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.