3Negotiation & Holder in Due Course 32CHAPTERNegotiation & Holder in Due Course“Behind 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)
4Learning Objectives Negotiation Indorsements Holder in Due Course & Rights32 - 4
5OverviewUnder 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]Instrument may be:Order paper: “to order of named payee”Bearer paper: “to bearer” or “to cash”When an employer gives an employee a paycheck payable “to the order of Susan Adams,” she is the holder of the check because she is in possession of an instrument payable to an identified person (Susan Adams) and she is that person.A person is a holder if in possession of an instrument (1) that is payable to bearer or (2) made payable to an identified person and she is that identified person [1–201(20)]Order paper: instrument is payable to the order of a specific payeeNegotiated 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)]32 - 5
6IndorsementIndorsement: Signature, alone or with words, made on an instrument for a specific purposeMay not be that of maker, drawer, acceptorIndorsement required for negotiation except in the case of depositary banksForm of indorsement may affect attempts to negotiate the instrument furtherIndorsement may be subject to rescission due to, e.g., lack of capacity, fraud, illegalityThe signature must be made by the holder or by someone who is authorized to sign on behalf of the holder, such as “Jane Doe on behalf of Doe & Company, Inc.”Signature may not be that of the maker, drawer, or acceptorProper purposes: (i) negotiating the instrument, (ii) restricting payment of the instrument, or (iii) incurring indorser’s liability on the instrument” [3–204(a)]Depositary banks often receive unindorsed checks under “lockbox” arrangements with customers receiving a high volume of checksDepositary 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]Indorsement makes a person indorsing the item liable for payment if person primarily liable (e.g., maker of a note) does not payExample: If promissory note indorsed by the original promisee to a bank and bank can’t recover funds from original promisor, promisee still owes the bankRecission: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 transactionHowever, under these circumstances the indorsement is subject to rescission before the instrument has been negotiated to a transferee who can qualify as a holder in due course or a person paying the instrument in good faith and without knowledge of the factual basis for rescission or other remedy [3–202]32 - 6
7Kinds of IndorsementA special indorsement is indorser’s signature and words to whom instrument is payableInstrument indorsed in blank if indorser signs without specifying to whom it’s payableRestrictive indorsement states purpose of the indorsement or how instrument to be usedA special indorsement is indorser’s signature plus words indicating to whom, or to whose order, the instrument is payableA 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 furtherAn instrument is indorsed in blank if the indorser signs without specifying to whom the item is payableIndorsement 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 indorsementA restrictive indorsement specifies the purpose of the indorsement or how the instrument must be usedCommon restrictive indorsements:Indorsements for deposit: “For Deposit Only” or “For Deposit to Account ## at First State Bank”See Lehigh Presbytery v. Merchants Bancorp. Inc.Indorsements for collection: “Pay any bank, banker, or trust company” or “For collection only”Added by banks for collection processBeneficial indorsements: “Pay to Abe Lincoln, Attorney at Law, in Trust for Clarence Darrow”32 - 7
8Holder in Due CourseHolder in due course: person holds negotiable instrument, taken for value, in good faith, without notice of defects or evidence of apparent forgery or alteration that raise questions about authenticityTakes negotiable instrument free of personal defenses, claims to instrument, and claims in recoupment of obligor or of a third partyA holder in due course does not take free of substantive defenses about validity of the instrument or claims that develop after s/he becomes a holderThe Golden Years Nursing Home, Inc. v. Gabbard case illustrates that a party in possession of a check indorsed in blank is a holder of the instrumentFrom 1972 until 1991, Nancy Gabbard, the office manager for the Golden Years Nursing Home, received at the nursing home Social Security checks drawn on the United States Treasury and made payable either to individual patients or to “Golden Years Nursing Home for [an individual patient].” From 1986 until 1991, Gabbard engaged in an embezzling scheme whereby she would have certain patients indorse their own checks in blank, that is, each patient would sign his own name on the back of the check placing no restrictions on the manner in which the check could subsequently be negotiated. Gabbard would then cash the checks and either keep the cash or deposit the funds into her personal bank account.In 1992, after Gabbard’s scheme was discovered, Golden Years brought suit against Gabbard and also against the Star Bank Corporation where the checks had been cashed. The patients had in other documents assigned their interests in the checks to Golden Years, and the claim against the bank alleged that it had converted Golden Years’property by cashing checks with forged indorsements. One of the issues in the lawsuit was whether the checks had been properly negotiated to Star Bank.The trial court granted summary judgment to Golden Years, finding that the bank was not a holder in due course because the checks contained “forged indorsements.” Star Bank appealed. On appeal, the court found for Star Bank based on (UCC 3–202): “Thus, in this case, Gabbard became a holder of the checks when the checks, indorsed in blank by the patient-payees, were delivered to her. When Star Bank accepted the checks that were indorsed with the genuine signatures of the payees, the checks bore no indication that they had been assigned to Golden Years. Star Bank cashed the checks in good faith without notice of any defenses and thus became a holder in due course.”32 - 8
9Negotiable Instrument Defects Overdue, dishonored, or has uncured defaultContains unauthorized signature or alterationHas a property or possessory interest claimHas any defense against it or claim in recoupment to itIf 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 would be overdue at the beginning of the next day after the due dateA negotiable instrument has been dishonored when the holder has presented it for payment (or acceptance) and payment (or acceptance) has been refused – the classic “bounced check.”If a person taking a negotiable instrument would be on notice of adverse claim, alteration, forged signature, or other irregularity, the person is not a holder in due courseCannot negotiate instrumentPotential defenses: fraud, duress, infancy, failure of considerationThe standard is a reasonable person standard. Examine the check in the photo. Would a student negotiate this check? This is an irregular paper!32 - 9
10Holder in Due Course Rights & Limitations Article 3 shelter rule: instrument transferee obtains all rights transferor had, including right to enforce instrument and any right as holder in due course [3–203(b)]Revised Article 3 establishes four categories of claims and defenses:Real defenses attack instrument’s validity and may be used as reasons against payment of a negotiable instrument to any holderArticle 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 instrumentSee Triffin v. Cigna Insurance Co. in which plaintiff was protected by the shelter ruleTriffin v. Cigna Insurance Co.: James Mills received a draft in the amount of $ dated July 7, 1993, from one of Cigna Insurance company’s constituent companies. The draft had been issued for worker’s compensation benefits. Mills falsely indicated to the issuer that he had not received the draft because of a change in his address and requested that payment be stopped and a new draft issued to him. The insurer complied and stopped payment on the initial draft. Mills nevertheless negotiated the draft to Sun Corp. t/a Sun’s Market before the stop payment notation was placed on the draft. Sun Corp. was a holder in due course of the draft. Sun Corp. presented the draft for payment through depositary and collecting banks. The issuer’s bank dishonored the draft in accordance with its customer’s direction, stamped it “Stop Payment,” and returned it to Sun Corp. At that point, as a holder in due course, Sun Corp. would have been able to enforce the draft against the issuer. Thereafter, Triffin, who is in the business of purchasing dishonored instruments, received an assignment of Sun Corp.’s interest in the draft and brought suit against the issuer. The trial court awarded summary judgment to Cigna and Triffin appealed.Appellate court: “These [UCC] sections could not be clearer. Triffin received by assignment the right of a holder in due course to this instrument, which apparently had been presented and then dishonored because of Cigna’s stop payment order. The draft itself remained the basis of a claim upon which Triffin or its assignor had three years to sue after dishonor of the draft or ten years after the date of the draft, whichever period expired first (3–118c). Judgment reversed in favor of Triffin.”Real DefensesReal defenses limit the rights of a holder in due course and refer to maker’s status, or the creation or discharge of the instrument:Status: maker’s minority, infancy or lack of capacity statusInstrument creation: duress, illegality, fraudDischarge: by bankruptcy or paymentReal defenses also include alteration and forgery of the instrument
11Holder in Due Course Rights & Limitations Revised Article 3 categories (continued):Personal defenses: legal reasons to avoid or reduce person’s liability for payment of negotiable instrument due to the transactionClaims to an instrument concern property or possessory rights in instrument or proceedsClaims in recoupment arise from transaction that created the instrument and offset, rather than prevent, liabilityPersonal DefensesPersonal 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 instrumentA holder in due course of a negotiable instrument (or one who can claim the rights of one) is not subject to personal defenses or claimsPersonal defenses include basic defects in contracts as well as defects in the creation of the instrumentSee General Credit Corp. v. New York Linen Co., Inc. in which a holder in due course of a check was not subject to personal defense of failure of consideration that the drawer of the check had against the payee of the checkPersonal defenses include: lack or failure of consideration, breach of contract, breach of warranty, fraud in the inducement, incapacity, illegality, duress, unauthorized completion or alteration, defects in issuance, failure to countersign a traveler’s check, modification of contract by separate agreement, payment violating a restrictive indorsement.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 indorsementA holder in due course takes free of claims that arose before s/he holder status but is subject to those arising after holder statusHolder in due course is protected from claims of recoupment
13Consumer Protection Issues Holder in due course rules may harm consumers, thus some states and the Federal Trade Commission limit holder in due course rule as it affects consumersFTC requires sellers who extend credit by note to include a statement warning of limited holder in due course rightsFTC warning 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.Music Acceptance Corp. v. LofingFacts:Lofing bought a Steinway piano from a Steinway dealer financed by an installment note from MACThe consumer note for $19, prepared by MAC and signed by Lofing included the following in boldface type:NOTICE ANY HOLDER OF THIS CONSUMER CREDIT CONTRACT IS SUBJECT TO ALL CLAIMS AND DEFENSES WHICH THE DEBTOR COULD ASSERT AGAINST THE SELLER OF GOODS OR SERVICES OBTAINED PURSUANT HEREIN OR WITH THE PROCEEDS HEREOF. RECOVERY HEREUNDER SHALL NOT EXCEED AMOUNTS PAID BY THE DEBTOR HEREUNDER.The piano was defective and Lofing stopped paying on the note, selling the piano to mitigate damages, then sued dealer, Steinway, and MACIssue: Did the Notice allow plaintiff to assert the breach of warranty as grounds for not continuing to pay off the note to MAC?Legal Reasoning and Holding:The FTC adopted a rule…identical to that in Lofing’s sales contractIn abrogating the holder in due course rule for consumer credit transactions, FTC reallocated the cost of seller misconduct to creditorThe 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.
14Test 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 purposeIf 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 # at First State Bank.”False. Order paper is an instrument payable to the order of a specific payee. Bearer paper is payable “to bearer” or “to cash.True.False. Signature may not be that of the maker, drawer, or acceptorFalse. This is a restrictive indorsement, but it does not render the check non-negotiable.
15Test Your Knowledge 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 Tisha a check dated 1/2/ Next day, Tisha indorses the check to Bryan’s Grocery. Bryan’s presented the check for payment to Bank on 7/1/ Bank must honor the negotiable instrument.True.False. The check is overdue. A check is payable on demand and it is overdue if presented 90 days after its date. The holder, Bryan’s, is not a holder in due course since it had notice that the check was overdue by reading the date on the check.
16Test Your KnowledgeMultiple ChoiceDan (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 may assert his 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 pay on the note or breach the contractThe correct answer is (a).
17Test Your Knowledge Multiple Choice Requirements for holder in due course status include:(a) take a negotiable instrument for value(b) take the instrument in good faith(c) take without notice of defects or claims against the instrument(d) all of the above(e) all of the above plus be in the business of taking negotiable instrumentsThe correct answer is (d).
18Thought QuestionsWhat 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?Opportunity to discuss policy issues of consumer protection and negotiable instruments.