Value, Good Faith, Notice: Special Note on New York

It is anticipated that negotiable instruments will be transferred to an intermediate transferee one of more times before payment is due.  The transfer of notes is huge business in the United States, particularly in the mortgage industry.  These transfers are quite different than the ones discussed previously which have been transfers of notes between individuals or small businesses.  The mortgage industry often involves transfers of notes with mortgages in large bundles of hundreds or thousands of notes, dramatically changing the dynamic of the historical typical transfer of a negotiable instrument.

Given the superior rights given to the ‘holder in due course’, one should expect that the circumstances under which this legal status is obtained must conform to sound commercial policy.  Consistent with general Uniform Commercial Code policy, one can expect that the circumstances must comport to criteria which facilitate commerce while at the same time, protect the integrity of the market place.

We have discussed the first three elements required for HDC status—there must be a ‘holder’; the writing must be a negotiable instrument; the writing must appear regular on its face.

            Once the first three elements are in place—the remaining criteria can be examined.  These are simple: ‘value’ must be given for the instrument; the instrument must be taken in ‘good faith’; the instrument must be taken ‘without notice’ of any claims or defenses to the instrument.  Each of these terms is defined under the Code.

            Value is defined under Section 3-303 as follows:

An instrument is issued or transferred for value if:

(1) the instrument is issued or transferred for a promise of performance, to the extent the promise has been performed;

(2) the transferee acquires a security interest or other lien in the instrument other than a lien obtained by judicial proceeding;

(3) the instrument is issued or transferred as payment of, or as security for, an antecedent claim against any person, whether or not the claim is due;

(4) the instrument is issued or transferred in exchange for a negotiable instrument; or

(5) the instrument is issued or transferred in exchange for the incurring of an irrevocable obligation to a third party by the person taking the instrument.

The giving of value for an instrument is not complicated.  For purposes of this initial discussion, value can simply be thought of as the payment of money for the instrument, using the instrument as collateral, or performing an agreed task for the instrument, such as painting the obligor’s house in exchange for the  instrument.

            It is the two remaining requirements that create difficulty and challenges.  First among these is our old friend ‘good faith’. The distinction between the amended version and unamended version of Article 1 has great significance here.  Remember, under the unamended version, ‘good faith’ means ‘honesty in fact in the conduct and transaction concerned’, while under the amended version, the good faith requirement further requires ‘the observance of reasonable commercial standards of fair dealing’.

                                                            Special Note

            It is particularly significant that New York, clearly the most active and sophisticated financial market in the United States, recently enacted most of revised Article 1, but chose to retain the ‘honesty in fact’ version of good faith.  Of equal and perhaps greater significance for purposes of the discussion of negotiable instruments, is the fact that New York has not enacted the 1990 version of Article 3, joined by South Carolina as the only two states to have not done so. Hence, good faith in matters pertaining to negotiable instruments does not incorporate ‘reasonable commercial standards of fair dealing in the trade’ as would be the case in other jurisdictions which have not enacted the amended definition contained in Article 1, but which have enacted the amended version of Article 3 which does incorporate ‘reasonable commercial standards of fair dealing’ for purposes of good faith under that Article.

      We therefore find ourselves in the following situation in New York:  the definition of ‘good faith’ under Article 1 is ‘honesty in fact in the conduct or transaction concerned’; the definition of ‘good faith’ under Article 3 in New York is ‘honestly in fact in the conduct or transaction concerned’.  Hence, one can become a holder in due course in New York without being required to observe ‘reasonable commercial standards of fair dealing’.  While this may be a just result when only one of the parties is a nonprofessional, the same policies do not apply if both parties are professionals.  Regardless, the law in New York on ‘good faith’ requires only honesty in fact.  The significance of this will be explored when cases are discussed.

Finally, for a party to become a holder in due course, he or she must not be on notice of anything stated in Section 3-302(a)(2)(iii).  Hence the instrument must be taken:

(iii) without notice that the instrument is overdue or has been dishonored or that there is an uncured default with respect to payment of another instrument issued as part of the same series, (iv) without notice that the instrument contains an unauthorized signature or has been altered, (v) without notice of any claim to the instrument described in Section 3-306, and (vi) without notice that any party has a defense or claim in recoupment described in Section 3-305(a).

The gist of Section 3-302(a)(2)(iii) is that the purchaser of the instrument has no notice of anything that would call the ultimate enforceability of the note into question.  Which brings us to the basic question of ‘notice’, a pervasive concept throughout the UCC.

Notice and related definitions are defined under Section 1-202.  Notice itself is specifically defined in Section 1-202(a):

(a)  Subject to subsection (f), a person has "notice" of a fact if the person: (1) has actual knowledge of it; (2) has received a notice or notification of it; or (3) from all the facts and circumstances known to the person at the time in question, has reason to know that it exists.

It is clear, as stated in Subsection 1-202(a) that a person has ‘notice’ of a fact if he or she has actual knowledge of the fact in question.  The question of when a person has received notice or notification stated in Section 1-202(a)(2) is answered in Section 1-202(e):

Subject to subsection (f), a person "receives" a notice or notification when: (1) it comes to that person's attention; or (2) it is duly delivered in a form reasonable under the circumstances at the place of business through which the contract was made or at another location held out by that person as the place for receipt of such communications.

                                                            Section 1-202(e)

Person is defined under Section 1-201(b)(27)

"Person" means an individual, corporation, business trust, estate, trust,    partnership, limited liability company, association, joint venture, government, governmental subdivision, agency, or instrumentality, public corporation, or any other legal or commercial entity.

 Notice to an organization is governed by Section 1-202(f):

(f) Notice, knowledge, or a notice or notification received by an organization is effective for a particular transaction from the time it is brought to the attention of the individual conducting that transaction and, in any event, from the time it would have been brought to the individual's attention if the organization had exercised due diligence….

Once again, we see the focus on the behavior of the person or entity giving notice, rather than the actual receipt of notice.  Once certain steps have been taken, notice is deemed given and received even if it is not actually received:

(d) A person "notifies" or "gives" a notice or notification to another person by taking such steps as may be reasonably required to inform the other person in ordinary course, whether or not the other person actually comes to know of it.  Section 1-202(d)

          The final way in which a person can be held to have notice is stated in Section 1-202(a)(3).  Under that section a person has ‘notice’ of a fact if the person:
 

from all the facts and circumstances known to the person at the time in question, has reason to know that it exists.

This relatively simple language raises many questions.  First, does a subjective or objective standard apply?  Does the amended definition of ‘good faith’, and the universal obligation to act in good faith under Section 1-304 minimize the importance of the objective/subjective standard by requiring that all duties under the Code require the observance of reasonable commercial standards of fair dealing?  There is ample case support for both the objective and subjective standard, and good policy arguments as well. 

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            As of this post, we have established the basic requirements to establish negotiability under Section 3-104 and related sections.  This was done to create a basis for discussing the transferability of negotiable instruments in the commercial setting, and hence to give a context in which to access the value and importance of negotiable instruments.  We know that if the writing is negotiable, and taken by a holder in ‘good faith’, for ‘value’ and without notice of a claim or defect to the instrument, the taker will become a holder in due course, and cut off all personal defenses on the instrument per Section 3-305(2).

            With this basic foundation, the next two posts will discuss cases which bear on the issues discussed.  For those seeking to learn this material, I suggest a review, in sequence, of the statutory provisions of Article 3 covered to date.

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Protecting the Holder in Due Course

As discussions of substantive provisions unfold, it is important to remember the policies involved.  As stated, the primary policy of Article 3 is the ‘free flow of commercial paper’.  It is within this broad philosophy that the importance of negotiability is evident.  Drafting writing in negotiable form dramatically increases the marketability of the paper by providing a commercial setting in which the purchaser of such paper will be insulated from certain defenses on the instrument that the obligor may have against his or her payee.  This has been stated several times, and it is now time to turn to the statutory provisions which produce this result. 

One of these provisions is Section 3-305 which deals with various defenses to liability on an instrument. There are two types of defenses recognized in Section 3-305: ‘personal’ defenses, which are cut off when a purchase of the instrument results in holder in due course status and ’real’ defenses which are not cut off by a holder in due course.  Examples of the former are duress or lack of legal capacity to sign a contract. If a minor signed a contract, for example, there would be a lack of legal capacity to enter into a contract.  Such a real defense is not cut off by a holder in due course. Other examples of real defenses are listed in Section 3-305(a)(1).

The basic rule regarding personal defenses to an instrument are contained in Section 3-305(a)(2):

(a) Except as otherwise provided in this section, the right to enforce the obligation of a party to pay an instrument is subject to the following:

(2) a defense of the obligor stated in another section of this Article or a defense of the obligor that would be available if the person entitled to enforce the instrument were enforcing a right to payment under a simple contract; …

This is a common sense rule and result. Fred issues a promissory note to Alice for $700 who has agreed to paint Fred’s portrait on his barn.  Alice paints Fred’s nose and glasses, but nothing else.  Alice presents her note to Fred on the due date demanding payment of $700.  Against Alice, Fred, by reason of Section 3-305(a)(2) can successfully defend with breach of contract, failure of consideration.  If however, Alice sold the note to Ralph who became a holder in due course, Fred would not be able to assert the breach of contract and failure of consideration against Ralph when Ralph demands payment:

(b) The right of a holder in due course to enforce the obligation of a party to pay the instrument is subject to defenses of the obligor stated in subsection (a)(1) [real defenses], but is not subject to defenses of the obligor stated in subsection (a)(2) [personal defenses] or claims in recoupment [personal defenses] stated in subsection (a)(3) against a person other than the holder.

This very short paragraph captures the essence of why it is so important to have the writing in negotiable form, for it is only in that form that Section 3-305(b) comes into play.  That result follows from the reference to ‘an instrument’ in Section 3-305(b) which is defined under Section 3-104(b) as a ‘negotiable instrument’. If not negotiable the writing is, for all practical purposes, outside the scope of Article 3.

      As we continue our discussion of Section 3-302, I refer you back to the primary policy of Article 3—free flow of commercial paper.  This of course must include rules which safeguard parties to those transactions.  But even in that instance, the existence of those rules are designed to create protections which of themselves promote the movement of commercial paper through a set of laws which let everyone know where he or she stands at any point in time.

Before reading Section 3-302 below, I suggest that you take a moment to think about how you would design a rule to protect the free flow of commercial paper in the marketplace.  What would a ‘protected purchaser’ look like? What rules would you include to balance the interests of the movement of the paper and maintaining sound commercial practices in the process?  The drafters of the Uniform Commercial Code answered the question in Section 3-302:  

(a)  Subject to subsection (c) and Section 3-106(d), "holder in due course" means the holder of an instrument if:

(1) the instrument when issued or negotiated to the holder does not bear such apparent evidence of forgery or alteration or is not otherwise so irregular or incomplete as to call into question its authenticity; and

(2) the holder took the instrument (i) for value, (ii) in good faith, (iii) without notice that the instrument is overdue or has been dishonored or that there is an uncured default with respect to payment of another instrument issued ‘as part of the same series, (iv) without notice that the instrument contains an unauthorized signature or has been altered, (v) without notice of any claim to the instrument described in Section 3-306, and (vi) without notice that any party has a defense or claim in recoupment described in Section 3-305(a).

There are five stated elements:

1.    There must be a ‘holder’;

2.    There must be an ‘instrument’ which appears regular on its face;

3.    The holder of the instrument must give value for it;

4.    The holder of the instrument must take the instrument in good faith;

5.    The holder must not have notice of claims or defenses to the instrument or of any other items listed in Section 3-305(a)(2)(iii)(iv)(v)(vi)

Before Section 3-305 is activated, two things must be in place.  First, there must be a ‘holder’ of the instrument.  Holder is defined under Section 1-201(b)(21)(a) as  ‘the person in possession of a negotiable instrument that is payable either to bearer or to an identified person that is the person in possession’.  Establishing ‘holder’ status has been difficult in a significant number of mortgage cases, which is an essential element to bringing a law suit on the note, for it established standing.  Once ‘holder’ status is established, and it has been established that the writing is negotiable, it must be shown that the instrument in question is in proper form as required in Section 3-302(a)(1).

 This is a common sense provision which simply requires that the instrument in question be in proper form and free from obvious tampering.  Obviously, the Code does not want to protect the free flow of irregular commercial paper.  Once holder status and negotiability have been established, and you have gotten past the physical appearance of the instrument, inquiry shifts to the circumstances of the transaction which are required under Section 3-305(b) in order for holder in due course status to arise.   These will be discussed in the next post.