Commercial Paper:
Holder in Due Course & Defenses

Problems arise when a holder seeking 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, for the person seeking payment, it becomes important to have the rights of a holder in due course (HDC). An HDC takes a negotiable instrument free of all claims and most defenses of other parties. Defenses fall into two categories: (1) Universal or real defenses; and (2) Personal defenses. Real defenses defeat payment to all holders, including HDCs. Personal defenses can be asserted successfully against ordinary holders.

Holder versus Holder in Due Course

A holder is a person who possesses an instrument drawn, issued, or indorsed to him, to his order, to bearer, or in blank. An ordinary holder obtains only those rights that the transferor had in the instrument. In this respect, a holder has the same status as an assignee. A holder normally is subject to the same defenses that could be asserted against the transferor, just as an assignee is subject to the defenses that could be asserted against the assignor.

In contract, a holder in due course is a holder who, by meeting certain acquisition requirements, takes the instrument free of most of the defenses and claims to which the transferor was subject. In other words, an HDC can normally acquire a higher level of immunity than can an ordinary holder in regard to defenses against payment on the instrument or ownership claims to the instrument by other parties.

Requirements for HDC Status

An HDC must be a holder of a negotiable instrument and must take the instrument (1) for value; (2) in good faith; and (3) without notice that it is overdue, that it has been dishonored, that any person has a defense against it or a claim to it, or that the instrument contains unauthorized signatures or alterations or is so irregular or incomplete as to call into question its authenticity.

Taking for Value

An HDC must have given value for the instrument. A person who receives an instrument as a gift or who inherits it has not met the requirement of value. In these situations, the person normally becomes an ordinary holder and does not possess the rights of an HDC.

The concept of value in the law of negotiable instruments is not the same as the cocnept of consideration in the law of contracts. An executory promise (a promise to give value in the future) is clearly valid consideration to support a contract. However, it does not normally constitute value sufficient to make one an HDC. A holder take an instrument for value only to the extent that the promise has been performed. Tehrefore, if the holder plans to pay for the instrument later or plans to perform the required services at some future date, the holder has not yet given value. In that situation, the holder is not yet an HDC.

Taking in Good Faith

The purchaser-holder must have acted honestly in the process of acquiring the instrument. Article 3 defines good faith as "honesty in fact and the observance of reasonable commercial standards of fair dealing." It is immaterial whether the transferor acted in good faith. Thus, a person who in good faith takes a negotiable instrument from a thief may become an HDC.

Becuase of the good faith requirement, one must ask whether the purchaser, when acquiring the instrument, honestly believed that the instrument was not defective. If a person purchases a $10,000 note for $300 from a stranger on a street corner, the issue of good faith can be raised on the grounds of both the suspicious sircumstances and the grossly inadequate consideration. The UCC does not provide clear guidelines to determine good faith, so each situation must be examined separately.

Taking Without Notice

A person will not be afforded HDC protection if he acquires an instrument on notice (knows or has reason to know) that it is defective in any one of the following ways: 1. It is overdue.
2. It has been dishonored.
3. There is an uncured (uncorrected) default with respect to another instrument issued as part of the same series.
4. The instrument contains an unauthorized signature or has been altered.
5. There is a defense against the instrument or a claim to the instrument.
6. The instrument is so irregular or incomplete as to call into question its authenticity.

What constitutes notice? Notice of a defective instrument is given whenever the holder (1) has actual knowledge of the defect; (2) has received a notice of the defect; or (3) has reason to know that a defect exists, given all the facts and circumstances known at the time in question. A purchaser's knowledge of certain facts, such as insolvency proceedings against the maker or drawer of the isntrument, does not constitute notice that the instrument is defective.

Holder through an HDC

A person who does not qualify as an HDC but who derives his title through and HDC can acquire the rights and privileges of an HDC. UCC 3-203(b). This is the shelter principle or shelter rule. It seems counter to the basic HDC philosophy. It is, however, in line with the concept of marketability and free transferability of negotiable instruments, as well as with contract law, which provides that assignees acquire the rights of assignors. The shelter principle extends the HDC benefits, and it is designed to aid the HDC in readily disposing of the instrument. Anyone, no matter how far removed from an HDC, who can trace his title ultimately back to an HDC comes within the shelter principle. Normally, a person who acquires an instrument from an HDC or from someone with HDC rights receives HDC rights on the legal theory that the transferee of an instrument receives at least the rights that the transferor had. Howver, persons who formerly held instruments cannot improve their positions by later reacquiring them from HDCs.


Real Defenses

Real or universal defenses are valid against all holders, including HDCs. Universal defenses include the following: (1) Forgery, (2) Fraud in the execution, (3) Material alteration (complete defense against a holder, partial defense against an HDC), (4) Discharge in bankruptcy, (5) Minority, (6) Illegality (when statute makes it void), (7) Adjudicated Mental Incapacity, and (8) Extreme Duress. Each of these is pretty much self-explanatory except number two, fraud in the execution.

Fraud in the execution occurs when a person is deceived into signing a negotiable instrument believing that he is signing something other than a negotiable instrument. This defense cannot be raised, however if a reasonable inquiry would have revealed the nature and terms of the instrument. Thus, the signer's age, experience, and intelligence are relevant.

Personal Defenses

Personal defenses are used to avoid payment to an ordinary holder of a negotiable instrument. Personal defenses are: (1) Breach of contract or breach of warranty, (2) Lack or failure of consideration, (3) Fraud in the inducement, (4) Illegality (when statute makes it voidable), (5) Unadjudicated mental incapacity, (6) Other defenses.

Federal Limitations on HDC Rights

Because of the sometimes harsh effects of the HDC doctrine on consumers, the federal government limits HDC rights in certain cicumstances. To protect consumers, the FTC in 1976 issued Rule 433, which effectively abolished the HDC doctrine in consumer credit transactions. it allows a consumer who is a party to a consumer credit transaction to bring any defense he or she has against the seller of a product against a subsequent holder as well. In essence, FTC Rule 433 places an HDC of the instrument in the position of a contract assignee. The rule makes the buyer's duty to pay conditional on the seller's full performance of the contract. Botht he seller and the creditor are responsible for the seller's misconduct.

The Rule requires that the parties must cinclude in the consumer credit contract a specific notice. What if the seller does not include the notice in a promissory note and then sells the note to a third party. In this case the third party does not become subject to the buyer's defenses against the seller, and the consumer is unprotected by the FTC Rule.