The following is a case update written by Dana James Hall, a member of the ad hoc group of the California Lawyers Association’s (CLA) Business Law Section, analyzing a recent decision of interest:
A promissory note is not rendered non-negotiable solely by virtue of a reference to an extrinsic agreement. Negotiability is only destroyed where the holder of the instrument would be required to look beyond the note to determine such holder’s rights with respect to payment. Comty. Fin. Servs. Bank v. Stamper, __ S.W.3d __, 2019 WL 5678461 (Ky. Oct. 31, 2019). To review the full decision, click here.
Facts: In 1997, Ronny Stamper, an individual (“Debtor”), obtained a loan from Community Financial Services Bank (f/k/a Bank of Benton) (“Lender”) in the amount of $18,408.18. In connection with his incurrence of the loan, Debtor executed a document titled “Note, Disclosure and Security Agreement” (the “Note”). The Note bore a maturity date of April 25, 2002. Debtor subsequently defaulted on the loan. Although the exact date of default is unknown, in a letter dated April 24, 2000, the Lender notified Debtor that Lender intended to sell certain collateral (a Chevrolet Blazer) at auction. Following the sale of the Chevrolet Blazer, on August 25, 2000, Lender sent a letter to Debtor informing him that he had a remaining balance of $9,703.16 and requiring that he either pay the balance or establish a payment plan by September 15, 2000. On June 5, 2001, Lender again wrote to Debtor to request that he contact Lender to negotiate a repayment plan for the remaining amounts. Many years passed and, in March 2008, Lender notified Debtor that the loan had been referred for collection. In January 2016, Lender finally filed suit seeking judgment against Debtor in the amount of $11,204.63, plus interest and costs.
In Debtor’s answer, he argued that Lender’s claim was barred by Kentucky’s 15-year statute of limitations applicable to written contracts. Debtor asserted that the obligations under the Note were accelerated on August 25, 2000 when Lender delivered a letter to him notifying him of his default and that, as a result, the claim was time-barred after August 25, 2015. Lender argued that the statute of limitations did not begin to toll until the maturity date of the Note, April 25, 2002, and, therefore, the claim would not have been time-barred until April 25, 2017. Despite the fact that Section 355.3-118 of the Kentucky Revised Statutes (“KRS”) provides a 6-year statute of limitations applies to negotiable instruments, neither party asserted that the Note was a negotiable instrument or that the 6-year statute of limitations would be applicable to the Note.
The trial court granted summary judgment in favor of Lender after agreeing with Lender that the cause of action accrued on the maturity date of the Note. On appeal, the Court of Appeals agreed that the cause of action accrued on April 25, 2002, but determined that the application of the 15-year statute of limitations for written contracts was an error of law because the Note was a negotiable instrument and should have been subject to the shorter, 6-year statute of limitations under KRS § 355.3-118. Accordingly, the Court of Appeals reversed the trial court and remanded with directions to dismiss Lender’s claim as time-barred. Lender sought discretionary review on the issue of whether the Court of Appeals appropriately considered the shorter, 6-year statute of limitations applicable to negotiable instruments despite the fact that neither party had raised that statute of limitations and, if so, whether that statute of limitations would apply to bar its suit. Debtor separately sought discretionary review on the issue of whether the loan was accelerated by way of the August 25, 2000 letter. The Supreme Court of Kentucky granted both motions. On appeal, the Supreme Court of Kentucky determined that the Court of Appeals had appropriately considered the applicability of KRS § 355.3-118, that the Note was a negotiable instrument and that Lender’s claim was, therefore, time-barred.
Reasoning: The court quickly brushed aside the Lender’s threshold contention that the Court of Appeals erred in applying law that was not cited by either party. Relying on Burton v. Foster Wheeler Corp., 72 S.W.3d 925 (Ky. 2002) and Mitchell v. Hadl, 816 S.W.2d 183 (Ky. 1991), the court held that the appropriate legal authority is not a matter of judicial notice – the question of what legal authority applies is a question of law, not one of evidence. Accordingly, the court determined that a court may sua sponte provide the applicable legal standard at any stage of a proceeding regardless of whether previously raised by the parties. Moving on to the crux of the matter, the court was left to determine whether the Note was a negotiable instrument and, therefore, subject to the 6-year statute of limitations set forth in KRS § 355.3-118. KRS § 355.3-104(1) conforms to Section 3104 of the Uniform Commercial Code (“UCC”) and provides that:
“(1) Except as provided in subsections (3) and (4) of this section, “negotiable instrument” means an unconditional promise or order to pay a fixed amount of money, with or without interest or other charges described in the promise or order, if it:
(a) Is payable to bearer or to order at the time it is issued or first comes into possession of a holder;
(b) Is payable on demand or at a definite time; and
(c) Does 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, but the promise or order may contain:
1) An undertaking or power to give, maintain, or protect collateral to secure payment;
2) An authorization or power to the holder to confess judgment or realize on or dispose of collateral; or
3) A waiver of the benefit of any law intended for the advantage or protection of an obligor.”
Ky. Rev. Stat. Ann. § 355.3-104(1) (West 2006) (emphasis added). Lender argued that the Note was not an unconditional promise because the Note contained two references to extrinsic documents. The definition of “Indebtedness” in the Note includes “all principal and interest, [and] all other amounts, costs and expenses for which [Debtor is] responsible under this [Note] or under any other agreement with Lender pertaining to the loan” (emphasis added). Similarly, the Note provided that Debtor will be in default if Debtor “break[s] any promise made to Lender or fail[s] to perform promptly at the time and strictly in the manner provided in [the Note] or in any other agreement with Lender” (emphasis added).
Fortunately, KRS § 355.3-106 (which conforms to Section 3106 of the UCC) provides clear parameters regarding what constitutes an unconditional promise:
“(1) Except as provided in this section, for the purposes of KRS 355.3-104(1), a promise or order is unconditional unless it states:
(a) An express condition to payment;
(b) That the promise or order is subject to or governed by another record; or
(c) That rights or obligations with respect to the promise or order are stated in another record. A reference to another record does not of itself make the promise or order conditional.
(2) A promise or order is not made conditional:
(a) By a reference to another record for a statement of rights with respect to collateral, prepayment, or acceleration; or
(b) Because payment is limited to resort to a particular fund or source.”
Ky. Rev. Stat. Ann. § 355.3-104(1) (West 2006) (emphasis added). Relying on the explicit language of KRS § 355.3-104(1) and cases from within and outside Kentucky (including a California case – United States v. Cottrell, 287 F. Supp. 877, 883 (E.D. Cal. 1968)), the court determined that “a promissory note’s mere reference to an outside agreement will not necessarily destroy negotiability.” Rather, negotiability will only be destroyed where the instrument is “subject to” the extrinsic agreement. The court (as with many other courts to have considered the issue) focused its attention on the Official Comments to the UCC, which provide that a note will not be negotiable if it is explicitly rendered subject to another agreement – e.g. “[t]his note is subject to a contract of sale…” or “[t]his note is subject to a loan and security agreement…” – the rationale being that a holder of a note “should not be required to examine another document to determine rights with respect to payment.” Official Comments to UCC § 3106. In the instant case, however, the reference to “any other agreement” is not analogous. Although the Note references the possibility of another agreement, a holder of the Note would not be required to look beyond the Note to determine whether it had a right to payment. Accordingly, the court determined that the note was a negotiable instrument for purposes of KRS § 355.3-104 and was therefore subject to the 6-year statute of limitations applicable to negotiable instruments. The court found it unecessary to determine when the cause of action accrued because, in either instance, the claim would have been time-barred.
Author’s Comments: Based on the facts of this case, a similar result would likely be reached in a California court. In the instant case, the court cited to United States v. Cottrell, 287 F. Supp. 877, 883 (E.D. Cal. 1968), a case in which the court held that “a reference in a note to an extrinsic agreement does not destroy negotiability unless the reference actually makes the note ‘subject to’ the terms of that agreement.” There are a number of California courts that had previously reached similar outcomes. For instance Allenberg v. Rapken & Co., 108 Cal. App. 99, 103 (Cal. Dist. Ct. App. 1930) and Johnston v. Wolf, 118 Cal. App. 388, 390 (Cal. Dist. Ct. App. 1931) both held that a recital in a contract stating that the underlying obligations in a negotiable instrument arose from an extrinsic agreement did not in and of itself render the instrument non-negotiable. But compare with Westlake Mercantile Fin. Corp. v. Merritt, in which the court found that a note providing for maturity to be in conformity with the original terms of purchase was non-negotiable because the instrument “made the underlying contract a part of [itself]…for the purpose of determining the maturity date…” 204 Cal. 673, 675 (Cal. 1928).
It also bears noting that while the reference to “any other agreement” in this case did not render the note “subject to” any other agreement, the UCC explicitly contemplates certain circumstances where a note may in fact be subject to another agreement but, nonetheless, still constitute a negotiable instrument. Section 3106(b) of the UCC provides that “[a] promise or order is not made conditional (1) by a reference to another writing for a statement of rights with respect to collateral, prepayment or acceleration, or (2) because payment is limited to resort to a particular fund or source.” Accordingly, the issuer’s rights to prepay the obligations, the holder’s rights to foreclose on collateral and the holder’s rights to accelerate the obligations could all conceivably be documented via an extrinsic agreement and not destroy the negotiability of the promissory note in question. Similarly, Section 3104 of the UCC provides that while a negotiable instrument may not include any undertaking or instruction by the person promising or ordering payment to do any act in addition to the payment of money, the obligor may (1) undertake to give, maintain or protect collateral to secure payment, (2) provide an authorization to the holder to confess judgment or realize upon, or dispose of, collateral or (3) waive certain defenses applicable to an obligor.
These materials were written by members of the California Lawyers Association Business Law Section for the Commercial Finance Newsletter, published weekly on Westlaw. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further distributed without the consent of Thomson Reuters.