Defenses To Payment Of Negotiable Instruments
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CPA Regulation (REG) › Defenses To Payment Of Negotiable Instruments
Under UCC Article 3, defenses to payment of a negotiable instrument are classified as either real (universal) defenses or personal (limited) defenses. Which of the following is a real defense that is effective against even a holder in due course (HDC)?
Failure of consideration by the original payee.
Forgery of the maker's signature on a promissory note.
Fraud in the inducement that caused the maker to sign the instrument.
Breach of contract by the original seller of goods.
Explanation
Real defenses are effective against all holders, including holders in due course. Forgery of the maker's signature (or the drawer's signature) is a real defense because a forged signature is wholly inoperative under UCC Section 3-403; the person whose name was forged has no obligation on the instrument. Answer A (failure of consideration) is a personal defense, not effective against an HDC. Answer C (breach of contract) is a personal defense arising from the underlying transaction. Answer D (fraud in the inducement) is a personal defense; only fraud in the factum - where the signer did not know they were signing a negotiable instrument - is a real defense.
Fraud in the factum (also called real fraud) is a real defense to payment of a negotiable instrument. Which of the following scenarios best illustrates fraud in the factum?
A party signs a note knowing it is a promissory note but is induced to do so by false representations about the interest rate.
A party signs a note under economic pressure but understands the nature and terms of the document.
A buyer signs a promissory note to purchase equipment but the seller misrepresents the equipment's quality.
A person signs a promissory note believing it to be an autograph request, having no knowledge that the document is a negotiable instrument.
Explanation
Fraud in the factum occurs when a person is deceived about the very nature of the instrument being signed - they do not know they are executing a negotiable instrument at all. This is a real defense effective against all holders, including an HDC. Answer B describes fraud in the inducement, a personal defense, where the signer knew they were signing a note but was misled about the underlying transaction. Answer C is also fraud in the inducement; the signer knew the document was a promissory note. Answer D describes duress or undue pressure but not fraud in the factum because the person understood what they were signing.
Discharge in bankruptcy is a real defense to payment of a negotiable instrument. Which of the following correctly explains why discharge in bankruptcy is a real defense?
Because federal bankruptcy law overrides state commercial paper law, and the discharge is effective against all creditors, including subsequent holders in due course.
Because the maker's obligation is satisfied when the bankruptcy court issues its discharge order.
Because the HDC knew about the bankruptcy when acquiring the instrument.
Because bankruptcy courts have jurisdiction over all state law claims.
Explanation
A discharge in bankruptcy is a real defense because it is granted by federal law, which supersedes state commercial law. The Bankruptcy Code discharge extinguishes the personal liability of the debtor on the debt, and this protection runs against all creditors including HDCs. The discharge is effective against subsequent transferees regardless of their HDC status because federal law cannot be overridden by a state's commercial paper rules. Answer A is overly broad and does not explain the real defense classification. Answer B is partially correct conceptually but does not explain why the defense is effective against an HDC specifically. Answer C incorrectly conditions the defense on HDC knowledge.
Orion Corp issued a promissory note to Belmont Supplies as payment for goods. Belmont subsequently negotiated the note to First National Bank, which qualifies as an HDC. Orion later discovers that Belmont delivered defective goods. Can Orion assert the defective goods defense against First National Bank?
No, because the defective goods defense is a personal defense that cannot be asserted against an HDC.
No, but only if the defect was discovered after the note was transferred to First National Bank.
Yes, because material defects in goods are a real defense under UCC Article 3.
Yes, because First National Bank stepped into Belmont's shoes and takes the note subject to all defenses.
Explanation
The defense of defective goods (failure of consideration or breach of contract) is a personal defense arising from the underlying transaction between Orion and Belmont. Under UCC Section 3-305(b), personal defenses are cut off when the instrument is transferred to an HDC. First National Bank, as an HDC, takes free of Orion's personal defense based on the defective goods. Orion's remedy is against Belmont, not the bank. Answer A is incorrect because an HDC does not step into the transferor's shoes for personal defenses. Answer C is incorrect because defective goods constitute a personal defense, not a real defense. Answer D is incorrect because the timing of discovery is irrelevant; the personal defense is cut off when an HDC acquires the instrument.
Duress that renders a contract void (as opposed to merely voidable) is classified as a real defense to payment of a negotiable instrument. Which of the following examples illustrates duress that would constitute a real defense?
A maker signs a note after being offered a lower interest rate that turned out to be unavailable.
A maker signs a note after being told the payee will sue them for a disputed debt if they do not sign.
A maker signs a note under economic pressure from business circumstances beyond the payee's control.
A maker signs a promissory note at gunpoint, with no true consent to the transaction.
Explanation
Extreme duress that renders the transaction void at its inception - such as signing at gunpoint - is a real defense because there was no genuine consent and the instrument is void, not merely voidable. Under UCC Section 3-305(a)(1), duress that voids the obligation is a real defense effective against even an HDC. Answer B describes economic or legal duress (threat of a lawsuit), which is typically only voidable duress and constitutes a personal defense. Answer C describes business pressure that does not rise to the level of duress voiding the contract. Answer D describes misrepresentation, not duress.
An instrument is issued without consideration (a gift check). The issuer stops payment before the donee cashes the check. The donee assigns the check to a creditor who qualifies as an HDC. Which of the following correctly states the HDC's rights?
The HDC can collect the full amount because lack of consideration is a personal defense cut off by HDC status.
The HDC cannot collect because the stop-payment order prevents collection by anyone.
The HDC cannot collect because lack of consideration is a universal defense.
The HDC cannot collect because gift checks are void instruments.
Explanation
Lack of consideration (or failure of consideration) is a personal defense under UCC Article 3. When the instrument is transferred to an HDC, personal defenses are cut off. The HDC may enforce the instrument despite the absence of consideration in the original transaction. A stop-payment order by the drawer on a check also does not defeat an HDC's right to collect; the HDC retains the right to sue the drawer. Answer A is incorrect because lack of consideration is a personal, not universal (real), defense. Answer B is incorrect because a gift check is not void; it is an enforceable instrument with a personal defense available to the drawer. Answer C is incorrect because a stop-payment order does not defeat an HDC's enforcement rights.
A promissory note contains an illegal interest rate that violates state usury law, rendering the obligation void under state law. Is this a real or personal defense, and may it be asserted against an HDC?
Personal defense; it cannot be asserted against an HDC.
Real defense; but only if the illegal interest rate exceeds twice the legal maximum.
Personal defense; it can be asserted against any holder because usury is a statutory right.
Real defense; it can be asserted against all parties, including an HDC, because illegality that voids the obligation under applicable law is a real defense.
Explanation
Under UCC Section 3-305(a)(1)(ii), illegality of the transaction that renders the obligation void under applicable law is a real defense, effective against all parties including an HDC. If the usury law makes the contract void (not merely voidable), the defense is real. Note that if the applicable law makes the contract merely voidable, it would be a personal defense. Answer A and B are incorrect because if state law voids the obligation (as opposed to making it voidable), illegality is a real defense. Answer D incorrectly conditions the defense on a mathematical threshold not found in the UCC.
A holder intentionally cancels a promissory note by writing 'VOID' across it and returning it to the maker. Under UCC Section 3-604, what is the effect of this cancellation?
The note is voidable but not void; the maker must confirm the cancellation in writing.
The cancellation is effective only against the maker but not against secondary parties.
The maker's obligation is discharged because the holder intentionally cancelled the instrument.
The note remains enforceable because cancellation requires a formal court order.
Explanation
Under UCC Section 3-604, a person entitled to enforce an instrument may discharge the obligation of a party by intentionally cancelling the instrument (such as destroying it, mutilating it, or writing 'void' across it) or striking out the party's signature. Writing 'VOID' across the instrument and returning it constitutes an intentional cancellation, discharging the maker's obligation. Answer A is incorrect because no court order is required for voluntary cancellation by the holder. Answer C is incorrect because a general cancellation of the instrument discharges all parties, not just the maker. Answer D is incorrect because intentional cancellation by the holder is immediately effective as a discharge.
A drawer issues a check and later convinces the payee to release the drawer from liability in exchange for a small payment. This release is in writing. Under UCC Section 3-601, what is the effect on secondary parties (endorsers) of this release?
The release has no effect on endorsers because it was not made by a court.
The release of the drawer makes the check void and discharges all parties including the drawee bank.
The release of the drawer discharges endorsers to the extent they would have had a right of recourse against the drawer, unless the holder expressly reserves rights against endorsers.
The release discharges all endorsers automatically because the primary obligor is released.
Explanation
Under UCC Section 3-605, when a holder releases a party from liability, parties who have a right of recourse against the released party are also discharged to the extent the release impairs their recourse rights, unless the holder expressly reserves rights against those parties. If a holder releases the drawer but expressly reserves rights against endorsers, the endorsers remain liable. Answer A overstates the discharge by making it automatic and total. Answer B is incorrect because private written releases are effective under the UCC without court involvement. Answer D is incorrect because the release of the drawer does not void the check or discharge the drawee bank's separate obligations.
An endorser's liability on a negotiable instrument is secondary, meaning the endorser is liable only if certain conditions are met. Which of the following must occur before an unqualified endorser can be held liable?
The maker must file for bankruptcy before the endorser's liability arises.
The holder must first obtain a court judgment against the maker.
The instrument must be properly presented for payment, dishonored, and the endorser must receive timely notice of dishonor.
The holder must notify the endorser by certified mail before the instrument is presented.
Explanation
An unqualified endorser (secondary party) is conditionally liable. To hold an endorser liable, the holder must: (1) properly present the instrument for payment on time, (2) have the instrument dishonored, and (3) give the endorser timely notice of the dishonor. Failure to satisfy any of these conditions may discharge the endorser's liability. Answer A is incorrect because no court judgment against the maker is required; presentment and dishonor are sufficient. Answer B is incorrect because there is no pre-presentment notification requirement by certified mail; notice of dishonor is given after dishonor. Answer C is incorrect because the maker's bankruptcy is not a prerequisite; the instrument simply must be dishonored.