Notes, Indorsements, Allonges, and the Pitfalls You Need to Know About (Part I)
Part I – Learn The Basics, Like “What’s an Indorsement?”
When we buy and sell a note, how does the seller transfer its rights to enforce the note to the buyer? Notes, as negotiable instruments, are negotiated or transferred by an “indorsement.” To determine what that means from a legal standpoint, let’s break it down by defining three essential terms: negotiated, transferred, and indorsement. First, we look to the Uniform Commercial Code.
The Uniform Commercial Code defines “negotiation” as a transfer of possession, whether voluntary or involuntary, of an instrument by a person other than the issuer to a person who thereby becomes its holder. UCC § 3-201(a). Generally, negotiation of an instrument payable to an identified person requires transfer of possession and an indorsement in favor of the payee.
The second thing to understand is, not all “transfers” are negotiations. A transfer is the physical delivery of any instrument, whether it be a negotiable instrument or not, with the intent of passing title to the instrument and the right to receive payments and enforce the instrument.
The difference between negotiation and other transfers is that a proper negotiation makes the new recipient the “holder” of the instrument – the note holder, as it were. The holder may be, in certain situations, entitled to take the instrument free from any defenses that the debtor might assert. However, for our purposes (at this point) it should suffice that a proper indorsement gives the note investor very good evidence of its right to enforce a note.
How do we know if a note has been properly indorsed?
Now that we understand the difference between “negotiated” and “transferred” we must define the “indorsement” and explain the requirements for a note to be properly indorsed. A proper indorsement only has a few technical requirements:
(1) a signature
(2) on the instrument
(3) with words describing what the signature is intended to do.
The UCC definition of indorsement is: “Indorsement” means a signature, other than that of a signer as maker, drawer, or acceptor, that alone or accompanied by other words is made on an instrument for the purpose of (i) negotiating the instrument, (ii) restricting payment of the instrument, or (iii) incurring indorser's liability on the instrument, but regardless of the intent of the signer, a signature and its accompanying words is an indorsement unless the accompanying words, terms of the instrument, place of the signature, or other circumstances unambiguously indicate that the signature was made for a purpose other than indorsement. For the purpose of determining whether a signature is made on an instrument, a paper affixed to the instrument is a part of the instrument.
Note investors are usually very familiar with the concept of indorsements. However, most have been familiar with the concept long before becoming note investors. A personal check is just another form of a negotiable instrument, and you have to indorse the back of a check to cash it or deposit it. A personal check is actually a very good example of one of the different types of endorsements.
How does an indorsement appear on a note?
A simple indorsement on a note looks like a stamped string of words like “Pay to the order of” and a line or a space that can be blank or can be filled in with the name of the party who is receiving the rights under the indorsement. Here are some examples:
So, we understand what an indorsement is, and what it means to negotiate a note. Put that information together, and you realize an indorsement is a means to negotiate a note to a buyer.
In some states, an indorsement is more than just one means to negotiate a note to a buyer, and it is in fact required. For example, Ohio courts have held that “Under Ohio law, the right to enforce a note cannot be assigned; rather, the note must be negotiated in conformity with Ohio's version of the Uniform Commercial Code.” Yemma v. Leber Real Est., Ltd., 2022-Ohio-3289, ¶ 27, 197 N.E.3d 596, 601, appeal not allowed, 2023-Ohio-86, ¶ 27, 168 Ohio St. 3d 1529, 200 N.E.3d 1159. Now this seems very strict, and the language indeed is strict. However, there are ways to establish the right to enforce a note in Ohio beyond UCC negotiation – they are just more convoluted. (For all you Ohio investors, don’t worry, we’ll talk more on those options in a later blog post!)
For now, we’ve established that a transfer of a negotiable instrument, such as a note, is best accomplished by negotiation via indorsement. It’s best because a signed indorsement and possession of the original note are the best evidence of a prior holder’s intent to transfer rights to the new owner and the new owner’s rights to enforce the note.
In Part 2 of this 3-part blog series “Notes, Indorsements, Allonges, and the Pitfalls You Need to Know About” we’ll discuss the very French-sounding and often misunderstood “allonge.”