1

Negotiable Instruments Bar Exam Guide

The Negotiable Instruments (NI) questions from the Business Entities and Negotiable Instruments (BENI) section of the Louisiana bar exam are not difficult. The questions are not well-written and the facts are sometimes confusing. But the legal rules and concepts involved are not difficult. To be successful on this part of the bar exam, one must be able to weed through confusing and sometimes misleading hypotheticals. Working through old exam questions is an excellent way to develop this critical skill.

The overwhelming majority of the points come from questions on the following topics:

• Negotiability

• The Holder in Due Course (HDC) rules

• The Check system

These three topics appear on nearly every exam. They are the “Holy Trinity” of NI law, at least in terms of the Louisiana bar exam. The last topic seems broad, but the questions fall into one of two general hypo types, as explained below.

Negotiability

To be a NI, a document must satisfy the following requirements:

1. In writing and signed

2. An unconditional order or promise to pay

3. To bearer or to the order of an identifiable person

4. A fixed amount (can include interest)

5. Of money

6. On demand or at a fixed time

7. With no other promises or undertakings (i.e., no baggage)

There are two basic types of NI: notes and drafts. The two specific types you are likely to see on the bar exam are the promissory note (i.e., a note) or a check (i.e., a draft). If you are asked with either of these types of documents is a NI, you must list the requirements and apply them to the facts. This is simple stuff. If you miss these points, you are in trouble!

2

What can make this type of question difficult? Nothing. It’s always an easy question. Sometimes, however, the facts will present a document that raises a close call on one or more of the negotiability requirements. But that does not make the question hard. You will get most of the credit just by listing the requirements and applying them to the facts. If you find that one of the requirements is a close call, just say that. And if you have no idea whether a certain requirement is met, just take a position and move on. At the very worst, you might lose a point or two.

Here are some examples from actual bar exams.

Example one - Bob is a booster for LA University's athletic programs and he raises monies from other boosters like himself to donate to the LA Athletic Foundation (LAF). Deep South, L.L.C. is a Louisiana limited liability company formed by Bob to raise funds to donate to the LAF. Bob is the managing member of Deep South. Given the mediocre results of the LA football team this year, Deep South, through Bob's fund raising efforts, agreed to donate $500,000 to the LAF in order to raise money to buy out the LAF coach’s remaining contract. Deep South hosted a televised press conference during which Bob donated the money ($500,000) to the LAF expressly stating that it was donated for the purpose of buying out the coach’s remaining contract. During the press conference, Bob presented the LAF a typical U.S. bank check drawn against Deep South’s account at Bayou Bengal Bank made payable to the LAF in the amount of $500,000, dated the date of the press conference. The check bears Bob’s signature but no other handwriting or comments.

Question: Is the check a NI? It doesn’t get any easier than this. Checks are almost always NIs. In fact, even if someone strikes through the “pay to the order” text on a standard check, we still treat it as a NI. So just list the 7 requirements, note that each one seems to be satisfied, and you’re done. Not convinced, here’s a model answer:

The check appears to be a NI, because it is

1. In writing and signed by Bob

2. It contains an unconditional order or promise to pay

3. To the order of LAF (i.e., contains order language)

4. A fixed amount

5. Of money ($500,000)

6. Payable on demand

3

7. With no other promises or undertakings (i.e., it contains no other “handwriting or comments”).

Having satisfied the negotiability requirements, this check appears to be a NI.

Example Two - Acme Trucking, Inc. is a local distributor of commercial trucks and has agreed to sell a new eighteen wheeler tractor trailer to its customer, Charlie. Acme will finance 90% of the purchase price for Charlie if Charlie pays 10% of the purchase price to Acme at the time of the sale. Charlie maintains his bank accounts with First Bank of New Orleans (hereafter “First Bank”) and has asked First Bank to issue a cashier’s check payable to Charlie as payee for the down payment of $8,000. As consideration for the cashier’s check, Charlie writes a personal check to First Bank for $8,000 plus the fees and costs for issuing the cashier’s check. The same day that Charlie writes a personal check from his account payable to First Bank and obtains the cashier’s check, Acme and Charlie sign the Bill of Sale for the eighteen wheeler, Charlie endorses the $8,000 cashier’s check payable to Acme and Charlie takes possession of the truck. The next day, Charlie’s personal check for $8,000 is not honored when presented for payment by First Bank because Charlie has insufficient funds in his account. Assume the cashier’s check bears a current month, day and year, is signed by a properly-authorized person of First Bank and is made payable to Charlie in the amount of $8,000 U.S. dollars. When Charlie’s check is dishonored, First Bank places a stop-payment order on the cashier’s check ($8,000).

Question: Is the cashier’s check a NI?

Answer: Of course it is! This is a good example of a fact pattern that gets confusing, but a question that is very simple. Just list the 7 negotiability requirements, showing how each is satisfied, and that’s it.

Example Three: Stephen owns a camp in Delacroix that Tom, the president of British Petroleum ("BP"), has approached Stephen about renting so that Tom and his girl friend, Susie, can live close to the site of the oil spill while efforts to cap the well and remediate the spill are underway. Stephen despises BP for causing the spill, but Stephen will be paid a nightly rate that exceeds what he usually charges for a week's rental, so Stephen reluctantly agrees. Tom is a little strapped for cash since he has not received his usual quarterly bonus given the cost of the clean-up efforts, so Tom decides to pay Stephen partially by way of a check for $10,000 and partially by way of a Promissory Note for $20,000. Unbeknownst to Susie, Tom signs a check from Susie's personal checking account at Texas Bank made payable to Stephen in the amount of $10,000. The check is a standard U.S. bank check bearing a date of July 1, 2010. Tom also signs a Promissory Note in his capacity as

4

president of BP payable to the holder in the amount of $20,000, which bears a maturity date of August 1, 2010. The Promissory Note contains no other terms and/or conditions.

Question: Is the Promissory Note a NI?

Answer: Probably so. Again, just go through the 7 negotiability requirements, explaining (briefly!!) how each is met. The only thing slightly tricky is this one is the “payable to holder” text. That is payable to bearer, which is good enough. It’s not a great use of the word “holder,” because that word has specific meaning under Article 3. But ignore all that. This note is payable to bearer. It seems to clearly meet all the other requirements.

Example Four - Tom Jones is an avid gambler. When he gambled at Harrah’s Casino last week, he was asked to sign a marker for the monies Harrah’s was loaning to him to gamble for that night -- $5,000. He signed the marker on January 31, 2013, although it was dated March 1, 2013. The marker is below:

Name: Tom Jones Date: March 1, 2013

GAMING MARKER

PAY ON DEMAND

TO BEARER OR TO ORDER OF: Harrah’s Casino $5,000

FIVE THOUSAND AND 00/100 ---------------------------------

I agree for this payment to be applied according to the terms of the Credit

Report Agreement with Harrah’s.

Acct. # 99999999 Signed: /s/ Tom Jones

On February 15, 2013, Harrah’s delivers the marker to the bank but forgets to endorse it. The bank credits Harrah’s account $5,000. On March 15, 2013, Tom Jones files for bankruptcy.

Question: Is the marker a NI?

Answer: This one is close. Of all the questions of this type, this one is probably the hardest I’ve seen. But it’s still simple! Just because the facts raise one or two close issues does not make the question hard. The key to maximizing points on these questions is to make sure you use the 7 negotiability requirements and apply them to the facts. Here’s a sample answer:

5

The marker appears to be a NI, because it is

1. In writing and signed by Tom

2. It contains an unconditional order or promise to pay

3. To bearer or to the order of Harrah’s (a NI must have bearer or order language; this one has both; that’s ok)

4. A fixed amount

5. Of money ($5,000)

6. Payable on demand

7. With no other promises or undertakings (this requirement is a close call because the marker does refer to Credit Report Agreement. If this reference makes the promise to pay subject to the other agreement, then the marker is not a NI. If this is merely a reference to the other agreement, the marker can still be a NI. I’d say this looks more like a reference, and so it satisfies this requirement).

Having satisfied the negotiability requirements, this marker appears to be a NI.

What if you had no clue whether it is ok to include both bearer and order language? It is weird. It probably was a mistake, even. But what if that throws you for a loop? Take a couple deep breaths and just answer as best you can. If you say that it’s not ok to include both bearer and order language, you might lose a point on that question. Big deal!! You’ll get some credit just for stating the requirement.

What if you think the reference to the other agreement destroys negotiability? Just say so. Frankly, I think it does destroy negotiability, but I know there is a Louisiana case that seems to say otherwise, and I suspect that case is the reason for this bar question. But you don’t need to know or worry about any of that! This one is close, and they better be giving full credit for either conclusion. What if they don’t? OMG, you might lose a point! Get over it.

And this is as hard as this issue gets. Absolute worst case scenario is you get one or two negotiability requirements you can’t figure out. End result, you lose maybe a point, probably not even that.

6

HDC

This is the second major topic tested on the NI part of the bar. It arises in two ways: (1) questions ask whether a party is a HDC; and, (2) questions ask about what defenses are available against a party. The latter questions are often not explicitly about the HDC doctrine, but to answer such questions, one must realize that HDC status means many defenses are not available. The HDC doctrine is the key point in the latter type of question, but you have to know that, because the questions don’t point that out. Both types of questions are very common on the bar exam.

HDC status questions

These questions are very straightforward and usually very easy. Deal with these just like you deal with the negotiability questions. List the HDC requirements and apply them to the facts.

These questions often turn, at least in part, on whether there was a valid negotiation. Negotiation is simple, and you should always get these points. What does it take to negotiate a NI?

• If the NI is order paper when negotiated, an indorsement by the named payee, together with transfer of the NI, is required

• If the NI is bearer paper when negotiated, transfer of the NI is all that is required

That’s it. The key is making sure you keep track of whether the NI is bearer paper or order paper when the alleged negotiation occurs. That is not hard, but it does sometimes require you to pay attention to the facts. That should be simple, but some of the hypos are hard to follow, and this can cause problems with these questions. So if a question asks whether there was a valid negotiation, go back through the facts to make sure you know whether the NI was bearer or order paper at the point of transfer.

There are pure negotiation questions on some bar exams, but this issue most often arises as part of a HDC status question. Before doing the HDC question, here is an example of a pure negotiation question. This is based on the Sam and the convenience store hypo provided below (in the Checks section). The question asked: What is required for Jack to negotiate the check to Jill? What is required for Jill to negotiate the check to Mike?

Here is a sample answer:

The check was order paper when Jack received it from Adam, so Jack must indorse the check for a proper negotiation and transfer possession of the check. When Jill received the check from Jack, it probably was bearer paper, because Jack probably just signed the back of the check (i.e., a blank

7

indorsement). If it was bearer paper, then Jill only needs to transfer physical possession of the check to negotiate it to Mike.

That’s it. You figure out if the NI is order or bearer paper and apply the appropriate negotiation rule.

Here are examples of HDC status questions. You will see that negotiation is often an issue in these questions, too.

Example One – [This is a continuation of the hypo provided above about Bob giving the $500,000 check to LAF. Here is what happened next.

Bob, feeling lucky, immediately headed to the casino after the press conference and spent several hours gambling. Unfortunately, Bob's luck was misplaced and he lost over a million dollars which includes all of the money he received in donations for Deep South. Because of this, he knows Deep South cannot afford to honor the $500,000 donation to the LAF. Three days after Bob lost Deep South's money at the casino, he called the LAF and disclosed his unfortunate turn at the gaming tables. LAF advised Bob that it had already presented the check for payment at its bank (Tigerland Bank) and has received the funds. Bob then advised the LAF that he contacted his bank (Bayou Bengal Bank) yesterday and placed a stop-payment on the check.

Question: Was Tigerland Bank a HDC?

Answer: To be a HDC, one must:

1. Be a holder (i.e., obtain the NI via a valid negotiation);

2. Give value

3. In good faith

4. Without notice that the NI was

a. overdue,

b. had been dishonored,

c. was altered,

d. had an unauthorized necessary signature,

e. that anyone else had a claim to the instrument, or,

f. that any prior party to the instrument had a defense to payment.

8

The check was order paper, with LAF the payee. LAF probably indorsed the check (facts don’t say, but this is a fair assumption) to Tigerland Bank (TB) when LAF deposited the check. Thus, TB was a holder.

TB gave value by making the funds available to LAF. TB probably was in good faith, and the facts don’t suggest TB had notice of any of the facts listed above.

TB, therefore, appears to be a HDC.

That’s it. List the requirements (yes, you do have to know them!) and apply them. Works every time.

Example Two – [Use the gambling marker hypo provided above.]

Question: Is the bank a HDC as of February 15?

Answer: This is harder, but the key is the same. List the HDC requirements and apply them. What makes this one harder? There is one HDC requirement that is tricky here. But that’s a single issue, and even if you miss it, you can still get most of the points simply by listing and applying the HDC requirements.

The tricky part of this question is deciding whether the bank is a holder. It’s really a negotiation issue. And to resolve that (more below on this point), you must focus on whether the NI was bearer paper or order paper at the time of the transfer.

The marker has both bearer and order language. What to do? This would confuse many examinees, and it might confuse you. The key is to not worry and just give it your best shot. If you decided the marker was not a NI, then obviously the bank can’t be a HDC. But do not stop your analysis there! You MUST list all the HDC requirements and go through them, all of them, any time you get a HDC status question.

What if you have no idea whether to treat this as bearer or order paper. It’s bearer paper. Article 3 is clear on that, but it’s an odd scenario and one you probably never reviewed in class. So you’re stumped. Just pick one and go with it. If you pick bearer, your answer will be correct on this point. If you pick order paper, you will be wrong. But if you list all the HDC requirements and analyze all of them, you will get most of the credit.

9

The worst thing you can do is let a small error wreck your entire

exam performance. You are bound to lose a few points here and there. The key is to grab as many points as possible, without getting caught up on small issues that stump you. This question is a great example of how that can happen.

Examples Three and Four – [Some bar exams have asked this same question more than once, usually with either variations in the facts or focusing on a different party with different issues. Your answer should be very similar no matter how many times this is asked. If it shows up more than once, just be thankful, because it means more easy points! Here is an example of two questions from the July 2010 exam.]

Stephen owns a camp in Delacroix that Tom, the president of British Petroleum

("BP"), has approached Stephen about renting so that Tom and his girl friend, Susie, can

live close to the site of the oil spill while efforts to cap the well and remediate the spill

are underway. Stephen despises BP for causing the spill, but Stephen will be paid a

nightly rate that exceeds what he usually charges for a week's rental, so Stephen

reluctantly agrees. Tom is a little strapped for cash since he has not received his usual

quarterly bonus given the cost of the clean-up efforts, so Tom decides to pay Stephen

partially by way of a check for $10,000 and partially by way of a Promissory Note for

$20,000. Unbeknownst to Susie, Tom signs a check from Susie's personal checking

account at Texas Bank made payable to Stephen in the amount of $10,000. The check is a

standard U.S. bank check bearing a date of July 1, 2010. Tom also signs a Promissory

Note in his capacity as president of BP payable to the holder in the amount of $20,000,

which bears a maturity date of August 1, 2010. The Promissory Note contains no other

terms and/or conditions.

On July 15, 2010, Stephen takes the Promissory Note to his bank--Bank of

Louisiana--and asks that the Bank purchase the Note at face value. Stephen is a good

customer, and Bank of Louisiana agrees and pays him $20,000 for the Promissory Note.

Contemporaneously, Stephen delivers the Promissory Note to Bank of Louisiana. A little

over two weeks later, Bank of Louisiana makes demand on BP on August 2, 2010 to pay

the Promissory Note consistent with its terms. BP denies that it is obligated to Bank of

Louisiana on the Promissory Note since Tom did not have the company's authority to

issue the Promissory Note on BP's behalf. On this same date, Tom and Susie have a

falling out and Susie decides not to move to Louisiana. Susie immediately contacts Texas

Bank and instructs Texas Bank to stop payment on the check. Stephen had already cashed

the check at Bank of Louisiana two weeks earlier.

Is Bank of Louisiana a holder-in-due course of the Promissory Note? Explain your

answer fully and any assumptions necessary to your answer.

10

Is Bank of Louisiana a holder-in-due course of the $10,000 check? Explain your answer

fully and any assumptions necessary to your answer.

Answer: To be a HDC, one must meet the following requirements:

1. Be a holder (i.e., obtain the NI via a valid negotiation);

2. Give value

3. In good faith

4. Without notice that the NI was

a. overdue,

b. had been dishonored,

c. was altered,

d. had an unauthorized necessary signature,

e. that anyone else had a claim to the instrument, or,

f. that any prior party to the instrument had a defense to payment.

The promissory note is bearer paper (payable to “holder”) so physical transfer is

enough for negotiation. BoL, therefore is a holder. BoL gave value (paid

Stephen $20K for the note), and appears to have been in good faith and without

notice of any of the things listed above. BoL, therefore, appears to be a HDC of

the note.

The “standard bank check” is probably a NI, as almost all checks are. [I would

not go through the full negotiability analysis here, but you can if you wish, and

have the spare time!] The check is order paper (Stephen is payee), and I assume

Stephen indorsed it when he “cashed” it at BoL. Thus, the check was properly

negotiated to BoL, and it is a holder. BoL paid value (it “cashed” the check – that

is, gave Stephen $10K in cash), probably was in good faith, and appears to lack

notice of any of the things listed above. BoL appears to be a HDC of the check.

HDC defenses questions – These questions should be very easy. The key is to remember that a HDC is not subject to personal defenses. Most defenses are personal defenses. Only the real defenses are available against a HDC. The real

11

defenses include: (1) infancy, to the extent it is a defense to a simple contract1; (2) duress, lack of legal capacity, or illegality of the transaction, to the extent it would nullify the obligation of the obligor; (3) fraud in fact; or (4) discharge in bankruptcy. You must know these four real defenses. Everything else is a personal defense, and therefore is not available against a HDC. Common personal defenses include fraud in the inducement; discharge by payment or other act; mistake; breach of contract, and so on.

The first two real defenses are easy to understand. They list conditions that would render a simple contract void (i.e., a nullity) under state law. Those conditions are rare, but important enough that we allow them to be raised against even a HDC. The fourth defense is also easy, but remember it is discharge in bankruptcy, not just filing that constitutes the defense.

The fraud in fact defense confuses some people. This is the most severe form of fraud and it is very rare. It means the person did not know what he signed, and that he had no reasonable way of understanding what he signed. Being blind isn’t good enough, because a blind person could ask someone else to read the document. If you think the facts support this defense, think again, because you are probably wrong.

The key to scoring points on these questions is listing the real defenses and briefly applying them to the facts. The bar questions sometimes tell you to assume the person is a HDC (or isn’t), but sometimes that is part of the question. Don’t stress on this. List the real defenses, determine whether any of them are raised by the facts (they probably won’t be), and then state a conclusion. I would make that conclusion work whether the party is a HDC or not, as the examples below will show.

Example One – [This is based on a slight variation on the hypo with Bob and the big check to LAF.] What type of defenses might Tigerland Bank successfully argue against paying a negotiable instrument to a holder-in-due course? Are any of these available under the facts presented?

Answer – Wow, this is a messed up question! If you chart out the players and the sequence of events, you will realize that Tigerland Bank (TB) would never be in the position of paying this NI to a HDC. Instead, TB probably is a HDC, and would be using that status to enforce the NI against someone else, like the drawer. But you get to ignore all that, because the question clearly is asking you about HDC defenses. That’s all you need to know. Here’s the answer:

1 This point could matter, but rarely does on the bar exam. Under La. law, an infant (one under 18) may make a

binding contract on a matter related to the minor’s business or necessary to the minor’s education. I would not

worry about these points on the bar exam. In fact, I would list the defense simply as “infancy,” and leave it at that.

12

Only real defenses may be asserted against a HDC. The real defenses are: (1) infancy; (2) illegality of the transaction, duress, or lack of capacity; (3) fraud in fact; and (4) discharge in bankruptcy. The facts do not support any of these defenses.

[I think that’s enough, but if you wish, you could briefly show why these defenses are raised. That is, you could add the following to your answer: Bob was not an infant; the transaction was legal, and there was no duress or incapacity; Bob knew what he was signing; and there was no bankruptcy.]

Example Two - [This is also based on the hypo with Bob and the big check to LAF] Assume for this subpart only that Bob had not gambled with the Deep South donations to LAF and instead stopped payment on the check because he learned that the board members of the LAF intended to use the money on building a new weight room rather than for buying out the coach’s contract. Discuss whether Deep South could successfully defend its liability on the instrument if Tigerland Bank honored the check when presented for payment by the LAF?

Answer –This is a harder question. It doesn’t say anything about HDC. You may not even notice at first glance that it is a question about defenses. So the first key to handling this question is to figure out what it is asking. First, identify the players. Once you do that, determine whether the negotiations were valid. If so, then the parties who received the NI via those negotiations were holders, and possibly HDC. This question has an additional twist, because it is the drawer of the check, Deep South, who is trying to “successfully defend its liability on the instrument.” That complicates things a bit, but not much. The drawer is liable on a dishonored check, unless the drawer can raise a valid defense. If the party trying to enforce the instrument is a HDC, then we’re back to the HDC defense question.

One thing to remember is that the bar examiner loves repetition. And the HDC defense question is one that appears, one way or another, on nearly every single bar exam. So if you are wondering what they are looking for on this question, my bet is they want to see you go through the HDC defense analysis. Of course, you also need to address the other issues, but do that briefly. Here is how I would answer this question:

I assume that Bayou Bengal Bank (BBB) dishonored the check based on Deep South’s stop payment order, and that the check was returned to Tigerland Bank (TB), which now wants to enforce the check against the drawer, Deep South. The drawer is liable on a dishonored check, unless it has a valid defense to payment.

13

TB is probably a HDC, for the reasons given above. [A prior sub part asked whether TB is a HDC, so just repeat your conclusion here.] Only real defenses may be asserted against a HDC. The real defenses are: (1) infancy; (2) illegality of the transaction, duress, or lack of capacity; (3) fraud in fact; and (4) discharge in bankruptcy. The facts do not support any of these defenses. If TB is a HDC, it should prevail against Deep South.

[What if you decided TB was not a HDC? Use almost the same answer, because this question is looking for the HDC defense analysis. Here is how that answer would go:

TB is probably not a HDC for the reasons stated above. Only real defenses may be asserted against a HDC. The real defenses are: (1) infancy; (2) illegality of the transaction, duress, or lack of capacity; (3) fraud in fact; and (4) discharge in bankruptcy. The facts do not support any of these defenses. If TB was a HDC, it probably would prevail against Deep South.

But because TB is not a HDC, it might be vulnerable to a personal defense. The only personal defense the facts support is a lack of consideration defense, because this was a charitable donation.

That’s it. Don’t go into a long discussion of personal defenses. If the facts seem to support one, just state that and move on. Remember, the points on this question are in the HDC defense analysis, which means listing and analyzing (briefly) the real defenses.

Checks – Almost every bar exam includes a question, usually with multiple subparts, on checks. The most common scenario involves numerous forged checks by someone the account holder knew and trusted. This scenario raises general negligence issues and the bank statement rule (BSR). The bar also has asked more general check questions, so you must have a good understanding of the check system and the loss allocation rules.

First, you need to know who the players are and the basic rules. The checking account holder is the drawer, the person who writes and signs the check in normal circumstances. The person to whom the check is payable is the payee. The payee is usually an individual or an entity. Note that the payee is not a party to a check until the payee indorses the check, at which point the payee becomes an indorser and has potential indorser liability on the check. A payee who never indorses a check is not a party to the check and cannot ever be liable on the check.

Any holder of the check (i.e., one who obtains possession of the check via a valid negotiation) who indorses the check also becomes an indorser and is potentially liable on the check.

14

There are two main roles banks play in the process. A bank in which a check is deposited is the depositary bank. This title is based on the role the bank plays. Every bank acts as a depositary bank when the bank takes checks as deposits. The depositary bank is very important in the check processing system, and there are some special rules for depositary banks. The depositary bank puts the check into the check collection system, which routes the check to its home bank, which we call the drawee or the payor bank.

The drawee/payor bank is the bank where the account holder has an account. If you have an account at Chase and write a check from that account, Chase is the drawee/payor bank. Only Chase can pay or dishonor your check. No other bank does that. Presentment is what we call it when a check is presented to the drawee/payor bank for payment. No other transaction is presentment.

It’s important to understand these points because the bar exam often gets these parties and steps mixed up. The questions in this area are very badly written. The examiner often speaks of a check being presented for payment when the check is actually being deposited with a depositary bank. You must recognize those errors and move past them. Know how the system works and answer the questions accordingly.

The other key element of these bar questions requires knowledge of the properly payable and wrongful dishonor rules. There are two basic ways a check can be properly payable:

1. the check is good (i.e., there is nothing wrong with it – no forgeries or alterations and it was authorized)

2. the check is deemed valid by a special validation rule (e.g., negligence, the bank statement rule, employee indorser rule, etc.)

The bar exam questions in this area typically ask which party will bear the loss on a check, and the primary candidates are: drawer, drawee/payor bank, or depositary bank. To answer these questions, you must know the basic liability rules, the properly payable rules, the basic loss allocation rules, and the validation rules. The first three are simple and you must know them well. The validation rules are somewhat complex, but the good news is that the bar focuses on just two of them: negligence and the bank statement rule (BSR).

The bar has not asked about warranty liability in the last six years. There have been no questions about indorser liability either, though there have been questions about whether a particular transfer of a check was a valid negotiation or whether a particular party was a HDC. The latter questions don’t raise any check-specific issues, so we don’t deal with them here.

There are two basic hypos used with these questions, and they raise very different issues. In the first, call it Hypo A, the drawer writes the check or

15

authorizes someone to write it, but later either can’t pay or issues a stop payment order. Sometimes the check is honored by the drawee/payor bank. When that happens, the question will ask whether the drawer or drawee will bear the loss. Unless there is some other material fact added to the hypo, the drawer will bear the loss because these checks are properly payable.

Sometimes the check is dishonored, usually because of a stop payment order. When that happens, the check is returned to the depositary bank. The question usually asks whether the depositary bank or the drawer will bear the loss. The answer is the same as above. The drawer is liable. When a check is dishonored, the drawer becomes liable on the check. So if there are no other material variations in the facts, the drawer is liable in these hypos whether the check is honored or dishonored.

What sort of material variation can change that result? Theft of the check and forgery of the payee indorsement is the most common one, and probably the only one you will see on the bar. In other words, the check was good when written and delivered to the payee, but it was later stolen and the payee’s name forged on the check. That breaks the negotiation chain, meaning no subsequent taker of the check can be a holder. That also means the check is not properly payable.

When this happens, the drawer will not be liable on the check. That’s the result, whether the check is honored or dishonored. If the drawee/payor bank honors the check in this variation, the bank must recredit the drawer’s account. The drawee/payor bank probably can move that loss back up the chain using warranty claims, but the bar has not asked for that analysis.

What if this stolen and forged payee check is dishonored (e.g., because the drawer learned of the theft and issued a stop payment order)? The check is returned to the depositary bank. The dishonor of the check does trigger drawer liability, but the depositary bank is not a holder, so it has no claim against the drawer. The only party in the chain who could possibly enforce the check against the drawer is the real payee. The bar usually asks if the depositary bank can enforce the check against the drawer. If the check was stolen and the payee indorsement forged, the answer will be NO.

That’s it for the first hypo type. If you pay attention and take it step-by-step, it’s not difficult. But if you panic, these questions can be confusing.

The second hypo, call it Hypo B, involves a number of forged checks by someone the account holder knows and trusts. In this scenario, the forger steals blank checks and forges the account holder’s name on the drawer’s signature line. Most of the time, the checks are written to other parties (e.g., to Macy’s or Dillard’s). The account holder doesn’t notice the problem until a few months later, and then wants its bank to recredit the account for all the forged checks.

16

This scenario raises a few important issues. First, these checks are not properly payable because the account holder never signed them. So as between the account holder and the drawee bank, the bank generally bears the risk of loss for these checks.2

Second, under the general loss allocation rules, the drawee/payor bank bears the loss for these checks. This may seem like the same result, but in the second setting, we are talking about allocating the loss between the parties other than the drawer. The point here is that for a forged account holder’s signature check, the drawee/payor bank cannot shift that loss to anyone else under the general rules.

Third, you need to look for a validation rule that might allow the bank to shift some or all of the loss back to the account holder. Two validation issues typically arise in these questions: negligence and the bank statement rule (BSR). These are the BSR questions, and many students struggle with these questions. There is no excuse for that. It’s not difficult. It does take some practice, and it does require attention to detail. But with practice and care, anyone can handle these questions.

The negligence rule is fairly simple. It says that if a party’s own negligence “substantially contributes” (those are the magic statutory words, so use them!) to the forgery or alteration, the party is precluded from raising the forgery. Presto, it’s like the forgery didn’t happen. That’s what validation rules do. They undo bad stuff like forgery or fraudulent alteration. These rules are, however, comparative negligence rules. So if it turns out the bank was also negligent, you might get some split in liability for a check or group of checks.

The BSR is simply a specific application of negligence standard. The BSR is a type of negligence that has been codified into a bright line rule. The BSR includes some specific requirements, and when those requirements are met, the drawee bank can shift a loss to the drawer. Not surprisingly, the bank has the burden of proving the requirements of the BSR.

There are two ways a bank and win using the BSR. First, any time a party is late reporting a bad check, the bank can avoid taking the loss if the bank can prove that it suffered a loss due to the delay. This is very hard for the bank to do. We won’t go into details here, and you shouldn’t on the bar, because I have not seen a single bar exam where this standard was met. You should know the rule, and I would write it down on the exam and state that it isn’t satisfied. Beyond that, don’t worry about this one.

The second part of the BSR applies to repeated forgeries by the same wrongdoer, and this is the scenario that appears frequently on the bar. This is a great example of a situation where you need to keep the big picture in mind. This

2 These checks are often called “forged checks,” meaning the account holder signature was forged.

17

rule allows the bank to put some of the loss on the account holder if the account holder could have and should have done something earlier to stop this pattern of forgeries. That’s pretty clear, right?

So what if your answer says the account holder bears the loss for the first few checks but not for the last few checks? I’ve seen exactly that answer on final exams. Think about it. That’s got to be backwards! The whole point of this rule is to say that after a certain time period, the account holder will take the loss. So don’t ever go with an answer that says the opposite! If there is a split in the result (i.e., the account holder taking the loss on some checks and the bank taking the loss on some), then the bank will take the loss on the earliest checks and the account holder will take the loss on the later checks.

Here are examples of actual bar questions on these topics.

Example One - Sam owns a convenience store. He employs Adam as a part-time manager

of the store. On days when Adam is on duty, Sam leaves checks from his personal bank account

in the checkout register so that Adam can pay for deliveries of supplies. Sam signs and dates the

checks with a current date and makes them payable to “cash.” He leaves the payment amount

blank. Jack is a vendor who supplies milk and soft drinks to Sam’s store. Jack makes deliveries

to Sam’s store every Saturday. Sam is dissatisfied with Jack’s last delivery, because the milk and

soft drinks he delivered were past their expiration dates.

The following Saturday, Adam is on duty at the store when Jack arrives with a delivery

of milk and soft drinks. Jack presents Adam an invoice for $2,000. Without inspecting the goods,

Adam fills out one of Sam’s checks in the amount of the invoice and gives it to Jack. Sam arrives

at the store on Monday morning and discovers that the milk and soft drinks delivered on

Saturday are again past their expiration dates. Sam calls his bank (First Bank) to stop payment,

but the check has already cleared.

On the Saturday that Jack received the check from Adam, Jack endorsed the check and

delivered it to his sister, Jill. Jill was aware of tension between Sam and Jack in their business

dealings and accepted the check from Jack. Jill paid Jack $1,800 for the check and kept the extra

$200 as a service charge for cashing the check on the weekend. Jill then delivered the check to

her boyfriend, Mike, in repayment of a debt that she owed him for a vacation they took last

summer. Mike endorsed the check in blank with his signature and deposited it into his account at

Second Bank. The check cleared and Mike’s account was credited for $1,800.00.

A. Who will bear the risk of loss between Sam and First Bank for payment of the check

given to Jack by Adam? Discuss.

B. What defenses might be available to First Bank in an action against the bank for

wrongful payment of the check? Explain your answer fully.

18

C. What is required for Jack to negotiate Sam’s check to Jill? What is required for Jill to

negotiate Sam’s check to Mike? Explain your answer fully.

D. Did Jill become a holder-in-due course of Sam’s check? Explain why or why not.

E. Did Mike become a holder-in-due course of Sam’s check? Explain why or why not.

Answer – First, note that only parts A and B deal with check issues. The rest of the questions are about negotiation and HDC rules. This is a very poorly written question, and I’ve criticized it before. You must get past that and give the examiner what he’s looking for. Even that is challenging on part B. Sample answers follow:

A. Sam signed this check and authorized Adam to complete the check. The check is properly payable, and Sam, therefore, is liable for the check. Sam bears the risk posed by signing an incomplete check, so he would take the loss even if Adam had not been authorized to complete and issue the check.

B. This check was properly payable and was paid, so there was no wrongful payment. The bank needs no defenses, because Sam has no claim against it. Only the drawer can sue the drawee bank for paying the check, and Sam has no claim. First Bank is in the clear.

The bar has asked this question twice. I’ve strongly criticized it, and others have, too. Will it appear again? I hope not.

What should you do with this hypo? Spin out variations on it. What if Adam had completed the check in a fraudulent manner? What if Adam completed the check and someone stole it from the payee?

There is one especially troubling aspect of this question. The sequence is impossible. The check was issued on Saturday, and a stop payment order submitted on Monday morning. Even if the check was presented to First Bank for payment first thing Monday morning (i.e., the earliest possible time), the bank had until midnight Tuesday, as the earliest, to decide whether to honor the check. The stop payment order could not have been too late, but the question tells us it was.

I would not discuss that in an answer, but it does make for a couple of good variations. First, what if the stop payment was timely, but the bank paid the check anyway? Then Sam would have a claim for wrongful payment against First Bank, and First Bank would need a defense. First Bank would have a defense by subrogating itself to the position of the depositary bank, which probably was a HDC. Because Sam would have to pay the HDC, First

19

Bank could avoid having to recredit Sam’s account. This is a more difficult question than the bar has asked in the past, but it is a fair one.

A second variation would be for First Bank to have complied with the stop payment and dishonored the check. This is what probably would have happened under these facts. The question would not be about liability between First Bank and Sam, because First Bank would have complied with Sam’s instructions to dishonor the check. The question would be whether Second Bank (i.e., the depositary bank) could enforce the check against Sam. It probably could, because it probably is a HDC.

Example Two - Mary’s son, Paul, is in financial trouble and recently filed for bankruptcy. He is now living back at home. Mary welcomes her son home and tells him to help himself to whatever he needs. She also asks Paul to purchase some groceries and authorizes him to sign one of her checks to get himself some cash for the groceries. Mary is the only authorized signatory on her checking account. Paul locates his mother’s checkbook and signs/dates a check payable to bearer in the amount of $150. After cashing the check at the Bank, Paul meets his girlfriend on the way to the grocery store. He changes his mind about grocery shopping and decides to take his girlfriend out to lunch. He spends all of the money ($150) on a lunch date at Commander’s Palace. The next month, Paul goes shopping at Dillard’s to buy himself new clothes. He writes another check drawn on Mary’s checking account payable at Dillard’s for $1,000 to pay for his clothes shopping spree. One month later, Paul goes shopping to Macy’s to buy himself some more clothes. He writes another check drawn on Mary’s checking account payable to Macy’s for $1,000. When Mary reviews her preceding two bank statements the next month, she discovers the checks written on the account to Dillard’s and Macy’s. She then looks back at her earlier bank statement from three months prior when Paul started living at home and recalls she authorized the check for $150 for the cash to buy groceries, but not the other two checks. Mary confronts Paul. Paul admits that he used the $1,000 checks to buy clothes and he admits he used the cash from the $150 check to take his girlfriend out to lunch and not to buy groceries. Mary immediately calls the Bank and advises the Bank of the checks misappropriated by Paul and asks that the Bank credit her account.

Question - Will the Bank be liable to refund to Mary’s account the check written

by Paul for $150? Discuss fully why or why not.

Answer – Mary authorized Paul to write this check, so his signature on the check as drawer was authorized. She authorized him to cash the check, so that act was authorized, too. Paul didn’t use the money as Mary intended, but that does not render his signature on the unauthorized. Because this check had an authorized signature on it, the check was properly payable, and Mary is responsible for it.

[This is somewhat close scenario, and some students will get it wrong.

That’s ok. If you recognize that the issue depends upon whether the check was authorized, then you should get most of the credit. The reason courts will always

20

put this loss on Mary is that she was foolish enough to authorize Paul to write out a check to cash. That’s like giving him cash. Once you do that, you take the risk that the recipient will use the cash in ways you didn’t intend.]

Question - Will the Bank be liable to refund to Mary’s account the $1,000 checks

to Dillard’s and Macy’s? Discuss all the Bank may argue in favor of not being fully liable for these checks.

Answer – Paul’s signature on these two checks was unauthorized, and as a

result, the bank would generally bear the risk of loss. There are, however, exceptions to that general rule. The most likely exception here is the negligence rule, which prevents a person from asserting a forgery or unauthorized signature if that person’s own negligence substantially contributed to the acts. Here, Mary allowed Paul access to her checkbook, and that access did substantially contribute to Paul’s bad acts. But was Mary negligent in allowing Paul such access.

That’s a close call. Paul was in financial trouble and had filed for

bankruptcy. But he was her son, and the facts do not suggest Mary had reason to expect her son to defraud her or steal from her. I think Mary acted as a reasonable mother would, and that Paul’s financial troubles were not enough to render Mary’s actions negligent. Therefore, the bank will still bear the loss for these unauthorized checks. It is close, however, and if a court found Mary negligent, then she would bear the loss. It is clear that her failure to keep her checkbook hidden from Paul substantially contributed to his writing these two checks.

The BSR does not help the bank here, because both checks were written

during the protected period under the rule. Even where the same wrongdoer forges multiple checks over time, the drawer is protected for a reasonable period of time. The drawer is given 30 days from the receipt of the first bank statement showing an unauthorized check. During that period (i.e., until the end of that 30 days), the drawer will not be liable for the checks under the BSR.

In this fact pattern, the $150 check was authorized, so it does not start the

BSR clock. The two unauthorized checks were only one month apart. That means the second check was written during the protected period. The first statement to show an unauthorized check came at some point after the first check was written. Mary had 30 days after receipt of that statement, which had to extend to more than one month after the first check was written. That means the second check (i.e., written one month after the first) fell within Mary’s 30-day review period. For that reason, the BSR will not help the bank avoid this loss.

[I disagree with the BAR/BRI model answer on this question, because I

believe you should discuss the BSR, even though it doesn’t help the bank in the end. Note the question explicitly asks you to discuss all the bank may argue in its favor. It’s true that the BSR doesn’t end up favoring the bank, but you have to

21

walk through it’s requirements to know that. Because the bar often asks about the BSR, I would include it in this answer.]

[Also, if you concluded that the $150 check was unauthorized, you will

get a different result using the BSR. You will conclude (if you apply the BSR correctly) that the last check is outside Mary’s 30-day review period, and therefore, that Mary is responsible for that check. This is wrong, because the first check was authorized. Missing that point will hurt you on both parts of this question. But, if you apply the BSR correctly, you should get most credit on the second part. Also, you must discuss the negligence rule to get full credit on the second part.]

Example Three - Adam owns several assisted care living facilities for the elderly. He

maintains a checking account for the business with First Bank (“the Bank”) and pays the

business expenses from that account. Adam’s best friend from childhood, Bruce, has been

recently released from an addiction treatment center and has asked Adam if he can live with him

until he can afford to live on his own. Adam agrees and also puts Bruce to work by having him

handle certain administrative tasks for the business. One of these tasks is having Bruce pay the

expenses of the business by filling out checks for Adam to sign, which are made payable to

various trade creditors of the business. In March 2011, Bruce fills out several checks drawn on

the account at the Bank and made payable to accounts payable of the business. Bruce also adds a

check to himself for $1,000. Bruce intends to ask Adam about paying him (Bruce) monthly for

this work in the amount of the check (i.e. $1,000 per month). Bruce absent mindedly forgets to

discuss the checks with Adam and instead forges Adam’s signature. Bruce later forges three

more checks payable to himself over the next three months. The checks made payable to Bruce

are for $1,000 each and are dated the fourth of each month for four consecutive months, i.e.

March 4, 2011, April 4, 2011, May 4, 2011 and June 4, 2011. Bruce deposits each of these

checks into his personal bank account on the fifth day of each month, respectively.

On July 1, 2011, Adam receives and opens his bank statement for the month of June 2011

and discovers a check for $1,000 which Bruce forged and dated June 4, 2011. Adam then checks

his bank statements for the months of March, April and May, which he also received on the first

day of the next month, respectively, i.e. March statement received on April 1, April statement

received on May 1 and May statement received on June 1. At this point, he discovers the other

three checks (March, April and May), which were also forged by Bruce.

Question – Who will bear the risk of loss on a check bearing a forged

signature of the account holder?

Answer – [This question is asking about the standard scenario rules. Anytime the question asks about the general rule or does not identify a specific check or group of checks, provide the standard scenario rules.]

22

The drawee/payor bank bears the risk of loss for a check with a forged drawer’s signature. This is the general rule.

Question – Adam is concerned that he permitted Bruce access to his checkbook. Does this have a bearing on which party will bear the loss for the forged checks?

Answer – [Note the examiner is breaking up the exceptions on this exam, and is asking only about the negligence rule here. That makes it easier.]

Yes, if Adam was negligent in allowing Bruce access to the checkbook, and if that negligence substantially contributed to Bruce’s forgeries, then Adam will be precluded from asserting the forgeries against a party who paid the checks in good faith. The bank probably paid the checks in good faith, and Bruce’s access to the checkbook did substantially contribute to the forgeries. The only question is whether Adam was negligent in allowing Bruce access to the checkbook. That is a close call. Bruce’s addiction, plus his financial troubles, may be enough to warrant more caution by Adam. I’d say Adam was not negligent under these circumstances. As a business, it’s reasonable for Adam to have someone preparing checks, and Bruce’s history is probably not enough to make him an unreasonable choice for that role. [Your conclusion here probably doesn’t matter. Use the right analysis, and you should get full credit, because it is a close call.]

Question – What other defenses could the bank raise regarding the checks Bruce forged?

Answer – [This is the BSR part of the question. Just apply the rule, step-by-step.]

We need the timeline of the checks and the bank statements to determine whether the bank can shift some of the loss to Adam under the BSR. Adam is given 30 days after receipt of the first statement showing an unauthorized check to report the problem to the bank.

For any checks written before the end of that 30 day period, the bank will bear the loss unless it can prove that it suffered a loss due to Adam’s delay in reporting. This is hard to do, because it means the bank must prove it cannot now recover from Bruce, but that it could have recovered from Bruce if Adam had reported the problem earlier. There are not sufficient facts to resolve this issue, since we don’t know if Bruce is still around or if he still has the money.

As for the checks Bruce forged after the 30-day review period, Adam will bear the loss for those checks under the BSR. The last two checks were

23

both written after the review period, and therefore Adam takes the loss for those checks.

The bank takes the loss for the first two checks, unless it can prove a loss due to the delay in reporting, as explained above. Adam takes the loss for the last two checks.