Story Case

Arthur Douglas held a note of one of his debtors, James Gordon, for $500, payable in six months, at five per cent, which he wished to convert into cash. One month after its issue, he took it to the Fairoaks Bank to have it discounted. The bank accepted it at six per cent discount, giving credit to Douglas for a deposit of $499.69. This amount is ascertained in the following way: At maturity, the note will call for $512.50, the principal and interest for six months. Since the bank is obliged to wait five months for this money, it takes out its interest in advance at the discount rate, here given as six per cent. That would amount to $12.81, which, deducted from $512.50, leaves the discount price of $499.69. At maturity, Gordon was unable to pay the note and the Fairoaks Bank brought suit against Douglas as indorser. He maintained that he had not sold the note but had discounted it, so that the bank, having received the note for less than its face value, could not expect to recover from him if it could not be collected. Is this a defense to the action?

Ruling Court Case. Farmei S' And Mechanics' Bank Vs. Baldwin, Volume 23 Minnesota Reports, Page 186; Volume 23 American Reports, Page 683

The Farmers' and Mechanics' Bank was incorporated under the laws of the state of Minnesota. It was provided in the law that "such person or association has power to carry on the business of banking by discounting bills, notes, and other evidences of debt, by receiving deposits, by buying and selling gold and silver bullion, foreign coin, and foreign and inland bills of exchange, by loaning money on real and personal securities, and by exercising such incidental powers as may be necessary to carry on such business."

Now Baldwin was the holder of a negotiable promissory note, which, before maturity, he sold and transferred to the bank herein. When the maker of the note refused to pay it, the bank sued Baldwin as indorser. Baldwin contended that the bank had no power to purchase a promissory note; that such power was not a necessary function of a bank; and that it had not been conferred by the law incorporating this bank.

Decision: The power to purchase promissory notes was not expressly given to the bank herein by the incorporating law. In order, therefore, for the bank to exercise such right, it must show that the power existed as a necessary incident in conducting a banking business. Now the usual functions of a bank are: to receive deposits, circulate its notes, and to make discounts. The court was of the opinion that the buying of promissory notes was not incidental to any of the usual functions of a bank. Therefore, the bank had no such power.

Mr. Justice Cornell said.: "Banks are of three kinds, known as banks of discount, deposit, and circulation; though usually in every American system of banking, all these functions are united in the same institution, as in the case under the present law. Discounting a note and buying it are not identical in meaning. The latter expression is used to denote the transaction 'when the seller does not indorse the note, and is not accountable for it,' and it is admitted that such was the character of the transaction in this case. In view of this understanding of the functions of a bank of discount, the legal signification attached to the word 'discount,' and the distinction between it and the word 'purchase' when applied to the business of banking, it is obvious that the power 'to carry on the business of banking by discounting notes, bills, and other evidences of debt' is only an authority to loan money thereon, with the right to deduct the legal rate of interest in advance." Judgment was held that the bank could not recover from Baldwin on this note, since it had purchased the instrument and had not discounted it.

Ruling Law. Story Case Answer

Another common function of a banking institution is that of discounting negotiable paper. The transaction is negotiated in this way: The owner of a certain bill or note, who wishes to realize cash from it immediately, may procure from a bank, a loan, giving such bill or note as collateral security. The bank may loan the amount promised in the instrument, less the interest on that amount computed at an agreed rate for the time the note has still to run. This is a loan upon, rather than of, the note.

The peculiarity of "discount" is almost wholly in the method of figuring interest and deducting it. It will be noticed, in the Story Case, that Douglas received only $499.69, while he is charged with interest figured upon $512.50. On an ordinary loan, he would receive $512.50 and have to repay $525.31. But in legal effect, an indorsement, by way of discount, is not different from any other indorsement, for instance, by way of security or of sale. It renders the indorser liable, in case of non-payment by the principal party, together with notice, for the amount called for by the note. The Fairoaks Bank, in the Story Case, should have judgment against Douglas for $512.50.