597
Chapter 25
Transferability and
Holder in Due Course
See Separate Lecture Outline System
INTRODUCTION
This chapter begins with the process of negotiation—that is, the transfer of negotiable instruments from one person to
another. The chapter discusses the types of indorsements that are required whenever certain types of instruments are being
negotiated, and notes some common indorsement problems that may arise during the process of negotiation, as well as the
consequences of various types of indorsements.
A negotiable instrument is not money—but it is payable in money. Article 3 of the Uniform Commercial Code (UCC)
governs a party’s right to payment of a check, draft, note, or certificate of deposit. Problems arise when a holder seeking
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payment of a negotiable instrument learns that a defense to payment exists or that another party has a prior claim to the
instrument. In such situations, it becomes important for the person seeking payment to have the rights of a holder in due
course (HDC). This chapter distinguishes between an ordinary holder and an HDC and examines the requirements for HDC
status.
ADDITIONAL RESOURCES—
VIDEO SUPPLEMENTS
The following video supplements relate to topics discussed in this chapter—
PowerPoint Slides
To highlight some of this chapter’s key points, you might use the Lecture Review PowerPoint slides compiled for
Chapter 25.
Business Law Digital Video Library
The Business Law Digital Video Library at www.cengage.com/blaw/dvl offers a variety of videos for group or
individual review. Clips on topics covered in this chapter include the following.
• Ask the Instructor
Negotiability & Transferability: Indorsing Checks—I thought bearer instruments didn’t need indorsements. Why do
banks always make you indorse checks made out to cash, which are bearer instruments?—Banks require all checks,
including bearer instruments, to be indorsed because the indorsement creates indorser liability for the indorsing party.
Also, it is more efficient and safer for a bank to have a policy requiring indorsement of all checks rather than for tellers
to make individual assessments of whether checks are order or bearer instruments.
• Legal Conflicts in Business
CHAPTER OUTLINE
I. Negotiation
When a transfer is by negotiation, the transferee can become a holder in due course and acquire greater rights than
the transferor had [UCC 3–203(b), 3–305].
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A. NEGOTIATING ORDER INSTRUMENTS
An order instrument is negotiated by delivery with any necessary indorsements.
B. NEGOTIATING BEARER INSTRUMENTS
A bearer instrument is negotiated by delivery alone.
II. Indorsements
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A. BLANK INDORSEMENTS
A blank indorsement specifies no particular indorsee and can be a mere signature [UCC 3–205(b)].
B. SPECIAL INDORSEMENTS
A special indorsement names the indorsee [UCC 3–205(a)]. An instrument indorsed in this way is an order
instrument. A blank indorsement converted to a special indorsement converts a bearer instrument into an order
instrument.
C. QUALIFIED INDORSEMENTS
Most indorsements are unqualified. A qualified indorsement disclaims an indorser’s liability.
2. Special v. Blank Qualified Indorsements
A qualified indorsement is accompanied by a special or blank indorsement that determines further
negotiation. A special qualified indorsement creates an order instrument, and indorsement and delivery are
required for negotiation. A blank qualified indorsement creates a bearer instrument, and only delivery is
required for negotiation.
CASE SYNOPSIS—
Case 25.1: Hammett v. Deutsche Bank National Co.
Vernon Hammett and others bought “a residential property” in Alexandria, Virginia. They signed a note for
$475,000 in favor of Encore Credit Corp. with no restrictions on its transfer. When they stopped paying on the note, the
property was sold at a foreclosure sale to Deutsche Bank National Co. Hammett and the others filed a suit in a Virginia
state court against Deutsche Bank and others, alleging that the defendants had no “right or interest” in the note. It had
been indorsed—“Pay To The Order of ___ Without Recourse Encore Credit Corp.”—and was in Deutsche Bank’s
possession.
The court dismissed the case. “If an instrument has a blank indorsement, it is considered ‘payable to bearer,’ and
may be negotiated by transfer of possession alone.” And a note is generally freely transferable, with the transferee
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Notes and Questions
What is the difference between a blank and a special indorsement? A blank endorsement is a mere signature by
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ANSWERS TO QUESTIONS AT THE END OF CASE 25.1
1. How do the requirements for negotiation of an instrument with a blank qualified indorsement differ from those for
negotiation of an instrument with a special qualified indorsement? A blank qualified indorsement makes the
2. Suppose that the indorsement at issue in this case had been written on a separate document that was not firmly
affixed to the note. Would this document have constituted an allonge? Would Deutsche Bank be entitled to enforce
the note? Explain. In the law governing negotiable instruments, an allonge is a piece of paper firmly affixed to an
instrument to provide room for an indorsement. If the indorsement is contained on a separate document that is not
stapled, taped, or otherwise firmly attached to the instrument, then the document is not an allonge. In this case, had
the paper containing Encore’s blank indorsement not been firmly affixed to the instrument, the note would not have
been indorsed, either with an indorsement in blank or a special indorsement—and Deutsche Bank would have no rights
in the instrument.
D. RESTRICTIVE INDORSEMENTS
Restrictive indorsements require indorsees to comply with certain instructions.
1. Indorsements Prohibiting Further Negotiation
2. Conditional Indorsements
A conditional indorsement conditions payment on the occurrence of a specified event [UCC 3–205(a)]. (A
3. Indorsements for Deposit or Collection
An indorsement for deposit or collection makes the indorsee the indorser’s collecting agent.
4. Trust (Agency) Indorsements
Indorsements that state they are for the benefit of the indorser or a third person are trust indorsements,
and legal title vests in the original indorsee. To the extent that the original indorsee pays or applies the
proceeds consistently with the indorsement, the indorsee is a holder and can become a holder in due course
[UCC 3–206(d), (e)].
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III. Miscellaneous Indorsement Problems
A. MISSPELLED NAMES
An indorsement should be identical to the name that appears on the instrument. A payee or indorsee whose
name is misspelled can indorse with the misspelled name, the correct name, or both [UCC 3–204(d)].
B. INSTRUMENTS PAYABLE TO ENTITIES
C. ALTERNATIVE OR JOINT PAYEES
If an instrument is payable to two or more persons jointly, then all the payees’ indorsements are necessary.
1. Alternative Payees Presumed If the Instrument Is Ambiguous
2. Suspension of the Drawer’s Obligation
Giving one alternative or joint payee a check suspends the drawer’s obligation [UCC 3–310(b)(1)]. The payee
holds the check for the benefit of all payees.
IV. Holder in Due Course (HDC)
A. HOLDER V. HOLDER IN DUE COURSE
A holder has the status of an assignee of a contract right. A holder obtains only those rights that the transferor
had in the instrument and is normally subject to the same defenses. An HDC takes an instrument free of most de-
fenses against payment on it or claims to it.
B. REQUIREMENTS FOR HDC STATUS
First, the instrument must be negotiable, and whoever seeks HDC status must be a holder. Then, the following
requirements must be met [UCC 3–302].
1. Taking for Value
A gift or inheritance does not meet the requirement of value for HDC status, nor does a promise to give
value in the future. A holder takes an instrument for value by—
• Performing the promise for which the instrument was issued or transferred.
• Acquiring a security interest or other lien in the instrument, except a lien obtained by a judicial
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• Purchasing an instrument at a judicial sale such as a bankruptcy or a creditor’s sale
• Obtaining an instrument by taking over a trust or estate (as administrator)
• Acquiring an instrument as part of a corporate purchase of assets
ADDITIONAL BACKGROUND—
Value and Consideration
The Official Comments of the Uniform Commercial Code explain the purposes and the changes in the prior law that
were effected by the UCC. The following is from the text of UCC 3–303, Comment 1.
1. . . . The distinction between value and consideration is a fine one. Whether an instrument is taken for value
is relevant to the issue of whether a holder is a holder in due course. If an instrument is not issued for consideration
is also value. A different rule applies in Article 3. Subsection (b) of Section 3–303 states that if an instrument is issued
for value it is also issued for consideration.
Case # 1. X owes Y $1,000. The debt is not represented by a note. Later X issues a note to Y for the debt.
Under subsection (a)(3) [an instrument issued as payment or security for an antecedent claim is issued for value,
Case # 2. X issues a check to Y in consideration of Y’s promise to perform services in the future. Although the
Case # 3. X issues a note to Y in consideration of Y’s promise to perform services. If at the due date of the
note Y’s performance is not yet due, Y may enforce the note because it was issued for consideration. But if at the
2. Taking in Good Faith
The holder must have acted honestly in the process of acquiring the instrument. Good faith is “honesty in
fact and the observance of reasonable commercial standards of fair dealing” [UCC 3–103(a)(4)]. This
requirement applies only to the holder.
CASE SYNOPSIS—
Case 25.2: Georg v. Metro Fixture Contractors, Inc.
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Cassandra Demery worked as a bookkeeper at Clinton Georg’s business Freestyle until he discovered she had
embezzled over $200,000 and failed to pay $240,000 of Freestyle’s taxes. Georg fired Demery and demanded
repayment. Demery went to work for her parents’ firm Metro Fixtures. She wrote a check to Freestyle for $189,000 on
Metro’s account without authorization and deposited it directly into Freestyle’s account, telling Georg that it was a
loan to her from her family. When Metro discovered Demery’s theft, it filed a suit in a Colorado state court against
Georg and Freestyle for conversion. The court issued a summary judgment in Freestyle’s favor. On Metro’s appeal, a
state intermediate appellate court reversed. Georg and Freestyle appealed.
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Notes and Questions
In an attempt to describe how the standard of “good faith” under Article 3 should be applied, a different state
court articulated the following test in Maine Family Federal Credit Union v. Sun Life Assurance Co. of Canada, 727 A.2d
335 (Sup. Jud. Ct. 1999).
The factfinder must therefore determine, first, whether the conduct of the holder comported with industry or
“commercial” standards applicable to the transaction and, second, whether those standards were reasonable
standards intended to result in fair dealing. Each of those determinations must be made in the context of the
specific transaction at hand. If the factfinder’s conclusion on each point is “yes,” the holder will be determined to
What do your students think about this standard of “good faith”?
Why is good faith required to attain HDC status? To allow otherwise would provide an incentive for holders to
manipulate the rules dishonestly with the knowledge that the enforcement of an instrument could still be sought in a
court.
Was it right for Georg to let the loss fall on Metro, and was it reasonable for him to believe that Demery’s parents
had loaned her the funds? Because there was a family relationship, the claim of a loan was believable. Demery knew
criminal charges could be pressed if she did not repay, so the family might help her. Given the family relationship, his
taking the funds was not unreasonable or indeed unethical.
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ANSWER TO “WHAT IF THE FACTS WERE DIFFERENT?” IN CASE 25.2
Suppose that Demery had gone to work for a company not owned or managed by a family member and had stolen
funds from it to pay Georg. Would Georg then be the more innocent party? Why or why not? That would make
Freestyle’s case quite weak. Georg did not report the theft to the authorities, so there was no record of what
ANSWER TO “THE ETHICAL DIMENSION” QUESTION IN CASE 25.2
Since Georg knew that Demery had previously embezzled funds from Freestyle when she was an employee,
shouldn’t he have been suspicious about the source of the funds that Demery was using to repay Freestyle? Why did
the court conclude that Freestyle acted in good faith in accepting the check? Discuss. On the question of whether
ADDITIONAL CASES ADDRESSING THIS ISSUE —
Recent cases in which a party’s good faith to attain HDC status was at issue include the following.
• In re AppOnline.com, Inc., __ Bankr. __ (E.D.N.Y. 2002) (the purchaser of mortgage notes from the original
mortgagee for value and in good faith, and without actual knowledge that the checks to closing agent would be
dishonored or of the seller’s claims, qualified as HDCs).
dealing).
ENHANCING YOUR LECTURE—
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“PROTECTED HOLDER” STATUS
Good faith is an issue not only in domestic transactions involving negotiable instruments but also internationally.
Under the United Nations Convention on International Bills of Exchange and International Promissory Notes (CIBN), the
equivalent of a holder in due course is known as a “protected holder.” As under the UCC, a protected holder is
afforded greater protection than an ordinary holder. Unlike the UCC, however, the CIBN does not provide an objective
test by which to measure good faith. Article 3 of the UCC, as revised in 1990, defines good faith as “honesty in fact and
FOR CRITICAL ANALYSIS
What might be a reason that the CIBN contains only a very broad and subjective definition of good faith?
3. Taking without Notice
A person will not be afforded HDC protection if he or she knew or should have known at the time the
instrument was acquired that it was defective because—
• It was overdue.
• It had been dishonored.
• There was an uncorrected default with respect to another instrument issued as part of the same
series.
• The instrument contains an unauthorized signature or has been altered.
• There is a defense against it or a claim to it.
• The instrument is so irregular as to call into question its authenticity.
a. What Constitutes Notice?