Chapter 24: Holder in Due Course and Liability

Chapter Objectives
Define a holder and a holder in due course.
Identify and apply the requirements for becoming a holder in due course.
Describe the signature liability of makers, drawers, drawees, and accommodation parties.
Distinguish between primary and secondary liability on negotiable instruments.
List the transfer warranties and describe the liability of parties for breaching them.
List the presentment warranties and describe the liability of parties for breaching them.
Identify real defenses that can be asserted against a holder in due course.
Identify personal defenses that cannot be asserted against a holder in due course.
Describe how liability on a negotiable instrument is discharged.
Describe the Federal Trade Commission rule that prohibits the holder in due course rule in consumer transactions.

• A holder is a person who is in possession of a negotiable instrument that is drawn, issued, or indorsed to him or his order, or to bearer, or in blank.
• A holder in due course is a holder who takes a negotiable instrument for value, in good faith, and without notice that it is defective or overdue.

Requirements for becoming a holder in due course
To be a holder in due course of a negotiable instrument, the negotiable instrument must be taken:

• For value (holder must have given value
• In good faith (honesty in fact in the conduct or transaction concerned)
• Without notice of defect
• Without any apparent evidence of forgery, alterations, or irregularity

Signature liability of makers, drawers, drawees, and accommodation parties
Signature liability means that a person cannot be held contractually liable on a negotiable instrument unless his or her signature appears on the instrument. A signature is any name, word, or mark used in lieu of a written signature. A signature may be handwritten, typed, printed, stamped, or made in almost any other manner and executed or adopted by a party to authenticate a writing.

• Primary liability is absolute liability to pay a negotiable instrument, subject to certain real defenses.
• Secondary liability is liability on a negotiable instrument that is imposed on a party only when the party primarily liable on the instrument defaults and fails to pay the instrument when due. Requirements for secondary liability include:
• The instrument is properly presented for payment.
• The instrument is dishonored.
• Timely notice of the dishonor is given to the person to be held secondarily liable on the instrument.

Transfer warranties and liability of parties breaching them
Any of the following five warranties are transfer warranties:

• The transferor had good title to the instrument or is authorized to obtain payment or acceptance on behalf of one who does have good title.
• All signatures are genuine or authorized.
• The instrument has not been materially altered.
• No defenses of any party are good against the transferor.
• The transferor has no knowledge of any insolvency proceeding against the maker, acceptor, or drawer of an unaccepted instrument.

Presentment warranties and liability of parties breaching them
Any person who presents a draft or check for payment or acceptance makes the following presentment warranties to a drawee or acceptor who pays or accepts the instrument in good faith:

• The presenter has good title to the instrument or is authorized to obtain payment or acceptance of the person who has good title.
• The instrument has not been materially altered.
• The presenter has no knowledge that the signature of the maker or drawer is unauthorized.

Real defenses that can be asserted against a holder in due course
Real defenses are defenses that can be raised against both holders and holders in due course:

• Minority
• Extreme duress
• Mental incapacity
• Illegality
• Discharge in bankruptcy
• Fraud in the inception
• Forgery
• Material alteration

Personal defenses that cannot be asserted against a holder in due course
Personal defenses can be raised against enforcement of a negotiable instrument by an ordinary holder, but not against a holder in due course:

• Breach of contract
• Fraud in the inducement
• Mental illness that makes a contract voidable instead of void
• Illegality of a contract that makes the contract voidable instead of void
• Ordinary duress or undue influence
• Discharge of an instrument by payment or cancellation

Discharge of liability on a negotiable instrument
Discharge is actions or events that relieve certain parties from liability on negotiable instruments. There three methods of discharge:

• Payment of the instrument
• Cancellation
• Impairment of the right of recourse

FTC and holder in due course
The Federal Trade Commission has adopted a rule that eliminates HDC status with regard to negotiable instruments arising out of certain consumer credit transactions. The rule equates the HDC of a consumer credit contract with the assignee of a simple contract.

• allonge—A separate piece of paper attached to the instrument on which the indorsement is written.
• assignee—The party to whom the right has been transferred.
• assignment—The transfer of contractual rights by the obligee to another party.
• assignor—The party who transfers the right.
• bearer paper—Bearer paper is negotiated by delivery: indorsement is not necessary.
• blank indorsement—An indorsement that does not specify a particular indorsee. It creates bearer paper.
• certificate of deposit (CD)—A two-party negotiable instrument that is a special form of note created when a depositor deposits money at a financial institution in exchange for the institution's promise to pay back the amount of the deposit plus and agreed-upon rate of interest upon the expiration of a set time period agreed upon by the parties.
• check—An order by the drawer to the drawee bank to pay a specified sum of money from the drawer's checking accounting to the named payee (or holder).
• collateral—Security against repayment of the note that lenders sometimes require; can be a car, a house, or other property.
• demand instrument—An instrument payable on demand.
• demand note—A note payable on demand.
• draft—A three-party instrument that is an unconditional written order by one party that orders the second party to pay money to a third party.
• drawee of a check—The financial institution where the drawer has his or her account.
• drawee of a draft—The party who must pay the money stated in the draft. Also called the acceptor of a draft.
• drawer of a check—The checking account holder and writer of the check.
• drawer of a draft—The party who writes the order for a draft.
• drawer's negligence—The drawer is liable if his or her negligence led to his or her forged signature or the alteration of a check. The payor bank is not liable in such circumstances.
• fictitious payee rule—A rule that says a drawer or maker is liable on a forged or unauthorized indorsement of a fictitious payee.
• fixed amount of money—A negotiable instrument must contain a promise or order to pay a fixed amount of money.
• fixed amount—A requirement of a negotiable instrument that ensures that the value of the instrument can be determined with certainty.
• forged indorsement—The forged signature of a payee or holder on a negotiable instrument.
• holder—A person who is in possession of a negotiable instrument that is drawn, issued, or indorsed to him or his order, or to bearer, or in blank.
• imposter rule—A rule that says if an imposter forges the indorsement of the named payee, the drawer or maker is liable on the instrument and bears the loss.
• imposter—A person who impersonates a payee and induces a maker or drawer to issue an instrument in the payee's name and to give it to the imposter.
• indorsee—The person to whom negotiable instrument is indorsed.
• indorsement for deposit or collection—An indorsement that makes the indorsee the indorser's collecting agent (e.g. for deposit only)
• indorsement—The signature (and other directions) written by or on behalf of the holder somewhere on the instrument.
• indorser—The person who indorses a negotiable instrument.
• instrument—Term that means negotiable instrument.
• maker of a CD—The bank (borrower).
• maker of a note—The party who makes the promise to pay (borrower).
• money—A "medium of exchange authorized or adopted by a domestic or foreign government."
• negotiable instrument—A special form of contract that satisfies the requirements established by Article 3 of the UCC. Also called commercial paper.
• negotiable instrument—A special form of contract that satisfies the requirements established by Article 3 of the UCC. Also called commercial paper.
• negotiation—Transfer of a negotiable instrument by a person other than the issuer to a person who thereby becomes a holder.
• nonnegotiable contract—Fails to meet the requirements of a negotiable instrument and, therefore, is not subject to the provisions of UCC Article 3.
• nonrestrictive indorsement—An indorsement that has no instructions or conditions attached to the payment of the funds.
• order paper—Order paper is negotiated by (1) delivery and (2) indorsement.
• order to pay—A drawer's unconditional order to a drawee to pay a payee.
• payable on demand or at a definite time requirement—A negotiable instrument must be payable either on demand or at a definite time.
• payee of a CD—The depositor (lender).
• payee of a check—The party to whom the check is written.
• payee of a check—The party to whom the check is written.
• payee of a draft—The party who receives the money from a draft.
• payee of a draft—The party who receives the money from a draft.
• payee of a note—The party to whom the promise to pay is made (lender).
• permanency requirement—A requirement of negotiable instruments that says they must be in permanent state, such as written on ordinary paper.
• portability requirement—A requirement of negotiable instruments that says they must be able to be easily transported between areas.
• promise to pay—A maker's (borrower's) unconditional and affirmative undertaking to repay a debt to a payee (lender).
• promissory note—A two-party negotiable instrument that is an unconditional written promise by one party to pay money to another party.
• restrictive indorsement—An indorsement that contains some sort of instruction from the indorser.
• restrictive indorsement—An indorsement that contains some sort of instruction from the indorser.
• sight draft—A draft payable on sight. Also called a demand draft.
• signature requirement—A negotiable instrument must be signed by the drawer or maker. Any symbol executed or adopted by a party with a present intent to authenticate a writing qualifies as his or her signature.
• special indorsement—An indorsement that contains the signature of the indorser and specifies the person (indorsee) to whom the indorser intends the instrument to be payable. Creates order paper.
• time draft—A draft payable at a designated future date.
• time draft—A draft payable at a designated future date.
• time instrument—An instrument payable (1) at a fixed date, (2) on or before a stated date, (3) at a fixed period after sight, or (4) at a time readily ascertainable when the promise or order is issued.
• time note—A note payable at a specific time.
• trade acceptance—A sight draft that arises when credit is extended (by a seller to a buyer) with the sale of goods. The seller is both the drawer and the payee, and the buyer is the drawee.
• unconditional promise or order to pay requirement—A negotiable instrument must contain either an unconditional promise to pay (note or CD) or an unconditional order to pay (draft or check).
• unconditional—Promises to pay and orders to pay must be unconditional in order for them to be negotiable.
• unqualified indorsement—An indorsement whereby the indorser promises to pay the holder or any subsequent indorser the amount of the instrument if the maker, drawer, or acceptor defaults on it.
• unqualified indorser—An indorser who signs an unqualified indorsement to an instrument.

Internet Links

PINs and Signatures and the Electronic Funds Transfer Code of conduct: http://www.law.usyd.edu.au/~alant/inchoate.html
Payroll Connect: http://www.payroll-connect.com/Articles/2002/January/HolderDueCourse.cfm
Cornell Legal Institute: http://www.law.cornell.edu/ucc/3/3-203.html