor occurred.Uniform Commercial Code, Section 3-503(c).

Presentment Waived or Excused

Under UCC Section 3-504(a), presentment is excused if (1) the creditor cannot with reasonable diligence present the instrument; (2) the maker or acceptor has repudiated the obligation to pay, is dead, or is in insolvency proceedings; (3) no presentment is necessary by the instrument’s terms; (4) the drawer or indorsers waived presentment; (5) the drawer instructed the drawee not to pay or accept; or (6) the drawee was not obligated to the drawer to pay the draft.

Notice of Dishonor Excused

Notice of dishonor is not required if (1) the instrument’s terms do not require it or (2) the debtor waived the notice of dishonor. Moreover, a waiver of presentment is also a waiver of notice of dishonor. Delay in giving the notice is excused, too, if it is caused by circumstances beyond the control of the person giving notice and she exercised reasonable diligence when the cause of delay stopped.Uniform Commercial Code, Section 3-504.

In fact, in real life, presentment and notice of dishonor don’t happen very often, at least as to notes. Going back to presentment for a minute: the UCC provides that the “party to whom presentment is made [the debtor] may require exhibition of the instrument,…reasonable identification of the person demanding payment,…[and] a signed receipt [from the creditor (among other things)]” (Section 3-501). This all makes sense: for example, certainly the prudent contractor paying on a note for his bulldozer wants to make sure the creditor actually still has the note (hasn’t negotiated it to a third party) and is the correct person to pay, and getting a signed receipt when you pay for something is always a good idea. “Presentment” here is listed as a condition of liability, but in fact, most of the time there is no presentment at all:

The Official Comment to UCC Section 5-502 says about the same thing:

Warranties Made by One Who Presents an Unaccepted Draft

1. The presenter is entitled to enforce the draft or to obtain payment or acceptance. This is “in effect a warranty that there are no unauthorized or missing indorsements.”Uniform Commercial Code, Section 3-417, Comment 2. Suppose Thief steals a check drawn by Drawer to Payee and forges Payee’s signature, then presents it to the bank. If the bank pays it, the bank cannot charge Drawer’s account because it has not followed Drawer’s order in paying to the wrong person (except in the case of an imposter or fictitious payee). It can, though, go back to Thief (fat chance it can find her) on the claim that she breached the warranty of no unauthorized indorsement.
2. There has been no alteration of the instrument. If Thief takes a check and changes the amount from $100 to $1,000 and the bank pays it, the bank can recover from Thief $900, the difference between the amount paid by the bank and the amount Drawer (customer) authorized the bank to pay.Uniform Commercial Code, Sections 3-417(2) and (b). If the drawee accepts the draft, the same rules apply.
3. The presenter has no knowledge that the signature of the drawer is unauthorized. If the presenter doesn’t know Drawer’s signature is forged and the drawee pays out on a forged signature, the drawee bears the loss. (The bank would be liable for paying out over the forged drawer’s signature: that’s why it has the customer’s signature on file.)

These rules apply—again—to warranties made by the presenter to a drawee paying out on an unaccepted draft. The most common situation would be where a person has a check made out to her and she gets it cashed at the drawer’s bank.

Warranties Made by One Who Presents Something Other Than an Unaccepted Draft

In all other cases, there is only one warranty made by the presenter: that he or she is a person entitled to enforce the instrument or obtain payment on it.

This applies to the presentment of accepted drafts, to the presentment of dishonored drafts made to the drawer or an indorser, and to the presentment of notes. For example, Maker makes a note payable to Payee; Payee indorses the note to Indorsee, Indorsee indorses and negotiates the note to Subsequent Party. Subsequent Party presents the note to Maker for payment. The Subsequent Party warrants to Maker that she is entitled to obtain payment. If she is paid and is not entitled to payment, Maker can sue her for breach of that warranty. If the reason she isn’t entitled to payment is because Payee’s signature was forged by Thief, then Maker can go after Thief: the UCC says that “the person obtaining payment [Subsequent Party] and a prior transferor [Thief] warrant to the person making payment in good faith [Maker] that the warrantor [Subsequent Party] is entitled to enforce the instrument.”Uniform Commercial Code, Section 3-417(d). Or, again, Drawer makes the check out to Payee; Payee attempts to cash or deposit the check, but it is dishonored. Payee presents the check to Drawer to make it good: Payee warrants he is entitled to payment on it.

Warranties cannot be disclaimed in the case of checks (because, as UCC Section 3-417, Comment 7, puts it, “it is not appropriate to allow disclaimer of warranties appearing on checks that normally will not be examined by the payor bank”—they’re machine read). But a disclaimer of warranties is permitted as to other instruments, just as disclaimers of warranty are usually OK under general contract law. The reason presentment warranties 2 and 3 don’t apply to makers and drawers (they apply to drawees) is because makers and drawers are going to know their own signatures and the terms of the instruments; indorsers already warranted the wholesomeness of their transfer (transfer warranties), and acceptors should examine the instruments when they accept them.

Discharge in General

Discharge of Indorsers and Accommodation Parties

The liability of indorsers and accommodation parties is discharged under the following three circumstances.Uniform Commercial Code, Section 3-605.

Discharge by Reacquisition

Suppose a prior party reacquires the instrument. He may—but does not automatically—cancel any indorsement unnecessary to his title and may also reissue or further negotiate the instrument. Any intervening party is thereby discharged from liability to the reacquiring party or to any subsequent holder not in due course. If an intervening party’s indorsement is cancelled, she is not liable even to an HDC.Uniform Commercial Code, Section 3-207.

Discharge by Unexcused Delay in Presentment or Notice of Dishonor

If notice of dishonor is not excused under UCC Section 3-504, failure to give it discharges drawers and indorsers.

Facts

Michael and Stacy Russell owned a mobile home in Harrah, Oklahoma. The home was insured by Oklahoma Farm Bureau Mutual Insurance Company (Farm Bureau). The insurance policy provided that in case of loss, Farm Bureau “will pay you unless another payee is named on the Declarations page,” that “Loss shall be payable to any mortgagee named in the Declarations,” and that one of Farm Bureau’s duties was to “protect the mortgagee’s interests in the insured building.” The Declarations page of the policy listed Conseco Finance as the mortgagee. Conseco had a mortgage security interest in the home.

In August 2002, a fire completely destroyed the mobile home. The Russells submitted an insurance claim to Farm Bureau. Farm Bureau then negotiated a $69,000 settlement with the Russells, issued them a check in this amount payable to them and Conseco jointly, and mailed the check to the Russells. Neither the Russells nor Farm Bureau notified Conseco of the loss, the settlement, or the mailing of the check.

The check was drawn on Farm Bureau’s account at BNH. The Russells deposited the check into their account at BOK. The check contains an endorsement by both Russells, and a rubber stamp endorsement for Conseco followed by a signature of a Donna Marlatt and a phone number. It is undisputed that Conseco’s endorsement was forged. Upon receipt, BOK presented the check to BNH. BNH paid the $69,000 check and notified Farm Bureau that the check had been paid from its account.

About a year later, Conseco learned about the fire and the insurance payoff. Conseco notified Farm Bureau that it was owed a mortgage balance of more than $50,000. Farm Bureau paid off the balance and notified BNH of the forgery. BNH reimbursed Farm Bureau the amount paid to Conseco. BNH then sued BOK.

Both banks relied on the Uniform Commercial Code. BNH asserted that under § 4-208, BOK had warranted that all the indorsements on the check were genuine. BOK asserted an affirmative defense under § 3-406, alleging that Farm Bureau’s own negligence contributed to the forgery. After a non-jury trial, the court granted judgment to BOK, finding as follows:

• Conseco’s endorsement was a forgery, accomplished by the Russells;
• Farm Bureau was negligent in the manner and method it used to process the claim and pay the settlement without providing any notice or opportunity for involvement in the process to Conseco;
• Farm Bureau’s negligence substantially contributed to the Russells’ conduct in forging Conseco’s endorsement; and
• BOK proved its affirmative defense under § 3-406 by the greater weight of the evidence.

From this judgment, BNH appeals.

Analysis

It cannot be disputed that BOK breached its presentment warranty to BNH under § 4-208.Section 4-208 provides as follows: “(a) If an unaccepted draft is presented [in this case, by BOK] to the drawee [BNH] for payment or acceptance and the drawee pays or accepts the draft,(i) the person obtaining payment or acceptance, at the time of presentment, and(ii) a previous transferor of the draft, at the time of transfer, warrant to the drawee that pays or accepts the draft in good faith, that:(1) The warrantor is, or was, at the time the warrantor transferred the draft, a person entitled to enforce the draft or authorized to obtain payment or acceptance of the draft on behalf of a person entitled to enforce the draft;(2) The draft has not been altered; and(3) The warrantor has no knowledge that the signature of the purported drawer of the draft is unauthorized.(b) A drawee making payment may recover from a warrantor damages for breach of warranty.…(c) If a drawee asserts a claim for breach of warranty under subsection (a) of this section based on an unauthorized indorsement of the draft or an alteration of the draft, the warrantor may defend by proving that…the drawer [here, Farm Bureau] is precluded under Section 3-406 or 4-406 of this title from asserting against the drawee the unauthorized indorsement or alteration.” Thus the primary issue raised is whether BOK established a preclusion defense under 3-406 [that BNH is precluded from complaining about BOK’s breach of presentment warranty because of its own negligence].(a) A person whose failure to exercise ordinary care substantially contributes to an alteration of an instrument or to the making of a forged signature on an instrument is precluded from asserting the alteration or the forgery against a person who, in good faith, pays the instrument or takes it for value or for collection. BNH asserts that the evidence fails to establish this defense because the mailing of its check to and receipt by the insured “is at most an event of opportunity and has nothing to do with the actual forgery.”

Section 3-406 requires less stringent proof than the “direct and proximate cause” test for general negligence.The parties do not address Section 3-406(b), which states that the person asserting preclusion may be held partially liable under comparative negligence principles for failing to exercise ordinary care in paying or taking the check. They also do not address any possible negligence by either bank in accepting the forged check without confirming the legitimacy of Conseco’s indorsement. Conduct is a contributing cause of an alteration or forgery if it is a substantial factor in bringing it about, or makes it “easier for the wrongdoer to commit his wrong.” The UCC Comment to § 3-406 notes that the term has the meaning as used by the Pennsylvania court in Thompson [Citation].

In Thompson, an independent logger named Albers obtained blank weighing slips, filled them out to show fictitious deliveries of logs for local timber owners, delivered the slips to the company, accepted checks made payable to the timber owners, forged the owners’ signatures, and cashed the checks at the bank. When the company discovered the scheme, it sued the bank and the bank raised § 3-406 as a defense. The court specifically found that the company’s negligence did not have to be the direct and proximate cause of the bank’s acceptance of the forged checks. Instead, the defense applied because the company left blank logging slips readily accessible to haulers, the company had given Albers whole pads of blank slips, the slips were not consecutively numbered, haulers were allowed to deliver both the original and duplicate slips to the company’s office, and the company regularly entrusted the completed checks to the haulers for delivery to the payees without the payees’ consent. The court noted:

The UCC Comment to § 3-406 gives three examples of conduct illustrating the defense. One example involves an employer who leaves a rubber stamp and blank checks accessible to an employee who later commits forgery; another example involves a company that issues a ten dollar check but leaves a blank space after the figure which allows the payee to turn the amount into ten thousand dollars; and the third example involves an insurance company that mails a check to one policyholder whose name is the same as another policyholder who was entitled to the check. In each case, the company’s negligence substantially contributed to the alterations or forgeries by making it easier for the wrongdoer to commit the malfeasance.

In the present case, we find no negligence in Farm Bureau’s delivery of the check to the Russells. There is nothing in the insurance policy that prohibits the insurer from making the loss-payment check jointly payable to the Russells and Conseco. Furthermore, under § 3-420, if a check is payable to more than one payee, delivery to one of the payees is deemed to be delivery to all payees. The authority cited by BOK, in which a check was delivered to one joint payee who then forged the signature of the other, involve cases where the drawer knew or should have known that the wrongdoer was not entitled to be a payee in the first place. See [Citations].

We also find no negligence in Farm Bureau’s violation of its policy provisions requiring the protection of the mortgage holder. Generally, violation of contract provisions and laxity in the conduct of the business affairs of the drawer do not per se establish negligence under this section. See [Citations].

However, evidence was presented that the contract provision merely reflected an accepted and customary commercial standard in the insurance industry. Failure to conform to the reasonable commercial standards of one’s business has been recognized by a number of courts as evidence of negligence. See, e.g., [Citations].

Here, evidence was presented that Farm Bureau did not act in a commercially reasonable manner or in accordance with reasonable commercial standards of its business when it issued the loss check to the insured without notice to the mortgagee. BOK’s expert testified that it is standard practice in the industry to notify the lender of a loss this size, in order to avoid exactly the result that occurred here. Mortgagees often have a greater financial stake in an insurance policy than do the mortgagors. That was clearly true in this case. While there was opinion testimony to the contrary, the trial court was entitled to conclude that Farm Bureau did not act in a commercially reasonably manner and that this failure was negligence which substantially contributed to the forgery, as contemplated by § 3-406.

We find the trial court’s judgment supported by the law and competent evidence. Accordingly, the trial court’s decision is affirmed. Affirmed.

I. Background

Martin, an attorney, received an e-mail message on August 16, 2008, from a person who called himself Roman Hidotashi. Hidotashi claimed that he was a representative of Chipang Lee Song Manufacturing Company and needed to hire a lawyer to collect millions of dollars from past-due accounts of North American customers. Martin agreed to represent the company.

On September 8, 2008, Martin received a check for $290,986.15 from a purported Chipang Lee Song Manufacturing Company customer, even though Martin had yet to commence any collections work. The check, which was drawn on First Century Bank USA, arrived in an envelope with a Canadian postmark and no return address. The check was accompanied by an undated transmittal letter. Martin endorsed the check and deposited it in his client trust account at PNC. Martin then e-mailed Hidotashi, reported that he had deposited the check, and stated that he would await further instructions.

Hidotashi responded to Martin’s e-mail message on September 9, 2008. Hidotashi stated that he had an “immediate need for funds” and instructed Martin to wire $130,600 to a bank account in Tokyo. Martin went to PNC’s main office in Louisville the next morning and met with representative Craig Friedman. According to Martin, Friedman advised that the check Martin deposited had cleared. Martin instructed Friedman to wire $130,600 to the Tokyo account.

Martin returned to PNC later the same day. According to Martin, Friedman accessed Martin’s account information and said, “I don’t understand this. The check was cleared yesterday. Let me go find out what is going on.” Friedman returned with PNC vice president and branch manager Sherry Jennewein, who informed Martin that the check was fraudulent. According to Martin, Jennewein told him that she wished he had met with her instead of Friedman because she never would have authorized the wire transfer.

First Century Bank, on which the check was drawn, dishonored the check. PNC charged Martin’s account for $290,986.15. PNC, however, could not recover the $130,600 the bank had wired to the Tokyo account. Martin’s account, as a result, was left overdrawn by $124,313.01.

PNC commenced this action. PNC asserts one count for Martin’s alleged breach of the transfer warranties provided in Kentucky’s version of the Uniform Commercial Code and one count for breach of Martin’s account agreement. PNC moves for summary judgment on both counts.

II. Discussion

III. Conclusion

For the foregoing reasons, IT IS ORDERED that PNC’s motion for summary judgment is granted…to the extent that…PNC is permitted to recover $124,313.01 from Martin.…