Negotiable Instruments, Credit, and Bankruptcy

1. Negotiable Instruments, Credit, and Bankruptcy Chapter 13 Meiners, Ringleb & Edwards The Legal Environment of Business, 12th Edition

2. Chapter Issues • Negotiable Instruments • Credit • Bankruptcy

3. 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

4. The Concept of Negotiability • Can be transferred to another party • Assigned - Assignee has same rights and responsibilities as assignor • Transferred by negotiation - Transferee takes instruments free of transferor’s responsibilities • Transfer order instrument by: • Payee endorses and • Delivers instrument to third party • Bearer instruments • Drawer my create “to bearer”; “to the order of bearer”, payable to bearer,” “to cash” or“pay to the order of cash” • Risky – if lost, can be cashed by finder • Transfer bearer instrument bydelivery

5. 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

6. Requirements for Holders in Due Course • Person in possession of negotiable instrument may be ordinary holderorholder in due course • Ordinary holderhas same contract responsibilities as assignee – holder in due coursedoes 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

7. International Perspective“MIXING RELIGION AND FINANCE” • In U.S. laws limiting high interest rates (usury) can be traced to Christian views that the practice is sinful. • Islamic limits on interest are even more stringent. • Some Islamic countries prohibit “banking as usual”, such as charging interest on loans & paying interest to depositors. • Many believers in the Koran hold this to be haramor banned by Islam. • In Malaysia and other countries, banks consult with advisers on Shariah (Islamic law) about what forms of loans and repayments are acceptable. • Modern financial instruments are now more widely available – but the presentation is different. (Continued)

8. International Perspective“MIXING RELIGION AND FINANCE” • Example: Conventional finance company may borrow $100 million and pay 6% ($6 million/year) on 10-year note. • Then repay principal. • Under rules permitted (halal) by some Islamists, the borrowing company transfers assets, like buildings to a legal entity like a trust (ijara sukuk). • Company leases assets back for payments of $6 million/year. • Borrower also pledges to buy back assets at the end of 10 years for $100 million. • Not all Islamists agree this is acceptable. • However, many banks using this method have seen explosion of growth.

9. 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 • See Exhibit 13.1

10. CaseAssociated Home and RV Sales v. Bank of Belen • Plaintiff sells recreation vehicles under trade name Enchantment. • Hired Ramos to assist with bookkeeping • In 20 months, Ramos forged 211 checks payable to herself or “to cash”; $283,547 stolen from Enchantment • Managers discovered forgeries and notified bank. • Bank refused to cover loses • Said it sent monthly statement • Included photocopies of cancelled checks • Enchantment sued Bank of Belen for common law fraud and negligence and for negligence under the UCC. • Trial court granted summary judgment to bank. • Enchantment appealed. (Continued)

11. CaseAssociated Home and RV Sales v. Bank of Belen • UCC states that usually common law principles are not preserved “in an area which is thoroughly covered by the UCC”. • Art. 4 of UCC: sets up a liability scheme & defenses between payor-bank and customers • A forged or altered check is not properly payable; Bank is strictly liablefor resulting losses to its customer • UCC 4-406 Bank may seek “safe harbor”from that strict liability if it makes statements available to the customer. • Customer can then ID forgery & must be reasonably prompt in notifying it to bank. This is within 30 days of receiving the statement – then bank is strictly liable for loss. • After 30-day period, bank is liable only if customer proved bank failed to exercise “ordinary care”in passing the forged item and bank “substantially contributed” to the loss. Loss is then apportioned between customer & bank based on comparative negligence. • Regardless, if a year or more has passed since customer receives statement and ID’s forgery, customer cannot bring a claim under the UCC – then customer bears the loss. • In this case, UCC 4-406 provides scheme for liability and defenses.

12. CaseAssociated Home and RV Sales v. Bank of Belen • HELD: Therefore common law claims by Enchantment are precluded. • Enchantment, however, was entitled to try to prove a lack of ordinary careby the Bank within 1 year of Enchantment alerting Bank of the forgeries. • If bank sent statements directly to Ramos, an employee, this is “a reasonable manner”of notification to Enchantment. • HELD: Summary Judgment reversed re: UCC negligence issue. • Enchantment did minimum necessary to raise issues of fact that jury may view. Jury can then determine whether Bank breached its duty of ordinary care to Enchantment.

13. Promises to Pay Notes • Promise by the makerto pay certain $ to payee • Usually called promissory notes • But also have • Collateral note • Real estate mortgage note • Installment note • Balloon note • See Exhibit 13.2 Certificates of Deposit • Bank is makerof 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

14. 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 sale of negotiable instruments subject to securities regulation • Debt financing: Borrowing money evidenced by contract • Credit Policyfocuses 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)

15. 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 – i.e. credit card • See Exhibit 13.4

16. Collections Policy • Needed for debtors who fail to make timely payments • Starts with a past-due letter • Followed by telephone call or 2nd letter • Letters may be followed by a personal visit. • Additional action may be necessary – depends on whether a creditor is unsecured or secured. • If debtor is insolvent, creditor will receive nothing.

17. Credit with Security • When creditor can take property of debtor to satisfy debt – can happen by agreement or by operation of law • By Agreement - Depends if property is real or personal • Suretyship - Promise by a third party to pay debt if debtor doesn’t • Guarantor – Provides a guarantee of payment to creditor should principal debtor fail to pay • Defenses of Sureties -Since debt falls under contract law, there are the same defenses that the principal (debtor) has – including, impossibility, illegality, duress, fraud • Surety’s Rights Against the Principal • If borrower could pay creditor but refuses to, surety is entitled to exoneration(court order for principal to pay) • Subrogation – Surety is entitled to rights of the creditor against the debtor

18. CaseGE Business Financial Services v. Silverman • Warren Park Partners, Ltd. borrowed $34.8 million from GE Financial. Bought land in Frisco, Texas. • When loan was made, Silverman & partners signed a guaranty “absolutely, unconditionally”guaranteeing full payment. • Warren Park defaulted; went into bankruptcy. GE demanded payment from Silverman. Silverman didn’t pay; GE sued. • Silverman & parties claimed affirmative defenses of (1) fraud, (2) extortion, (3) theft & (4) economic duress. • Said hours before signing the documents, GE notified them changes in terms of the agreement. They had no time to contest, as loan was needed immediately. He signed agreement because he was trapped. • Claimed GE employee told him new terms would not be enforced. • GE moved for summary judgment. (Continued)

19. CaseGE Business Financial Services v. Silverman • HELD: Summary judgment for GE. • GE offered evidence of both claims that defendants did not contest. Instead defendants asserted the 4 affirmative defenses (above). GE argued even if affirmative defenses are true, allegations are barred by the Credit Agreement Act (ICAA). • ICAA bars all actions or defenses by a debtor based on an oral agreement (similar to Statute of Frauds). • Defendants didn’t dispute that they made “credit agreements”. Defendants say ICAA does not bar their affirmative defenses. They also argue “unclean hands” of the plaintiff, GE. • The court was not swayed, because – • Oral promises by GE contradict the terms of Counts I and II; therefore the ICAA bars defendant’s affirmative defenses. • Silverman loses.

20. Secured Transactions • Product may secure debt • Commercial sale of goods - UCC Article 9 (not real estate) • Must create security interest - be sure it is: 1. Attached (Attachment) • Signed by customer • Seller provided value • Customer has legal, transferable rights in collateral 2. Perfected (Perfection) • Filing w/proper official • Interests in Inventory • As collateral, equipment, inventory, raw materials (tangible property) are used as security • “Floating Lien” Inventory • Goods held for sale as well as raw materials • Inventory is constantly changing

21. Default by Debtor • Some property my be exempt, i.e. homestead exemption(when personal assets have been placed as collateral • Default is when the buyer doesn’t repay • Creditor can take back property and keep or may resell it (in a“commercially reasonable manner”) • Any excess from sale of repossessed property over debt owed must be returned to debtor • See Fordyce Bank & Trust Co. v. Bean Timberland, Inc. • See Exhibit 13.5

22. CaseFordyce Bank & Trust v. Bean Timberland, Inc. • Fordyce Bank made series of loans to Bean Timberland so it could buy timber from landowners. Bean would cut timber and sell logs to Potlatch and Idaho Timber (P&I) – it would then mill logs into timber. Bean’s proceeds from timber sales would repay loans. • Bank perfected its interest by filing UCC Financing Statement with the Secretary of State’s Office of Arkansas. Bean sold timber but failed to repay loans; went bankrupt. • Bank sued P&I because it had a priority interest in the timber sale proceeds. Bank said P&I was negligent in its dealings for failing to do a lien search and did not “exercise good faith” required under the UCC. • Trial court held for P&I, ruling they were not negligent. • Trial court said that P&I was not required to perform a security interest search in the “ordinary course of business.” • The bank appealed. (Continued)

23. CaseFordyce Bank & Trust v. Bean Timberland, Inc. • Under Arkansas UCC 4-9-320, a buyer in the ordinary course of business(P&I) “takes free of a security interest created by the buyer’s seller [Bean], even if the security interest is perfected [by the bank] and buyer knows of its existence.” • If P&I were buyers in “ordinary course of business”, they had no duty to perform a lien search. Even if they know of bank’s security interest, P&I can take free of Bank’s security interest. • HELD: Affirmed. P&I won. • Clear evidence that purchasing gatewood (lumber brought to the mill’s front gate, and if meets mills specs, then mill purchases it) without performing a lien search is standard timber industry practice. • P&I’s actions were “usual or customary practices” in the timber industry, and they were therefore “buyers in the ordinary course of business.” • Owed no duty to the bank to conduct a lien search.

24. 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 lienin most states • In case of default, the mortgagee has the right to foreclose on property • Deficiency judgment:If proceeds from foreclosure not sufficient, a separate legal action against debtor is maintained • Most mortgages are non-recourse debt – Lender can seize collateral/property but not seek a deficiency judgmentfor money owed not covered by sale of property • Statutory redemption: Period of time mortgagor has the right to redeem the property by paying the debt (normally within 6 months after default) • Most states have this procedure

25. Liens • Nonconsensual lien • Obtained by Operation of Law No Need for Debtor’s Consent • Procedures of using liens under state statutes; Must be removed before property is sold • Mechanic’s Lien • Party that furnished material, labor, or services for construction or repair of building or other real property places the lien • Possessory or Artisan’s Lien • Party that added value to or cared for personal property puts on lien • Court-Decreed Liens • Attachment lienis court-ordered seizure of goods throughwrit of attachment • Judgment lien occurs when creditor has successful action against debtor; If debtor doesn’t pay judgment, creditor asks court forwrit of execution

26. CaseSummers Group, Inc. v. Tempe Mechanical, LLC • Summers Group d/b/a Rexel, sold electrical materials for construction on property owned by Metro Lofts. Rexel was not paid on June 26, 2008 and recorded a mechanic’s lien on Metro Lots property. Other contractors on the work including Tempe Mechanical, also filed liens against Metro Loft. • No payment received – Rexel brought suit on December 24, 2008 against Metro Lots and all other lienholders. Some of lienholders (contractors) did not respond – had default judgments. • Tempe, answered Rexel’s complaint • Metro was in bankruptcy & under control of bankruptcy trustee ML Manager. • All parties agreed bankruptcy court would determine priority of payment of liens. • ML Manager argued that it stood first to receive payment, since it should not be challenged and that Rexel should pay all attorney fees related to litigation. • Trial Court agreed. • Rexel appealed. (Continued)

27. CaseSummers Group, Inc. v. Tempe Mechanical, LLC • Arizona law establishes lien procedures, including naming of all other mechanics’ lien claimants if those others fail to file a lien themselves. Remaining Lien Claimants asserted their lien priorities. • The bankruptcy court’s decision also affected their claims. Therefore ML Manager had to defend its lien priority. Statute requires that when sale is ordered in mechanics’ lien foreclosure action, proceeds are prorated over all lienholders that have equal footing with the foreclosing lien. Attorneys fees are apportioned between successful and unsuccessful efforts. • HELD: Reversed and Remanded. • Trial court erred in holding Rexel solely responsible for payment of ML Manager’s attorney fees. These fees should be prorated among lien claimants. • Intent of statute is to create an even playing field for all who provided services and materials, regardless of date work was performed. • All Remaining Lien Claimants will be liable for ML Manager’s attorney fees in proportion to their claims.

28. Bankruptcy • Purpose: Orderly resolution where debtor owes more than can be paid. • Federal Bankruptcy Code has been amended – most recent revision was The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. • Most bankruptcies involve individuals. • A person must take credit counseling before filing bankruptcy. • After filing bankruptcy, there must be debtor education about budgeting, use of credit, etc. • Key feature: fair treatment of creditors

29. Personal Bankruptcy • Most bankruptcies involve individuals. • Creditors usually do not get paid. • Before filing, person must complete a debtor education course. • Dept. of Justice’s U.S. Trustee Program approves organization s to provide mandatory credit counseling & debtor education. • Credit counseling is taken before filing bankruptcy. • Debtor education is taken after filing. • Income and Means Testing • Income test determines if person files under Chapter 7 (liquidation) or Chapter 13 (reorganization of debts). • People with higher income less likely to have debts extinguished. • There is a test of income against expenditures – to see if person is living above average for a given income level.

30. Chapter 7 • Most bankruptcies are voluntary, but creditors may force an involuntary proceeding. • Some assets, such as car, clothing, appliances, some home equity and pension are exempt. • Upon filing, there is a freezeon actions against the debtor and the debtor’s property. • Trustee is appointed to administer the debtor’s estate. • Assets are liquidated and proceeds distributed to creditors. • After discharge, debtor is not liable for debts covered by proceeding. • Liquidation and fair distribution of debtor’s non-exempt assets to creditors.

31. Chapter 13 • Available only to individuals; only voluntary option. Sole proprietorship owned by an individual may file under Chapter 13. • Debtor files plan for payment of creditors over time. Usually over 5 years. • Debtor keeps property and shares administration of the bankrupt estate with court-appointed trustee. • Trustee makes sure payments are made and that creditors don’t try to “go around” fixed payment schedule. • Court protected debt repayment plan. Confirmation Plan that was approved makes these payments. • Debts of those bankrupt not discharged. • Long-term secured debt (i.e. house mortgage) treated differently. • IF plan fails, possible to shift to Chapter 7 for hardship discharge.

32. Priority Classes of Creditors • Secured creditors • Costs of preserving and administering debtor’s estate • Unpaid wage claims • Certain claims of farmers and fishermen • Refund of security deposits • Alimony and child support • Taxes • Unsecured creditors • All creditors of a particular class must be paid before going to next class

33. CaseIn re Darby • After Darby filed Chapter 13 bankruptcy, Time Warner canceled cable service. Darby filed motion with bankruptcy court to compel Time Warner to reinstate his service, with his assurances of future payment. • Bankruptcy Court and District Court ruled that cable service was not a “utility” that must be provided as a “necessity” under law. Darby appealed. • HELD: Affirmed. Cable service is not a “necessity”. • Bankruptcy laws give protections to debtors from cut-off of service by a utility after they file for bankruptcy. • Utilities are “necessities” and must be provided to debtors. Includes electric company, gas supplier or telephone company that is a monopoly in the area. • Cable service is not a “necessity”, and bankruptcy court need not require its reinstatement to Darby.

34. 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 • Staysfurther 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

35. CaseIn the Matter of Kmart Corporation • Kmart consists of parent company and 37 affiliates and subsidiaries. • Kmart, requested to pay, in full, claims of “critical vendors.” Kmart said that if it didn’t pay these vendors, they would not do business in the future and were necessary for Kmart to stay in operation. • Bankruptcy judge agreed – granted order. No notice to disfavored creditors. • Kmart determined the critical vendors, paying 2330 suppliers $300 million. • Other 2000 vendors not paid, and 43,000 additional unsecured creditors received 10 cents on the dollar (mostly in stock of reorganized company). (Continued)

36. CaseIn the Matter of Kmart Corporation • Some of creditors appealed. • District court reversed order of payments to critical vendors. Decision was appealed. • HELD: Affirmed. • Kmart argued that the District Court’s reversal order was too late – money had already changed hands. • To order payment of critical vendors, it is necessary to show • (1) Disfavored creditors will be as well off with reorganization as with liquidation (this was never demonstrated), and • (2) That critical vendors would cease deliveries if old debts were left unpaid during litigation. This was not always true, i.e. some of the critical vendors must continue business due to have long-term contracts