CHAPTER
32
NEGOTIATION AND HOLDER IN DUE
COURSE
I. OBJECTNES:
The objective of this chapter is to discuss the concepts of negotiation and holder in due
course
and to detail the requirements for qualifying as a holder in due course as well as the special
rights
that status entails. After reading the chapter and attending class, a student should be able
to:
1. Expla1n how negotiable instruments are transferred from one person to
another.
2. Describe how order paper and bearer paper are
negotiated.
3. Distinguish among blank, special, restrictive, and qualified
indorsements.
4. Explain the importance of being a holder in due course of a negotiable
instrument.
5. Identify and apply the requirements for becoming a holder in due
course.
6. Define
holder.
7. Distinguish real defenses from personal
defenses.
8. Explain how the Federal Trade Commission has changed the holder in due course rule as it
applies to consumer credit
transactions.
II. ANSWER TO
INTRODUCTORY PROBLEM
A. The first question following the hypothetical that appears at the beginning of the
chapter
asks what rights a person gets if he/she takes a negotiable instrument indorsed in blank by
the payee. When the instrument was indorsed in blank, it became bearer
paper–can
could either be enforced by the holder or negotiated by transfer of possession
alone.
B. The second question asks whether the maker of a note can assert a defense of failure
of
consideration or breach of contract against a subsequent holder of the instrument
who
took it from the payee under circumstances by which it became a holder in due course
of
the note. The defense of failure of consideration is a so-called
“personal”
defense
which
cannot be asserted against a holder in due course of the
instrument.
C. The third question asks whether the result would be different if the note contained
the
clause that the Federal Trade Commission requires be included in consumer notes
or
installment sales contracts. If the instrument contained the required notice, then
the
defense could be asserted against any holder of the instrument, including a holder in
due
course, because the note on its face indicates that subsequent holders are subject to
such
defenses.
III. SUGGESTIONS FOR LECTURE
PREPARATION:
A.
Negotiation
1. Briefly review the purposes of negotiable instrument law, that the law is creating
a
substitute for money. Negotiable instruments are like money because they may
come
into the possession of holders in due course. A concept important to determining
whether
a person is a holder in due course is
negotiation.
Chapter 32 -Negotiation and Holder in Due Course
32-1
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2. Set out the formal requirements for negotiation. Define and differentiate order paper
and
bearer paper.
It
should be noted that this use of the word “order” is its third different
use
i
n
negotiable instrument law. Students could be referred to the handout on the three
uses
of the word “order,” included at the end of the previous chapter of this teacher’s
manual.
Town of Freeport v. Ring (page 878). Delivery of a check which did not contain
the
indorsement of the payee along with a letter signed by the payee that was not
physically
attached to the check indicating an intention that the payee intended the town take
the
check in payment of taxes did not result in a negotiation of the check to the town.
A
signature on another paper which is not attached to the check does not constitute a
valid
indorsement and is not effective to negotiate the check to the
town.
Points for Discussion: Note the different ways the facts could be changed to result in
a
negotiation. Ring might have signed his name below the words “payable to the town
of
Freeport” or that accompanying letter might have been physically attached to the
check.
3. Note that an indorsement is made by adding the person’s signature to the back of
the
instrument.
4. Wrong or Misspelled Name. Note the rules that are applicable when the payee’s name
is
wrong or is
misspelled.
5. Note that a depository bank has the right to provide its depositor’s indorsement and
that
the transferee of an instrument has the right to the unqualified indorsement of
the
transferor.
B.
Indorsements
1. List on the chalkboard the various types of indorsement and discuss them with
the
students. As an introduction note the two basic functions of an indorsement: (1)
To
negotiate the instrument; (2) To make the indorser contractually liable on the
instrument.
2. Special Indorsement. A holder specially indorses an instrument when he designates
a
specific payee in his indorsement. For
example:
a. Pay to Joe Brand, Alex
Smith.
b. Pay to the order of Joe Brand, Alex
Smith.
Both are special indorsements, because Alex has designated Joe as a payee. Note
that
order or bearer language is not needed here, because whether an instrument
is
negotiable is determined by whether the issuer, not the indorser, of the
instrument
use
s
order or bearer
language.
There are three consequences of the special
indorsement:
1) It satisfies one element necessary to negotiate order
paper.
2) The indorser becomes contractually liable on the instrument, as the next
chapter
shows.
3) The instrument remains or becomes order paper; that is, the new
payee’s
indorsement is required for negotiation. In the examples above Joe must
now
indorse the instruments to negotiate them, because they are order
instruments.
3. Blank Indorsement. A holder indorses an instrument in blank when he indorses his
name
without designating a new payee. For example, merely signing “Alex Smith” is a
blank
indorsement, because no payee is
designated.
There are three consequences of the blank
indorsement:
a.
It
satisfies one element necessary to negotiate order
paper.
b. The indorser becomes contractually liable on the
instrument.
c. The instrument remains or becomes bearer paper, which can be negotiated
by
delivery
alone.
Bearer paper will be converted to order paper by a special indorsement. Order
paper
if indorsed in blank becomes bearer
paper.
Example for Discussion: Problem Case
#2.
4. Restrictive Indorsement. Define restrictive indorsement and give some
examples.
a. For deposit only, Joe
Brand.
b. Pay any bank, Joe
Brand.
c. Pay to Alex Smith only, Joe
Brand.
d. Pay only if Alex Smith gives me his stereo, Joe
Brand.
Note that none of these indorsements affects negotiability, although if the issuer of
the
instrument had written some of these on the instrument, it would not be negotiable.
There
are three effects of the restrictive
indorsement:
1)
It
satisfies one element necessary to negotiate order
paper.
2) The indorser becomes contractually liable on the
instrument.
3) In order to become a holder in course of the instrument the transferee must pay
or
apply any value given for the instrument consistent with the
indorsement.
The restrictive indorser has a claim against a person who does not fulfill this
obligation.
Example: Problem Case
#1.
Lehigh Presbytery v. Merchants Bancorp, Inc. (page 881). Where checks made
payable
to the Lehigh Presbytery and indorsed for deposit to its account were allowed by
the
depository bank to be credited to the individual account of the church’s bookkeeper,
the
bank was liable to Reliable for the amount of the checks that it paid inconsistently
with
the restrictive
indorsement.
Points for Discussion: Note what the bank should have done with these checks give
the
indorsement on
them.
5. Qualified Indorsement. Define the qualified indorsement and give its most
common
form, “Without recourse.” There are three effects of a qualified
indorsement:
a. It satisfies one element necessary to negotiate order
paper.
b. It eliminates the
indorser’s
contractual
liability.
c. It modifies one of the transfer warranties that an indorser makes to all
subsequent
holders. This will be explored in more detail in the next
chapter.
6. Summary. Note that many of the above types of indorsements may be combined.
Ask
the students to identify and explain the effect of the following
indorsements:
a. Pay to Sam
Spade
Without
recourse
Miles
Archer
b. Pay to Sam Spade
only
Pay only if Sam Spade delivers the
goods
Miles
Archer
c. For Deposit
only
Acct.
74632-1
Miles
Archer
d. Miles
Archer
The Global Business Environment: Convention on International Bills of Exchange
and
International Promissory Notes (page 882): Note for the
student’s
benefit that the
common
law and civil law countries have some fundamental differences in their laws
concerning
negotiable instruments. The Convention on International Bills of Exchange and
International
Promissory Notes, adopted by the United Nations in 1988, tries to accommodate
or
harmonize the differences between the civil law and common law
approaches.
C. Holder in Due
Course
I. Introduction. Review the importance of a person being a holder in due course,
and
remin
d
students that the law’s recognition of holders in due course results in
negotiable
instruments being substitutes for money. For this purpose you should again
distinguish
between a holder in due course of a negotiable instrument and an assignee of an
ordinary
contract.
2. List the conditions a person must meet to become a holder in due
course.
a. Holder. The holder has possession, but not necessarily title, of a
negotiable
instrument. Holder may be explained in two
ways.
1) A person becomes a holder by taking an instrument by negotiation. This
requires
that order paper be properly indorsed to make subsequent possessors
holders.
Bearer paper need merely be delivered to the possessor for him to be a
holder.
Ask the students whether the possessor is a holder in the following
situations:
a) John possesses a check drawn payable to him.
(
Holder
)
b) John possesses a check drawn payable to the order of Jane, and
indorsed
“Jane” on its back.
(
Holder
)
c) Same as 2 except Jane has not indorsed the check. (Not a
holder
)
d) John possesses a check drawn payable to bearer, indorsed “Pay to
Alex,
Jane”, but not indorsed by Alex. (Not a
holder
)
e) John possesses a check drawn payable to bearer, indorsed “Jane”, and
not
indorsed by Alex who sold it to John.
(
Holder
)
f) John possesses a check drawn payable to Jane and Jane’s signature has been
forged by Alex. (Not a
holder
)
g) Problem Case #3.
(
Holder
)
Bank of America, NA. v. Inda (page 884). Where the bank was in possession of
a
note indorsed in
blank-and
for which it was serving as the servicer of the
note-the
bank was a holder in due course of the note and was a party entitled to enforce
it.
Example: Problem case
#4.
Cyberlaw in Action (885). This comment details some of the problems with
serial
electronic assignments of notes that surfaced during the recent (2007)
subprime
lending
crisis.
Chapter 32
-Negotiation
and Holder in Due
Course
b. Of an Instrument. Mention that the holder must possess a negotiable
instrument,
whose elements were discussed in Chapter
31.
c. For Value. Define value. For the most part, value is the same thing as
consideration,
except executory promises are excluded from, and antecedent claims are included
in,
value
Example: Problem Case
#5.
d. In Good Faith. The holder in due course must be honest in fact. This is the
white
heart, empty head test. The two most common examples of bad faith are paying
a
high discount under the circumstances and suspecting future defenses against
a
transferor due to a history of complaints against the
transferor.
e. Without Notice that the Instrument is Overdue or Dishonored or Has Any
Defense
Against It. Note that this element is designed to stop the transferring of
instruments
when a transferee is aware that something is not quite right. A person should
not
expect to be paid on an instrument if it is overdue or dishonored. He should
ask
himself why
it has been dishonored. Likewise when he is aware of a
defense,
whether real or personal, he should not be permitted to take advantage of
another’s
misfortune.
Explain what notice is.
It
includes what the person knows or should know. You
may
want to indicate that lack of good faith and notice often go hand in
hand.
Discuss the following examples of
notice.
1) Alex takes a check marked “NSF” on the
back.
2) Alex takes a note after the due
date.
3) Alex takes a note that is one note in the series of notes issued by Martin.
Alex
knows that some other notes in the series have been
dishonored.
4) Alex takes a check dated April 1,
2011.
Example: Problem Case
#6.
f. Without Notice
of Unauthorized
Signature or
Alteration.
Example: Problem
case# 7.
g. Without Notice of an Adverse
Claim
1) Negotiation by a Fiduciary. Note that a person may be on notice of defenses
and
thus unable to qualify as a holder in due course of a negotiable instrument if he
is
aware that he is taking the instrument from a
fiduciary.
h. Without Notice of any Defenses or Claims in
Recoupment.
i.
Irregular and Incomplete Instruments. Note that a person cannot be a holder in
due
course of a negotiable instrument if, when she takes it, the instrument is
irregular
New Randolph Halstead Currency Exchange, Inc. v. Regent Title Insurance
(
page
888). While there were significant irregularities that called the authenticity of
a
check into question, the check cashing service investigated the irregularities in
a
commercially reasonable way, including calls to the issuer of the check.
Because
they had acted in a commercially reasonable way, the court determined that
they
qualified
as
a holder in due course of the
check.
j.
Summary.
1) Remind the students of the importance
of being
a holder in due course: that
one
takes an instrument free of personal defenses and claims against the
instrument.
2) Ask the students who in the following problem are holders in due course; that
is,
who will be able to enforce the note against Mark despite Mark’s
defense:
Mark issues a $3,000 negotiable note due in one year to Peter’s Supply Co. in
return
for shelves Mark will use in his business. The shelves are defective, and Mark
tells
Peter’s he won’t pay the note. Peter’s sells the note to Nick for $2,900 cash
after
telling Nick that Mark has a dispute with Peter’s. Nick gives the note to Hank in
satisfaction of Nick’s $2,800 debt to Hank. After Hank takes the note in
satisfaction
of the debt, Nick tells Hank that Mark has a dispute with Peter’s. Hank sells the
note
to Val who pays $2,000 cash and promises to pay another $750 in a month. Val
isn’t
informed of the dispute. Val sells the note to Bonnie for $1,500
cash.
Answer: Hank is a holder in due course for $3,000. Val is a holder in due course
to
the extent of $2,000. No one else is a holder in due
course.
1.
The Shelter Rule. Explain the operation of the shelter rule and the reason for it:
it
protects the holder in due course by allowing him to pass his rights to his
transferee,
even though the transferee is not a holder in due course. Without the
shelter
provision if it becomes public that a maker has a defense against a note, no
one
would buy the note from the holder in due course, and thereby, the free
transferability
of the note would be destroyed. Of course the maker is no worse off by
permitting
transferees of a holder in due course to take it free of the maker’s defenses, for if
the
transferee could not enforce the note he could return it to the holder in due
course,
who can enforce
it.
D. Rights of a Holder in Due
Course
1. Note that Revised Article 3 sets out four categories of claims and defenses: (1)
real
defenses; (2) personal defenses; (3) claims to an instrument; and (4) claims
in
recoupment.
Next, clearly define each of these defenses and claims, give examples
of
each, and indicate the extent to which a holder in due course is–if at all–subject to
each.
2. Real Defenses. Real defenses go to the validity of the instrument. They do not exist in
the absence of the issuance of a negotiable instrument. Real defenses can be used as
a
reason against payment of a negotiable instrument to any holder, including a holder
in
due course. The following are real
defenses:
a. Minority of the Maker or Drawer. This depends upon the law of the state
of
issuance. For example, an eight year old makes a note. The note is void in
most
states.
b. Incapacity that under state law makes the instrument void. For example,
an
adjudicated incompetent signs a
note.
c. Duress. For example, Joe signs a note at
gunpoint.
d. Illegality that under state law renders the obligation
void.
Example:
Problem Case
#9.
e. Fraud in the Essence. For example, Mary signs a piece of paper that she has
been
assured is her will. In reality it is a note. If she had no opportunity to discover
the
true
character of the paper, the note is void, for she was defrauded in the execution
of
the
note.
Example: Problem Case
#8.
f. Discharge in Bankruptcy. Bankruptcy commonly extinguishes most of a
debtor’s
obligations, including negotiable
instruments.
Note the other reasons a person otherwise liable to pay may have a defense that
is
good against a holder in due course: (1) forgery; (2) alteration (partial defense);
and
(3)
discharge.
E
&
G Food Corp. v. Cumberland Farms (892). The right to enforce an obligation
of
a party to pay an instrument is subject to a defense based on illegality of
the
transaction which under other law nullifies the obligation of the obligor. Even
the
right of a holder in due course is subject to this defense. Where four checks
were
created by an unknown person unrelated to the purported drawer of the checks
who
did not sign them, a party that was the holder in due course of the checks was
subject
to the defense of illegality when it sought to enforce them against the
purported
drawer.
3. Personal Defenses. Personal defenses generally arise from the transaction that
underlies
the issuance of transfer of an instrument, although the UCC also creates some
additional
personal defenses related to the instrument in question. One test to identify the
personal
defenses (other than those created by the UCC) is this: would the defense exist even if
a
negotiable instrument had not been used? If the answer is yes, the defense is
personal,
and therefore not assertable against a holder in due
course.
The following are personal
defenses
a. Lack or Failure of Consideration. For example, a supplier does not
deliver
merchandise to the
maker.
b. Breach of Contract, including Breach of Warranty. For example, a farm
tractor’s
engine fails after one week‘s
use.
c. Fraud in the Inducement. For example a truck dealer tells Jane a used truck has
a
new engine when the dealer knows it is not
new.
d.
Misrepresentation.
This is the same as fraud except the misstatement may
be
inadvertent. With fraud, the misstatement must be
intentional.
e. Incapacity to the extent that state law makes the obligation voidable–as opposed
to
void.
f. Illegality that makes the obligation
voidable.
g. Duress that makes the obligation
voidable.
h. Unauthorized completion or material alteration of an
instrument.
i. Non-issuance of the instrument, conditional issuance or issuance for a
special
purpose.
j. Failure to countersign a traveler’s
check.
k. Payment that violates a restrictive
indorsement.
1.
Breach of warranty when a draft is
accepted.
It
should be emphasized that real defenses are assertable against any person
seeking
payment on an instrument, but that personal defenses are assertable only against
persons
who are not holders in due course and who cannot claim under the rights of a person
who
is a holder in due course (shelter
rule
).
General Credit Corp. v. New York Linen, Inc. (page 894): Where a check was
negotiated
to a holder in due course before the issuer/drawer of the check realized it had made
a
mistake, stopped payment on the check and issued a second check for the correct
amount,
the holder in due course was entitled to payment of the check by the drawer despite
the
fact it had a personal defense of failure of consideration that it might have
asserted
against the payee of the first
check.
Points for Discussion: Explore with the students the policy rationale behind this
result.
Ask them why it is better that the drawer may have to bear the risk of having to pay
twice
in this situation than it is to place the burden on the Holder in due
course.
Ethics in Action: Asserting the Defense of Illegality against Payment of a Gambling
Debt
(page 892): [This problem raises the issue of whether one should feel obligated to keep
a
bargain even though the legislature has relieved you of the legal responsibility for doing
so.
You might also ask whether between you and the holder in due course the loss should fall
on
the holder in due course until he or she can recover the amount of the check from the
payee.]
4. Discuss claims to instruments and claims in recoupment, giving examples. Explain
how
they relate to the rights of a holder in due
course.
E. Changes in the Holder in Due Course
Rule.
1. Note the particular ignorance that many consumers have of the consequences of
drawing
checks or issuing notes, and briefly point out the burden the holder in due course
rule
places on consumers. Because most consumers have insufficient resources to sue
their
sellers, withholding payment on a note or check is a more effective
remedy.
2. Uniform Consumer Credit Code. Check whether your state has adopted the
UCCC
Nevertheless, the changes the UCCC has made should be noted. Note that it applies
only
to transactions in which the consumer receives goods and
services.
3. Federal Trade Commission Rules. Point out that the FTC rules require the seller and
the
financing institution to include a legend in any consumer note that limits the
protection
available to a subsequent holder. Note that no consumer right of action exists
for
noncompliance with the rules, which noncompliance will permit the instrument to be
held
by a holder in due course. However, there is a civil fine of $10,000 per
violation.
Music Acceptance Corp. v. Lofing (page 897). Where a consumer note signed
in
conjunction with a piano that turned out to be defective contained the notice mandated
by
the FTC concerning subsequent holders being subject to claims and defenses against
the
seller, the finance company to whom the note was assigned took subject to the claims
the
buyer/maker of the note had against the
seller.
Points for Discussion: What would the result have been in this case if the note had
not
contained the FTC mandated notice? What rights would the FTC or Lofing had
against
(a) Sherman Clay or (b) MAC if the notice had not been
included?
Example: Problem Case
#10.
IV. SUGGESTED
REFERENCES:
See the same references listed for Chapter 31, Negotiable
Instruments.