Commercial paper is the legal term for negotiable instruments such as promissory notes, checks, drafts, and certificates of deposit. These documents function as substitutes for money and as tools for credit, and their special legal status allows them to move through the economy quickly. Article 3 of the Uniform Commercial Code governs negotiable instruments, while Article 4 deals with bank deposits and collections. Understanding negotiability is a core part of commercial law on paralegal exams.

Types of Negotiable Instruments

Article 3 recognizes two basic forms:

Notes: a two-party instrument in which the maker promises to pay money to the payee. Promissory notes and certificates of deposit are examples.
Drafts: a three-party instrument in which the drawer orders the drawee to pay money to the payee. Checks are the most common draft, a draft drawn on a bank and payable on demand.

Requirements for Negotiability: UCC 3-104

For a writing to be a negotiable instrument, it must satisfy all of the following:

Be in writing and signed by the maker or drawer. A signature can be any symbol adopted with present intent to authenticate the writing.
Contain an unconditional promise or order to pay. A note must contain a promise; a draft must contain an order. A statement that the payment is subject to or governed by another agreement can destroy negotiability, though a mere reference to the transaction does not.
State a fixed amount of money, with or without interest or other charges described in the instrument. The sum must be ascertainable from the face of the instrument, though a variable interest rate is permitted.
Be payable to bearer or to order at the time it is issued or first comes into possession of a holder. A check is excepted from the order language requirement in some cases.
Be payable on demand or at a definite time.
Not state any other undertaking or instruction by the person promising or ordering payment to do any act in addition to the payment of money, with limited exceptions such as terms about collateral or waivers of benefits.

A document that fails any requirement is not a negotiable instrument. It may still be an enforceable contract, but the special rules of Article 3 will not apply.

Negotiation and Indorsements

Negotiation is the transfer of possession of an instrument by a person other than the issuer to a person who becomes its holder. An instrument payable to bearer is negotiated by transfer of possession alone. An instrument payable to order requires transfer of possession and the indorsement of the holder.

Types of Indorsements

Blank indorsement: only a signature, which makes the instrument payable to bearer.
Special indorsement: names the person to whom the instrument is payable, which requires that person's indorsement for further negotiation.
Restrictive indorsement: such as "for deposit only." Under current Article 3, such restrictions generally affect only the first transferee in limited ways, and the bank must act consistently with them.
Qualified indorsement: usually "without recourse," which disclaims the indorser's contract liability for payment but not the transfer warranties.

Holder in Due Course

The central concept of commercial paper is the holder in due course (HDC). Under UCC 3-302, an HDC is a holder who takes the instrument:

For value;
In good faith, meaning honesty in fact and observance of reasonable commercial standards of fair dealing;
Without notice that it is overdue, has been dishonored, contains an unauthorized signature or alteration, has an adverse claim, or that a defense or claim exists; and
Where the instrument does not bear apparent evidence of forgery, alteration, or irregularity that calls its authenticity into question.

Why HDC Status Matters

An HDC takes the instrument free of most defenses and claims. This is what makes commercial paper reliable. A person who purchases a note can enforce it even though the original borrower might have had a defense against the original payee.

Shelter Rule

Under the shelter rule (UCC 3-203), a transferee of an instrument acquires the rights of the transferor, including HDC rights, even if the transferee is not an HDC. An exception exists for a transferee who engaged in fraud or illegality affecting the instrument.

Defenses: Real and Personal

Real (Universal) Defenses

These are good against even an HDC:

Infancy, to the extent it is a defense to a simple contract.
Duress, lack of legal capacity, or illegality that renders the obligation void.
Fraud in the factum, also called fraud in the execution.
Discharge in insolvency proceedings.
Forgery or lack of authority, which makes the signature ineffective.

Personal Defenses

These are good against ordinary holders but not an HDC, and include breach of contract, failure of consideration, fraud in the inducement, nonperformance, and ordinary duress or misrepresentation that is not void. The FTC Holder Rule adds a significant twist in consumer credit sales, preserving the consumer's defenses against assignees of the credit contract.

Liability of the Parties

Makers and acceptors are primarily liable on the instrument.
Drawers and indorsers are secondarily liable, which means they are liable only if the instrument is properly presented, dishonored, and notice is given where required.
Transfer warranties (3-416) and presentment warranties (3-417) impose liability independent of signature liability.

Signature liability requires that a person sign the instrument; an unsigned person is not liable on it. Agents who sign on behalf of a principal are not personally liable if the instrument shows the principal's name and the agent's representative capacity.

Frequently Asked Questions

Is a check a negotiable instrument?

Yes, as a draft drawn on a bank payable on demand, provided it meets the 3-104 requirements.

Is a note secured by a mortgage still negotiable?

Generally yes. Reference to collateral does not destroy negotiability.

What happens if an instrument is incomplete?

An incomplete instrument can be enforced as completed, if completed as authorized, and an HDC can enforce it as completed in some circumstances.

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Understanding Commercial Paper and Negotiability: UCC Article 3 Made Simple