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Chapter 17 Holders in Due Course, Defenses, and Liabilities
Chapter 17
Holders in Due Course, Defenses, and Liabilities
I. Key Terms
Failure of consideration (p. 408) Personal defenses (p. 407)
Holder (p. 401) Presentment (p. 413)
Holder in due course (p. 401) Real defenses (p. 409)
Holder in due course rule (p. 409) Shelter provision (p. 406)
Lack of consideration (p. 407) Universal defenses (p. 409)
Limited defenses (p. 407)
II. Learning Objectives
1. State the requirements of being a holder in due course and describe the special protection
given to such a holder.
2. Define a holder.
3. Explain the protection given to a holder through a holder in due course.
4. Name six personal defenses.
5. Discuss the protection given to people who sign consumer credit contracts.
6. Name six real defenses and explain the significance of a real defense.
7. Differentiate between primary liability and secondary liability, and list the parties who are
primarily liable and secondarily liable.
8. Describe the conditions that must be met to hold a secondary party liable.
III. Major Concepts
17-1 Holder in Due Course
A holder in due course is a holder who takes the instrument for value, in good faith,
without notice that it is overdue or has been dishonored, and without notice of any
defenses against it or claim to it. Good faith means honesty in fact. A holder who receives
an instrument from a holder in due course receives all the rights of the holder in due
course.
17-2 Personal Defenses
Personal defenses can be used against a holder but not a holder in due course. The most
common personal defenses are breach of contract, lack or failure of consideration, fraud
in the inducement, lack of delivery, and payment. Holders of consumer credit contracts
who are holders in due course are subject to all claims and defenses that the buyer could
use against the seller, including personal defenses.
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distribution without the prior written consent of McGraw-Hill Education.
Chapter 17 Holders in Due Course, Defenses, and Liabilities
17-3 Real Defenses
Real defenses can be used against anyone, including a holder in due course. Real
defenses are infancy and mental incompetence, illegality and duress, fraud as to the
essential nature of the transaction, bankruptcy, unauthorized signature, and alteration.
17-4 Liability of the Parties
Makers of notes and acceptors of drafts have an absolute liability to pay. Indorsers have a
liability to pay only if an instrument is presented properly for payment, the instrument is
dishonored, and proper notice of dishonor is given to the secondary party.
IV. Outline
I. Holder in Due Course (17-1)
A. Introduction
1. An exception to the principle of contract law that people cannot transfer greater rights
than they have themselves occurs in the law of negotiable instruments.
2. People who are holders in due course of negotiable instruments can receive more
rights than those who held the instruments.
3. A holder in due course is a holder who takes an instrument: (1) for fair value; (2) in
good faith, and (3) without notice that anything is wrong with it.
4. Good faith means honesty in fact and fair dealing.
B. The Holder in Due Course Requirements
1. The Value-Taking Requirement
a. The taking for value requirement differs little from the ordinary concept of
consideration.
b. A party taking a negotiable instrument as a gift cannot be a holder in due course.
2. The Good Faith Requirement
a. The concept of good faith involves two basic elements: (1) honesty in fact and (2)
conforming to accepted commercial practices of fairness.
b. To be operating in good faith from an objective perspective, a party who claims to
be a holder in due course must act (1) according to the commercial standards of
the industry, and (2) those commercial standards must themselves be reasonable.
3. The Without Notice of Defect Requirement
a. To be a holder in due course, a holder must not have notice of any claim or
defense to an instrument or notice that an instrument is overdue or has been
dishonored.
b. A holder has notice that a demand instrument is overdue when more than a
reasonable length of time has elapsed since it was issued.
c. A check is overdue 90 days after its date.
4. Holder through a Holder in Due Course
a. Under the shelter provision, a holder who receives an instrument from a holder in
due course acquires the rights of the holder in due course, even though he or she
does not qualify as a holder in due course.
b. The shelter does not apply to a holder who has committed fraud or an illegal act.
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distribution without the prior written consent of McGraw-Hill Education.
Chapter 17 Holders in Due Course, Defenses, and Liabilities
II. Personal Defenses (17-2)
A. Introduction
1. Holders in due course take instruments free from all claims to them on the part of any
person and free from all personal defenses of any party with whom they have not
dealt.
2. Personal defenses are defenses that can be used against a holder but not a holder in
due course.
3. The most common personal defenses are breach of contract, failure or lack of
consideration, fraud in the inducement, lack of delivery, and payment.
B. Breach of Contract
1. Negotiable instruments are often issued in exchange for property, services, or some
other obligation as part of an underlying contract.
2. If the contract is breached, breach of contract is a personal defense that may be
asserted against a holder but not a holder in due course unless the parties dealt with
each other.
C. Lack or Failure of Consideration
1. Lack of consideration is a defense that may be used by a maker or drawer of an
instrument when no consideration existed in the underlying contract for which the
instrument was issued.
2. Failure of consideration is a defense that the maker or drawer has available when the
other party breaches the contract by not furnishing the agreed consideration.
3. Both lack and failure of consideration are personal defenses that may not be used
against a holder in due course.
D. Fraud in the Inducement
1. Fraud in the inducement occurs when someone is induced by a fraudulent statement
to enter into a contract.
2. Fraud in the inducement is a personal defense and may not be used against a holder in
due course.
3. Fraud as to the essential nature of the transaction is a real defense.
E. Lack of Delivery, Payment, Consumer Protection
1. Delivery is the voluntary transfer of possession of an instrument from one person to
another.
2. If the voluntary transfer of possession of an instrument from one person to another is
not voluntary, the instrument has not been “issued”.
3. Lack of delivery is a personal defense that is not good against a holder in due course.
4. Payment of an instrument by a maker or drawee usually ends the obligations of the
parties.
5. If a negotiable instrument is negotiated to a holder in due course after it has been
paid, it will have to be paid again because payment is a personal defense which
cannot be used against a holder in due course.
6. Anyone who pays a demand instrument should have it marked “paid” and take
possession of it.
7. No one can be a holder in due course of a past due time instrument.
8. In 1976 the FTC adopted the holder in due course rule.
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distribution without the prior written consent of McGraw-Hill Education.
Chapter 17 Holders in Due Course, Defenses, and Liabilities
9. Under the holder in due course rule, holders of consumer credit contracts who are
holders in due course are subject to all claims and defenses that the buyer could use
against the seller, including personal defenses.
III. Real Defenses (17-3)
A. Introduction
1. Defenses that can be used against everyone, including holders in due course, are
known as real defenses or universal defenses.
2. Real defenses include infancy and mental incompetence, illegality and duress, fraud
as to the essential nature of the transaction, bankruptcy, unauthorized signature, and
alteration.
B. Infancy and Mental Incompetence
1. A minor or mental incompetent need not honor a negotiable instrument if it was given
in payment for a contract that the minor or mental incompetent may disaffirm on the
grounds of minority or incompetency.
2. The defense is valid even if the instrument comes into the hands of a holder in due
course.
3. Persons who have been found insane by a court are not liable on a negotiable
instrument because their contracts are void.
C. Illegality and Duress
1. An instrument that is associated with duress or an illegal act is void and uncollectible
by anyone, even a holder in due course.
2. The instrument is uncollectible even if held by a holder in due course with no
awareness of the illegal acts or condition.
D. Fraud as to the Essential Nature of the Transaction
1. Fraud as to the essential nature of the transaction occurs when the defrauded party has
no knowledge or opportunity to learn the true character or terms of the matter.
2. It is a real defense and may be used against anyone.
E. Bankruptcy
1. Bankruptcy may be used as a defense to all negotiable instruments.
2. Holders of such instruments will receive equal treatment with other similar creditors
when the debtor’s assets are collected and divided according to the bankruptcy law.
F. Unauthorized Signatures
1. Whenever someone signs another’s name on an instrument without authority, it is a
forgery, a real defense.
2. Unless ratified, it does not operate as the signature of the person whose name is
signed and instead operates as the signature of the person who signed it.
G. Alteration
1. An alteration usually involves changing the payee’s name or raising the amount of an
instrument.
2. The alteration of an instrument may be used as a real defense.
3. Unless the instrument is written negligently, drawers are not required to pay altered
amounts; and they must pay only the amount for which the instrument was originally
written.
IV. Liability of the Parties (17-4)
A. Makers, Acceptors, and Certain Drawers
1. Some parties are obligated to pay an instrument without reservation.
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distribution without the prior written consent of McGraw-Hill Education.
Chapter 17 Holders in Due Course, Defenses, and Liabilities
2. They include the maker of a note, the issuer of a cashier’s check or other draft in
which the drawer and the drawee are the same person, and the acceptor of a draft.
B. Other Drawers and Indorsers
1. Other drawers and indorsers have limitations on their obligation to pay an instrument
and are said to be secondarily, or conditionally, liable.
2. If a bank accepts a draft, the drawer is discharged.
3. If a drawee other than a bank accepts a draft and it is later dishonored, the obligation
of the drawer is the same as an indorser.
4. Indorsers are obligated to pay an instrument only when the following conditions are
met:
a. The instrument must be properly presented to the drawee or party obliged to pay
the instrument, and payment must be demanded.
b. The instrument must be dishonored.
c. Proper notice of the dishonor must be given to the secondary party within the time
and in the manner prescribed by the UCC.
5. Nonbank holders must give notice of dishonor to the drawer and indorsers within 30
days following the day of dishonor.
6. Banks taking instruments for collection must give notice before midnight of the
banking day following the day the bank was notified of the dishonor.
7. Delay in giving notice of dishonor is excused when the holder has acted carefully and
the delay is due to circumstances beyond the holder’s control.
8. Presentment and notice of dishonor are also excused when the party waived either
presentment or notice of dishonor.
V. Background Information
A. Cross-Cultural Notes
1. PayPal can be used for cross-border payments. More information is available at
https://www.paypal.com/us/cgi-bin/webscr?
cmd=xpt/cps/general/PayPalIntlHub-outside
2. Possible problems in regard to international purchases are discussed at the website of
the U.S. Customs and Border Protection at
http://www.cbp.gov/trade/basic-import-export/internet-purchases.
B. Historical Notes
1. Courts of “equity,” or fairness, which developed in medieval England, still exist in
some U.S. court systems. It was in the courts of equity that such maxims as “He who
seeks equity must do equity” and “He who seeks equity must have clean hands” were
developed as precedents.
C. State Variations
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distribution without the prior written consent of McGraw-Hill Education.
Chapter 17 Holders in Due Course, Defenses, and Liabilities
1. The Federal Trade Commission provides information on fake checks along with a link
to the various state Attorneys General at
http://www.consumer.ftc.gov/articles/0159-fake-checks.
2. Cornell University Law School provides links to state statutes that correspond to
Articles of the Uniform Commercial Code including the chapter on commercial paper
at https://www.law.cornell.edu/uniform/ucc.
D. Quotations
1. Fraud is the homage that force pays to reason.
— Charles Curtis (1860–1936), U.S. Vice-President, 1929–1933
VI. Terms
1. Induce has its origins in the Latin term inducere, which means “to draw” or “to lead.”
2. Legally, the term duress refers to any conduct that deprives a victim of free will. All
transactions entered into under such conditions are legally voidable by the victim.
Duress comes from the Latin word meaning hard.
3. Liable is related to the term ligature, which refers to something that is used to bind
two things together.
VII. Related Cases
1. In Tiffin v. Cigna Insurance Co., 687 A.2d 1045 (N.J. App. Div. 1997), the court
applied the shelter rule to allow recovery to a plaintiff who purchased a dishonored
instrument from a holder in due course.
2. The court in C-Wood Lumber Co. v. Wayne County Bank, discusses a bank’s liability
based on an employee’s embezzling funds from an employer in the form of checks
and placing the funds into her account and that of her children.
VIII. Teaching Tips and Additional Resources
1. Fun quizzes involving check fraud scams can be found on the web site of the National
Consumers League at http://www.fakechecks.org/fraudtest.html. The site also has a
link to videos involving illegal scams.
2. The web site of the Comptroller of the Currency provides a number of resources
involving fraud and forgery at
http://www.occ.gov/topics/consumer-protection/fraud-resources/index-fraud-resource
s.html.
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distribution without the prior written consent of McGraw-Hill Education.
Chapter 17 Holders in Due Course, Defenses, and Liabilities
3. An article on the Forbes website at
http://www.forbes.com/forbes/2007/0618/040b.html discusses home foreclosure and
also references claims of predatory lending in connection with holder in due course
status.
4. Ask students to practice detecting forgeries of the signatures of classmates. The
Internet has many sites advertising the detection of forgeries. On the web site of the
National Postal Museum at http://www.postalmuseum.si.edu/inspectors/a8p4.html.
is information regarding the solving of a murder through the detection, by
handwriting analysis, of forged checks stolen through the mail.
5. An article titled “FDIC Loan Sales: It's Good To Be A Holder In Due Course” is
available at
http://www.constructionlawtoday.com/2009/11/fdic-loan-sales-its-good-to-be-a-holde
r-in-due-course/.
6. The Comptroller of the Currency provides answers to questions about checks and
bank fraud at
http://www.helpwithmybank.gov/get-answers/bank-accounts/forgery-and-fraud/bank-
accounts-forgery-fraud-quesindx.html.
7. Emphasize the importance of the holder-in-due-course concept in the law of
negotiable instruments. Discuss with the class the various problems financial
institutions would encounter if there were no holder-in-due-course rules.
8. Have students divide into teams and go to different financial institutions to research
what fees are assessed against a check which has been dishonored. Then have the
students research what recourse the financial institution has to recover the lost money.
9. Discuss whether a holder in due course should have real defenses for failure of
consideration and breach of contract. Remind students that a holder in due course
may have obtained the negotiable instrument in question from another holder in due
course and not from the maker.
10. Stress how important it is for the maker of a note to get back the note when it is paid
off. Discuss with the students that when they sign a promissory note for financial aid,
the note should be returned to them when paid. If it is not, and it is negotiated to a
holder in due course, they may have to pay again.
11. Have students recall the different elements of a contract, and remind them if one
required element is missing, the contract is invalid. Then discuss how real defenses
are similar in that, if one is present, it also will void a negotiable instrument.
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distribution without the prior written consent of McGraw-Hill Education.
