1. C H A P
Negotiation and
T E R
32
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)
32-1

2. 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
32-2

3. Overview
• 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
32-3

4. Requirements for Negotiation
• 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)]
32-4

5. Indorsement
• 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)]
32-5

6. Exception to Indorsement
• 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]
32-6

7. Effects of Indorsement
• 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
32-7

8. Kinds of Indorsement
• 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
• A restrictive indorsement specifies
purpose of the indorsement or
how the instrument must be used
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9. Examples of Indorsement
• 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
32-9

10. Examples of Restrictive Indorsements
• 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”
32-10

11. Recission of Indorsement
• 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]
32-11

12. Holder in Due Course
• 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
32-12

13. Requirements for
“Holder in Due Course” Status
• 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
32-13

14. Golden Years Nursing Home, Inc.
v. Gabbard
• 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
32-14

15. Golden Years Nursing Home, Inc.
v. Gabbard
• 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
32-15

16. Notice of Defects
• 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
32-16

17. Overdue Instruments
• 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
32-17

18. Dishonored Instruments
• A negotiable instrument has been
dishonored when the holder presented it for
payment (or acceptance) and payment (or
acceptance) was refused
The classic
“bounced”
check
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19. Notice of Claims
• 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
32-19

20. Shelter Rule
• 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
32-20

21. Holder in Due Course
Rights & Limitations
• 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
32-21

22. Real Defenses
• Real defenses limit the rights of a holder in
due course and refer to maker’s status, or
creation or discharge of the instrument:
– Status: maker’s minority, infancy
or lack of capacity status
– Instrument creation: illegality,
duress, or fraud
– Discharge: by bankruptcy or
payment
32-22

23. Personal Defenses
• 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
32-23

24. Personal Defenses
• 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
32-24

25. Holder in Due Course
Rights & Limitations
• 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
32-25

26. Holder in Due Course
Rights & Limitations
• 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
32-26

27. Commercial Paper Chart
32-27

28. Consumer Protection Issues
• 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
32-28

29. FTC Notice
• 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.
32-29

30. 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?
32-30

31. Music Acceptance Corp. v. Lofing
• 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.
32-31

32. 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.”
32-32

33. Test 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 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.
32-33

34. Test Your Knowledge
• 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
32-34

35. Test 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 instruments
32-35

36. 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?
32-36