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Negotiation and Holder in Due Course

PA ET RHC 32Behind all its global responsibilities and impersonal style banking is still a ‘people business’…it may be the most personal business of all for it always depends on the original concept of credit, meaning trust.

Anthony Sampson, The Moneylenders: Bankers in a Dangerous World (1981)

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Learning Objectives

• Explain the process of transferring negotiable instruments from one person to another

• Distinguish order paper from bearer paper, and blank, special, restrictive, and qualified indorsements

• Identify and explain requirements for becoming a holder in due course

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• A negotiable instrument is a contract with assignable rights

• Under UCC Revised Article 3, negotiation is the transfer of voluntary or involuntary possession of a negotiable instrument by a person (other than issuer) to another person who becomes its holder [3–201]– Example: when an employer pays

employee with paycheck, the employee is a holder

Overview

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• Order paper: instrument is payable to the order of a specific payee– Negotiated by transfer of possession of

paper after indorsement by the payee [3–201(b)]

• Bearer paper: instrument is payable “to bearer” or “to cash” – Negotiated by mere transfer of

possession of paper [3–201(b)]

Requirements for Negotiation

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• Indorsement is a signature that, alone or with other words, is made on an instrument for a specific purpose– Signature may not be that of the maker,

drawer, or acceptor– Proper purposes: (i) negotiating the

instrument, (ii) restricting payment of the instrument, or (iii) incurring indorser’s liability on the instrument” [3–204(a)]

Indorsement

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• Indorsement is required for negotiation except in the case of depositary banks

• Depositary banks often receive unindorsed checks under “lockbox” arrangements with customers receiving a high volume of checks– Depositary bank becomes a holder and

warrantor of an item delivered to it for collection, whether or not indorsed by customer, if the customer at the time of delivery qualified as a holder [4–205]

Exception to Indorsement

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• The form or lack of indorsement may affect future attempts to negotiate instrument– See Town of Freeport v. Ring

• Indorsement makes a person indorsing the item liable for payment if person primarily liable (e.g., maker of a note) does not pay – Example: If promissory note indorsed by the

original promisee to a bank and bank can’t recover funds from original promisor, promisee still owes the bank

Effects of Indorsement

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• A special indorsement is the indorser’s signature plus words indicating to whom, or to whose order, the instrument is payable

• An instrument is indorsed in blank if the indorser signs without specifying to whom the item is payable

Kinds of Indorsement

• A restrictive indorsement specifies purpose of the indorsement or how the instrument must be used

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• A special indorsement: – Alfie indorses a check payable to him with

“Payable to Brenda,” thus Brenda must indorse it with her signature to negotiate the item further

• Indorsement in blank:– John Woo indorses a check payable to him with

his signature “John Woo;” check is now bearer paper and bearer could negotiate it immediately or transform it into special indorsement by adding “Pay to the order of ________” above Woo’s indorsement

Examples of Indorsement

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• Indorsements for deposit: “For Deposit Only” or “For Deposit to Account ## at First State Bank”– Lehigh Presbytery v. Merchants Bancorp. Inc.: bank

failed to apply value given for checks consistently with restrictive indorsements on the checks

• Indorsements for collection: “Pay any bank, banker, or trust company” or “For collection only” (added by banks for collection process)

• Beneficial indorsements: “Pay to Abe Lincoln, Attorney at Law, in Trust for Clarence Darrow”

Examples of Restrictive Indorsements

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• Negotiation effects an instrument transfer even if the negotiation is made:– (1) by a minor, a company exceeding its

powers, or any other person without contractual capacity; (2) by fraud, duress, or mistake of any kind; (3) in breach of duty; or (4) as part of an illegal transaction

• Under these circumstances, the indorsement is subject to rescission before negotiation to a holder in due course [3–202]

Recission of Indorsement

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• A holder in due course takes a negotiable instrument free of all personal defenses, claims to the instrument, and claims in recoupment of the obligor or a third party

• A holder in due course does not take free of the real defenses regarding validity of the instrument or claims that develop after s/he becomes a holder

Holder in Due Course

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• Person must be a holder of a negotiable instrument, and take it (1) for value, (2) in good faith, (3) without notice of defects or evidence of apparent forgery or alteration that raises a question of authenticity– See Golden Years Nursing Home, Inc. v. Gabbard

Requirements for “Holder in Due Course” Status

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• Facts: – Golden Years Nursing Home received Social

Security checks made payable either to individual patients or to “Golden Years Nursing Home for [an individual patient]”

– For 5 years, office manager Gabbard embezzled by having some patients indorse their checks in blank, then she would cash or deposit the checks for herself

Golden Years Nursing Home, Inc. v. Gabbard

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• Procedural History & Appellate Decision: – Golden Years Nursing Home sued Gabbard

and bank where checks had been cashed• Basis for suing bank was that patients had

assigned interest in checks to nursing home

– Appellate court found for bank because checks provided to bank cashed checks in good faith without notice of defenses, thus became holder in due course

Golden Years Nursing Home, Inc. v. Gabbard

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• A holder in due course must not have notice that the instrument is overdue or dishonored, has an uncured default, contains unauthorized signature or alteration, has a property or possessory interest claim, or has any defense against it or claim in recoupment to it

Notice of Defects

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• If a negotiable instrument is payable on demand, it is overdue: – (1) day after demand for payment made;

(2) 90 days after its date if a check; and (3) if other than a check, if outstanding for an unreasonable time for the instrument and trade practice [3–304(a)]

• If a negotiable instrument due on a certain date is not paid by that date, it becomes overdue at the beginning of the next day after the due date

Overdue Instruments

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• A negotiable instrument has been dishonored when the holder presented it for payment (or acceptance) and payment (or acceptance) was refused

Dishonored Instruments

The classic “bounced”

check

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• If a person taking a negotiable instrument would be on notice of adverse claim, alteration, forged signature, or irregularity, person is not a holder in due course– Cannot negotiate instrument– But see New Randolph Halstead

Currency Exchange, Inc. v. Regent Title Insurance Agency, LLC

– Potential defenses: fraud, duress, infancy, failure of consideration

Notice of Claims

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• Article 3 shelter rule: the transferee of an instrument obtains rights the transferor had, including the transferor’s right to enforce the instrument and any right as a holder in due course [3–203(b)]– Exception: a transferee involved in

fraud or illegality affecting the instrument

Shelter Rule

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• Revised Article 3 establishes four categories of claims and defenses relevant to a holder in due course: – Real defenses, personal defenses, claims to an

instrument, and claims in recoupment

• Real defenses attack the instrument’s validity and may be used as reasons against payment of a negotiable instrument to any holder, including a holder in due course

Holder in Due Course Rights & Limitations

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• Real defenses limit the rights of a holder in due course and refer to maker’s status, or creation or discharge of the instrument:

Real Defenses

– Status: maker’s minority, infancy or lack of capacity status

– Instrument creation: illegality, duress, or fraud

– Discharge: by bankruptcy or payment

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• Personal defenses are legal reasons for avoiding or reducing a person’s liability for payment of a negotiable instrument and arise out of the transaction that issued the negotiable instrument

• A holder in due course of a negotiable instrument (or one who can claim the rights of one) is not subject to personal defenses or claims

Personal Defenses

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• Personal defenses include basic defects in contracts as well as defects in the creation of the instrument

• In General Credit Corp. v. New York Linen Co., Inc. , a holder in due course of a check was not subject to the personal defense of the failure of consideration that the drawer of the check had against the payee of the check

Personal Defenses

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• Claims to an instrument concern property or possessory rights in an instrument or its proceeds: claim to instrument ownership because owner wrongfully deprived of possession, claim of a lien, or claim for rescission of an indorsement

• A holder in due course takes free of claims that arose before the holder status, but is subject to those arising after holder status

Holder in Due Course Rights & Limitations

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• Claims in recoupment arise out of the transaction that gave rise to the instrument and offset, rather than prevent, liability– A holder in due course is protected

Primarily based in warranty or breach of contract disputes

Holder in Due Course Rights & Limitations

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Commercial Paper Chart

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• Holder in due course rules may harm consumers, thus some states and the Federal Trade Commission limited the holder in due course rule as it affects consumers

Consumer Protection Issues

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• FTC requires sellers who extend credit by note or installment contract to include the following statement:– NOTICE: ANY HOLDER OF THIS CONSUMER

CREDIT CONTRACT IS SUBJECT TO ALL CLAIMS AND DEFENSES WHICH THE DEBTOR COULD ASSERT AGAINST THE SELLER OF THE GOODS OR SERVICES OBTAINED PURSUANT HERETO OR WITH THE PROCEEDS HEREOF. RECOVERY HEREUNDER BY THE DEBTOR SHALL NOT EXCEED AMOUNTS PAID BY THE DEBTOR HEREUNDER.

FTC Notice

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Music Acceptance Corp. v. Lofing

• Facts: – Lofing bought a Steinway piano from a Steinway

dealer financed by an installment note from MAC– Consumer note contained the FTC notice– The piano was defective and Lofing stopped

paying on the note, selling the piano to mitigate damages, then sued dealer, Steinway, and MAC

• Issue: Did the Notice allow plaintiff to assert the breach of warranty as grounds for not continuing to pay off the note to MAC?

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• Legal Reasoning and Holding: – The FTC adopted a rule…identical to that in

Lofing’s sales contract– In abrogating the holder in due course rule

for consumer credit transactions, FTC reallocated the cost of seller misconduct to creditor

– The jury’s finding that dealer breached its warranties mandates that the judgment in favor of MAC and against Lofing be reversed. Judgment in favor of Lofing.

Music Acceptance Corp. v. Lofing

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Test Your Knowledge

• True=A, False = B– Order paper is a negotiable instrument

payable to the order of cash.– Indorsement is a signature that is made

on an instrument for a specific purpose– If Jamil writes a check to Mary, Jamil may

indorse the back himself to negotiate it.– A check is rendered non-negotiable if it is

indorsed on the back, “For Deposit to Account #5000005 at First State Bank.”

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• True=A, False = B– Indorsement is required for negotiation except

in the case of depositary banks. – The shelter rule states that a transferee of a

negotiable instrument obtains all rights that the transferor had.

– Megan writes Sam a check dated Jan. 2, 2007 and Sam indorses the check the next day to Bryan’s Grocery. Bryan’s presented the check for payment to a bank on July 1, 2007. The bank must honor the negotiable instrument.

Test Your Knowledge

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• Multiple Choice– Dan (16 years old) signed an installment

note with Dude’s for a surfboard. Dude’s sold the note at a discount to Factors Co. The board broke after 1 month and Dan stopped paying. Factors Co. is:

a) a holder in due course, but Dan is a minor and like any contract, may assert minority status to void the contract

b) not a holder in due course & has no rights c) is a holder in due course and Dan must

continue to pay on the note or be in breach of contract

Test Your Knowledge

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• Multiple Choice– Requirements for holder in due course

status include: a) take a negotiable instrument for valueb) take the instrument in good faithc) take without notice of defects or

claims against the instrumentd) all of the abovee) all of the above plus be in the business

of taking negotiable instruments

Test Your Knowledge

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Thought Questions

• What do you think of the FTC rule limiting the rights of a holder in due course in consumer transactions?

• Do you think the FTC rule achieves the underlying policy to protect consumers?