Holder in Due Course Wrap Up

As of this writing, we have covered the basic statutory criteria for negotiability contained in Part 1 of Article 3.  We have also discussed the basic mechanics of the transfer of a negotiable instrument under Part 2 of Article 3, and the basic rights attendant to a transfer of a negotiable instrument.  Finally, we have focused on the circumstances under which a transfer of a negotiable instrument will give rise to holder in due course status by the transferee of a negotiable instrument.

            The nuances contained in the ‘good faith’ requirement and ‘notice’ requirement have been discussed as well the impact of these nuances on HDC status.  A careful reading of the amended definition of Section 1-201(b)(20) leaves plenty of room to argue that the subjective standard of honesty in fact still applies, and that the only additional requirement is ‘commercial fairness’ in the transaction.  Similarly, one can argue that the notice requirement, particularly ‘reason to know’ of a particular fact under Section 1-202(a)(3), could be read to require an objective standard or subjective standard.  This creates many possibilities for a creative advocate, particularly one who has a solid understanding of the overall content and flow of the UCC.

             The notice of particular items which will block HDC status are listed in Section 3-302(a)(2).  Thus, in order for a transferee of a negotiable instrument to satisfy the lack of notice requirement, he or she must take the instrument:

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 items listed in Section 3-302(a)(2) and cross references in that section are straightforward, and will not be further discussed at this time.  The main point is that a purchaser of an instrument must take the instrument under circumstances which create holder status, in a good faith transfer which is conducted in a manner consistent with reasonable commercial standards of fairness, and without notice of claims or defenses to the instrument.  Moreover, the instrument must appear to be regular on its face and free of forgeries or alterations as required by Section 3-302(a). 

            If the transferee acquires HDC status, he or she will have the rights contained in Section 3-305(2). By way of introduction, Section 3-305 is broken down into two major components for this analysis.

1.    Defenses which can be asserted against payment;

2.    Rights of a Holder in Due Course viz‘a viz those defenses.

Section 3-305(1) discusses defenses which may asserted against payment of an instrument.  There are two major categories of defenses discussed: ‘real’ defenses and ‘personal’ defenses.  Real defenses are stated in Section 3-305(a)(1):

[A] defense of the obligor based on (i) infancy of the obligor to the extent it is a defense to a simple contract, (ii) duress, lack of legal capacity, or illegality of the transaction which, under other law, nullifies the obligation of the obligor, (iii) fraud that induced the obligor to sign the instrument with neither knowledge nor reasonable opportunity to learn of its character or its essential terms, or (iv) discharge of the obligor in insolvency proceedings;

These defenses are ‘real’ by name, and absolute in practice.  If any of the foregoing are proven, no one, including a holder in due course will be able to successfully enforce payment on the instrument.

            As between a payee of an instrument, or other holder of an instrument, certain personal defenses against payment on the instrument. Section 3-305(a)(2) states:

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:

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;  

As clearly stated in the text of Section 3-305(a)(2), the full range of contract defenses are available to an obligor upon a demand of payment on which he or she is obligated.  Failure of consideration and breach of warranty are two common examples of the type of personal defenses typically used in breach of contract cases.

            It is within the context of Section 3-305(a)(2) that the impact of holder in due course status is most prominently seen:     

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) or claims in recoupment stated in subsection (a)(3) against a person other than the holder.  Section 3-305(b)

 

A holder in due course will take free of the personal defenses that would otherwise be available to the obligor, and hence the critical importance of holder in due course status.

            This sets the framework from which to view the whole discussion of negotiable instruments up to this point, and particularly the importance of articulating what is meant by ‘good faith’ and ‘notice’.  Is good faith still a subjective test with the additional element of commercial fairness?  Or does good faith require some element of commercial reasonableness in the conduct involved?  Is notice determined by an objective standard—i.e.—what would the ‘reasonable person’ have notice of?  Or is it a subjective standard—what this particular person would have reason to know?   Or is it a combination?

            As a litigator, these fluctuating definitions create opportunities for creative advocacy.  Once a position is determined, the case is made stronger by the application of the policies and procedures of Section 1-103(a)(1)(2)(3).  The idea of drafting to  accommodate for the definitions of ‘good faith’ and ‘notice’ raises interesting possibilities.  For example, can the drafter of a promissory note include a term which states what good faith means when the note is transferred, subject only to the limitation that the standards set are not ‘manifestly unreasonable’ per Section 1-302?  These questions are both interesting and raise very practical considerations for drafting and litigation strategies.

            The next post will begin a discussion of liability of the parties under Part 4 or Article 3.