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______________________________________________ CHAPTER 3

HOLDERS IN DUE

COURSE

I. ACQUIRING HOLDER IN DUE COURSE STATUS

If you remember the rule that a holder in due course takes free of

most of the defenses the parties to the original transaction have against

one another, it is easy to see why it is important to determine if the

person currently possessing the instrument qualifies as a holder in due

course. The basic definition is found in §3-302(a), which you should read

carefully.

Official Comment 4 to §3-302 makes it clear that the payee can qualify

as a holder in due course in some rare situations. Normally, the payee is

so involved in the underlying transaction that he or she has notice of

problems affecting payment obligations, and thus cannot be a holder in

due course. But the examples given in Official Comment 4 describe fact

patterns where the payee is innocent of such knowledge and can there-

fore qualify for the protection given to holders in due course. See also

Eldon’s Super Fresh Stores, Inc. v. Merrill Lynch, Pierce, Fenner & Smith,

Inc., 296 Minn. 130, 207 N.W.2d 282, 12 U.C.C. Rep. Serv. 490 (1973), for

an example of the payee as a holder in due course.

Subsection (c) gives a list of extraordinary transactions — creditors

seizing instruments by judicial process, the sale of an inventoried business

(a ‘‘bulk transaction’’), or the appointment of the administrator of an

estate containing negotiable instruments — in which the transferee is

statutorily denied holder in due course status.

A. ‘‘Holder’’

Note first of all that in order to be a holder in due course the

possessor of the instrument must qualify as a holder. This means that the

instrument must be technically negotiable and must have been technically

negotiated into the hands of its current possessor (however, the named

payee becomes a holder on issuance of the instrument without the ne-

cessity of a negotiation, as does anyone to whom a bearer instrument is

issued). No one can be a holder in due course of a non-negotiable in-

strument, nor even of a negotiable instrument if there is some defect in

the transfer (negotiation) process.

One technical point: the drawee bank on which a check is drawn,

taking the check for payment, does not qualify as a ‘‘holder.’’ The reason

is that an instrument must be negotiated to a holder, and the process by

which the drawee bank acquires the instrument is not a negotiation, it is a

mere surrender for payment (a ‘‘presentment’’). Thus the drawee bank is

not a holder, and consequently not a holder in due course.

B. ‘‘Value’’

It is important to emphasize that whether or not someone qualifies

as a holder in due course is measured at the moment he or she gave

value for the instrument (assuming there has been a valid negotiation so

as to create holder status). Things that happen after value is given (such

as receiving notice of problems with the instrument) do not destroy

holder in due course status once achieved.

1. In spite of §3-302(c), which would seem to reach the opposite result, the federal

courts have held that federal agencies such as the FDIC when taking over failed financial

institutions acquire holder in due course status as a matter of federal law. Campbell

Leasing, Inc. v. FDIC, 901 F.2d 1244, 12 U.C.C. Rep. Serv. 2d 138 (5th Cir. 1990); but see

DiVall Insured Income Fund Ltd. Partnership v. Boatmen’s First National Bank, 69 F.3d

1398, 28 U.C.C. Rep. Serv. 2d 589 (8th Cir. 1995). However, the federal courts have made

it clear that the FDIC cannot be a holder in due course for non-negotiable instruments;

Sunbelt Savings, FSB, Dallas, Texas v. Montross, 923 F.2d 353, 13 U.C.C. Rep. Serv. 2d 792

(1991).

36 3. Holders in Due Course

What is ‘‘value’’?

First of all, the gift of an instrument will never create holder in due

course status in the donee (though the donee may get similar rights

under the shelter rule, discussed below). The confusing part of the value

requirement is that giving value is not the same thing as giving consider-

ation. Read §3-303’s Official Comment 1, first paragraph. The drafters of

the Code decided that one gives value only to the extent that the holder

has performed the consideration or made some irrevocable commitment

in connection with it. If all that has been exchanged for the instrument is

an unexecuted promise and then a problem arises, the holder has the

self-help remedy of refusing to perform and does not need the extraor-

dinary status of holding in due course; thus, the holder has not given

value under the Code. This is true even though the promise would be

sufficient consideration at common law. Read §3-303 and its Official

Comment and then resolve the Problems that follow.

PROBLEM 20

Joe Lunchpail arrived home one day to find a note from his wife stating

that she was divorcing him and that he should get a lawyer. Since he had

just been paid that day, he took his paycheck down to the law office of

Nathan Novice and indorsed it over to Nathan in return for the latter’s

promise to represent Joe in his divorce. Later that evening, Joe’s wife sent

the sheriff to seize his paycheck. Joe laughingly referred the sheriff to his

attorney. Can the sheriff succeed in wresting the check from Nathan’s

hands? See §§3-306, 3-303; Carter & Grimsley v. Omni Trading, Inc., 306

Ill. App. 3d 1127, 716 N.E.2d 320, 39 U.C.C. Rep. Serv. 2d 484 (1999).

PROBLEM 21

Zach Taylor bought a car for his business from Fillmore Motors,

signing a promissory note for $23,000 payable to Fillmore. Fillmore sold

the note to the Pierce Finance Company for $22,800, a $200 discount. The

car fell apart, and Zach refused to pay. Is the finance company (assuming

good faith and lack of notice) a holder in due course for $23,000 or

$22,800? See Bankers Guar. Title & Trust Co. v. Fisher, 2 Ohio Misc. 18,

204 N.E.2d 103 (C.P. 1964). If Millard Fillmore, the owner of Fillmore

Motors, owed his mother $21,000 and gave her the note with the

understanding that the extra $2,000 was a Mother’s Day gift, would the

mother be a holder in due course for the full amount? See §3-303.

I. Acquiring Holder in Due Course Status 37

PROBLEM 22

Tom Winker tricked old Mrs. Nodding into writing a check payable to

Tom (she thought he was the agent for a local charity). The check for

$1,000 was drawn on her bank, the First County Bank. Tom took the check

to his bank, the Last National Bank, and, after indorsing it, put it in his

checking account. Last National Bank sent the check to the First County

Bank for payment, but by the time it got there Mrs. Nodding had stopped

payment so that the check was dishonored and returned to Last National.

Is Last National Bank a holder in due course? This question will be

important if Tom has skipped town and Last National decides to sue

Mrs. Nodding under §3-414.

The bank’s major problem in situations like Problem 22 is in proving

that it paid value for the check. Is the bank out of pocket anything? If so,

the Code will permit the bank to recover. Thus, if the bank had permitted

Tom to get the money before the check cleared through the drawee bank,

the Last National Bank would be a holder in due course. Article 4 of the

UCC (which deals with bank collection) sets out special rules for this kind

of value. Section 4-211 provides that for purposes of determining its

holder in due course status, a bank gives value whenever it has a security

interest in the instrument. The situations in which this occurs are spelled

out in §4-210(a). Read these sections, and consider the following case.

Falls Church Bank v. Wesley Heights Realty, Inc.

District of Columbia Court of Appeals, 1969

256 A.2d 915, 6 U.C.C. Rep. Serv. 1082

HOOD,J.

The sole issue on this appeal is whether and under what circum-

stances, may a depositary bank achieve the status of holder in due course

of negotiable paper deposited with it by a customer. The facts are un-

disputed.

The appellees drew a check for $1,400.00, payable to the order of a

customer of appellant bank. The customer deposited this check in his ac-

count with the bank and was given a provisional credit of this amount. The

customer was permitted to withdraw $140.00 from this account prior to the

bank’s discovering that appellees had stopped payment on the $1,400.00

check. When the check was returned to the bank dishonored, the bank’s

customer had ‘‘skipped,’’ leaving no credits in his account on which to

charge the $140.00. The bank, thereupon, made demand on appellees for

that amount and when appellees refused, this action was brought.

38 3. Holders in Due Course

At trial appellees moved for, and were granted, judgment on grounds

that the bank ‘‘was an agent for collection only and did not have a

security interest and was not a holder in due course for value.’’

We reverse. The Uniform Commercial Code, which controls in this

case, expressly provides that a bank acquires a security interest in items

deposited with it to the extent that the provisional credit given the cus-

tomer on the item is withdrawn. UCC §4-208 [§4-210 in the revised ver-

sion of Article 4 — Ed.]. It further provides that, for purposes of achieving

the status of holder in due course, the depositary bank gives value to

the extent that it acquires a security interest in the item in question. UCC

§4-209 [§4-211 in the Revision — Ed.].

We agree that appellant bank is deemed by the Uniform Commercial

Code to be an agent of its customers (§4-201) but under the scheme of

the Code, a ‘‘bank may be a holder in due course while acting as a

collecting agent for its customer.’’ Citizens Bank of Booneville v. National

Bank of Commerce, 334 F.2d 257, 261 (10th Cir. 1964). See also cases

collected at 18 A.L.R.3d 1388-1391.

As a holder in due course as to $140.00, appellant’s claim cannot be

defeated except by those defenses set out in UCC §3-305(2), none of

which are herein alleged. The judgment below is accordingly reversed

with instructions to enter judgment for appellant.

PROBLEM 23

Same situation as Problem 22 except that when Tom deposits the

$1,000 check in his account, the account contains $500. Later that

afternoon he withdraws $500. Is the bank a holder in due course for any

amount? See §4-210(b) (the FIFO rule: First In, First Out). What result if he

withdraws $750?

C. ‘‘Good Faith’’ and ‘‘Notice’’

To become a holder in due course, the owner of the instrument

must be, in effect, a bona fide purchaser — that is, the owner must have

given value for the instrument in good faith (defined in §1-201(19) as

‘‘honesty in fact in the conduct or transaction concerned,’’ but redefined

in §3-103(a)(4) to include not only ‘‘honesty in fact’’ but also ‘‘the ob-

servance of reasonable commercial standards of fair dealing’’), thus

making the test one that is both subjective and objective. Read Official

Comment 4 to §3-103. The holder must also be without notice that there

are problems with the instrument.

I. Acquiring Holder in Due Course Status 39

These latter two concepts — good faith and notice — are inevitably

intertwined: if, at the time value is given for the instrument, a person has

notice of a defense the maker of a note has against the payee, the holder

cannot be said to take the note with the good faith expectation that it

should be paid in spite of the defense. See Annot., 36 A.L.R.4th 212. In

the cases that follow, you should note how often the court fails to sepa-

rate these two issues.

General Investment Corp. v. Angelini

New Jersey Supreme Court, 1971

58 N.J. 396, 278 A.2d 193, 9 U.C.C. Rep. Serv. 1

FRANCIS,J.

The trial judge sitting without a jury, held that plaintiff was a holder

in due course of a note signed by defendants Anthony V. Angelini and

Dolores H. Angelini and consequently in this action brought thereon was

immune from certain defenses sought to be asserted by them. Therefore,

he entered judgment against defendants in the amount of $5,363.40 plus

interest. The Appellate Division affirmed the judgment in an unreported

opinion. We granted defendants’ petition for certification. 57 N.J. 238

(1970).

On December 10, 1966, defendants Anthony and Dolores Angelini,

husband and wife, entered into a contract with Lustro Aluminum Pro-

ducts, Inc. for certain repair work on their home at 689 Clark Avenue,

Ridgefield, N.J. It provided that Lustro, ‘‘a home repair contractor, duly

licensed under the New Jersey Home Repair Financing Act, Chapter 41,

Laws 1960,’’ would

Supply & Install Gold Bond Plasticrylic Avocado Siding with Grey Sills &

Trim. Apply Heavy Quilted Breather Foil on all wall areas around complete

house. Corner posts to be green, all mullions to be fabricated in grey

aluminum. Supply & install 2 anodized storm doors (Rear & Side Entrances).

2. Incidentally, more cases than usual appear in this segment of the book. Whether

or not the holder took in good faith and without notice is largely a factual question; its

resolution calls for the kind of detailed analysis only full court opinions can give. The FTC

Holder in Due Course Regulation would now settle many of these cases, and all of them

were decided before the revised version of Article 3 took effect, so their citations are to

the 1962 version. However, the cases are all still good law, with one point only being

different: the 1990 revision of Article 3 added an objective component to the test of good

faith (which the original version lacked), so that holders must also behave in a commercially

reasonable fashion to achieve holder in due course status. The test is no longer purely

subjective, as it was when some of these cases were decided under the 1962 standard.

40 3. Holders in Due Course

All overhangs & trim to be covered with special Marine Paint in grey color (as

close as possible to Oxford grey trim).

This will include cleaning up job.

The cash price for the work was fixed at $3,600 but the time payment

price was $5,363.40, payable in 84 monthly installments of $63.85 each.

Payments were to commence ‘‘60 days after completion’’ of the work. The

agreement provided also that the Angelinis would ‘‘execute a note and

application for credit, and any other appropriate instrument for the

purpose of financing. . . .’’ On the same date as the contract, they did sign

a note in the principal sum of $5,363.40, promising to pay that amount to

the order of Lustro in equal consecutive monthly installments of $63.85

each ‘‘commencing February 19, 1967, with interest after maturity at the

highest rate.’’ According to defendants, at the time they signed the note it

was not dated and the date of commencement of payment was not set

forth. Anthony Angelini testified that he was told by Lustro’s represen-

tative that the payments would not begin until he was completely satisfied

with the job. The trial court found as a fact that when the note was

executed it bore ‘‘no dates.’’

Plaintiff General Investment Corp. is a home improvement contract

financier. It deals with 300 contractors and arranges approximately 1,800

home improvement loans per year. Approximately 10 percent of its vol-

ume came from Lustro. General Investment’s representative testified that

the Angelini note was purchased for value from Lustro on the day of its

alleged execution, December 19, 1966. It was endorsed without recourse,

except that the endorser-contractor warranted as part of the endorsement

that it ‘‘has furnished and installed all articles and materials and has fully

completed all work which constitutes the consideration for which this

note was executed and delivered by the maker.’’ When the note was

endorsed and delivered by Lustro plaintiff required the home improve-

ment contract to accompany it. The two documents were separate pieces

of paper but it was obvious from the contract form that they were in-

terrelated parts of a single transaction. Plaintiff’s agent read the contract

before discounting the note, and he conceded, in any event, that his

experience with the nature of Lustro’s operation made him fully familiar

with the terms of the contract and the note. Defendants’ contract and

note to his knowledge were in the form customarily used by Lustro. He

said also that in cases involving home improvement notes one of the

requisites of the transaction was to obtain a copy of the work contract.

Having obtained it as part of the note-discounting event, both documents

were kept as part of plaintiff’s records. Thus, General Investment knew

that under Lustro’s method of operation the homeowner’s obligation to

commence payments did not come into being until 60 days after the

I. Acquiring Holder in Due Course Status 41

home improvements were completed. It had to know also by inescapable

implication that ‘‘60 days after completion’’ were not just words, but that

they meant after completion in a workmanlike manner.

When plaintiff’s representative received the note and contract and

discounted the note, he did not inquire of the Angelinis if the work had

been completed prior to or on December 19, the ostensible execution

date of the note, nor did he ask Lustro for a certificate of completion

signed by defendants. See N.J.S.A. 17:16-66, L.1960, c.41, §5, which pro-

vides that ‘‘[n]o home repair contractor shall request or accept a certif-

icate of completion signed by the owner prior to the actual completion of

the work to be performed under the home repair contract.’’ This quoted

section is part of the Home Repair Financing Act of 1960 under which

plaintiff knew Lustro was licensed to do business. N.J.S.A. 17:16C-93;

17:16C-77. If a request had been made by General Investment for a cer-

tificate of completion, it would have learned immediately that the work

had not been completed. Instead plaintiff chose to accept the represen-

tation in the printed form of endorsement, appearing on the back of the

note and above Lustro’s signature, that the work had been ‘‘fully com-

pleted’’ in the 10 days between the contract date, December 10, 1966 and

December 19, the ostensible but false date of execution of the note.

According to Anthony Angelini’s undenied testimony, Lustro began

work on his house on December 15. After working on that one day

nothing further was done for several days. It never did complete the work

and the part performance neither conformed to the contract nor met

reasonable workmanlike standards. Ultimately Lustro became insolvent

and, according to the Angelinis, the contract was never fulfilled.

The plaintiff’s testimony is to the effect that when it discounted the

note, the payment commencement date appeared therein as February 19,

1967. As already noted, the trial court found as a fact that the places for

dates thereon were blank at the time of its execution. At any rate, on or

about December 24, 1966 the Angelinis received from plaintiff an in-

stallment payment coupon book which called for the first payment to be

made on February 19, 1967. Defendants promptly returned the book to

plaintiff with the advice that the contract called for payments to begin 60

days after completion of the work and that it had not been completed.

Defendants also sent a copy of their letter to Lustro. Moreover, it appears

that plaintiff wrote Lustro about defendants’ complaint stating that it

‘‘would appreciate your immediate adjustment of same.’’ This letter was a

printed form, thus indicating that plaintiff was prepared for such com-

plaints. In spite of some further correspondence and the Angelinis’ as-

surance that they would begin payments as soon as the work was

completed, Lustro failed to perform. Some months later plaintiff filed

this suit.

42 3. Holders in Due Course

Plaintiff took the position in the trial court and here that it has the

status of a holder in due course of defendants’ negotiable note, and as

such it is immune from the defense of failure of consideration. A holder

in due course is defined in the Uniform Commercial Code, §3-302 as

(1) . . . a holder who takes the instrument

(a) for value; and

(b) in good faith; and

of any person.

If the plaintiff is not such a holder it is subject to the defense of

failure of consideration on the part of Lustro. Unico v. Owen, 50 N.J. 101,

109 (1967).

As we said in Unico:

In the field of negotiable instruments, good faith is a broad concept.

The basic philosophy of the holder in due course status is to encourage free

negotiability of commercial paper by removing certain anxieties of one who

takes the paper as an innocent purchaser knowing no reason why the paper

is not as sound as its face would indicate. It would seem to follow, therefore,

that the more the holder knows about the underlying transaction, and par-

ticularly the more he controls or participates or becomes involved in it, the

less he fits the role of a good faith purchaser for value; the closer his rela-

tionship to the underlying agreement which is the source of the note, the

less need there is for giving him the tension free rights considered necessary

in a fast-moving, credit-extending commercial world. [Id. at 109-110.]

Good faith is determined by looking to the mind of the particular

holder. New Jersey Study Comment 1B to N.J.S.A. 12A:3-302, at p.134,

§1-201(19). The test is neither freedom from negligence in entering into

the transaction nor awareness of circumstances calculated to arouse sus-

picions either as to whether the instrument is subject to some defense not

appearing on its face or whether the promise to pay is not as uncondi-

tional as it appears therein. Joseph v. Lesnevich, 56 N.J. Super. 340, 348

(App. Div. 1959). However, evidence of circumstances surrounding the

negotiation of the note which excite question as to whether the obliga-

tion it represents is really dependent upon performance of some duty by

the payee is of probative value if it provides some support for a finding of

a bad faith taking by the holder. Id. at 348. Of course in evaluating the

circumstances, we recognize that the unique policy considerations atten-

dant upon consumer home repair transactions, . . . require us to closely

scrutinize the existence of good faith in these situations. Ordinarily where

the note appears to be negotiable in form and regular on its face, the

I. Acquiring Holder in Due Course Status 43

holder is under no duty to inquire as to possible defenses, such as failure

of consideration, unless the circumstances of which he has knowledge rise

to the level that the failure to inquire reveals a deliberate desire on his

part to evade knowledge because of a belief or fear that investigation

would disclose a defense arising from the transaction. Id. at 349; First

Natl. Bank of Blairstown v. Goldberg, 340 Pa. 337, 17 A.2d 377, 379

(1941). And, in this connection, once it appears that a defense exists

against the payee, the person claiming the rights of a holder in due

course has the burden of establishing that he is in all respects such a

holder. N.J.S.A. §3-307 [§3-308 in the Revision — Ed.].

In this case, as already noted, plaintiff required that the underlying

home improvement contract be submitted with the note at the time it

was discounted. Plaintiff therefore knew that the February 19, 1967 date

appearing in the note as the date of commencement of the installment

payments meant that the owner agreed they were to begin as the con-

tract said, ‘‘60 days after completion’’ of the work. The only sensible

meaning of the agreement obviously is that the Angelinis’ liability to

commence payments was dependent upon completion of the improve-

ment in a good and workmanlike manner 60 days prior to February 19.

In spite of the substantial nature of the work to be performed under the

contract, the fact that the note was being discounted only 10 days after

execution of the contract, that the contractor’s duty was to complete the

work 60 days before the first payment became due, and the knowledge

that under the statute, N.J.S.A. 17:16C-66, the contractor could obtain

from the owner and submit to the finance company a certificate of

completion if the work had been completed, plaintiff neither demanded

such a certificate nor inquired of the owner as to completion. Instead it

chose to accept the contractor’s representation in the note endorsement

form that he had fulfilled his contractual obligation. Such conduct jus-

tifies a strong inference that plaintiff wilfully failed to seek actual

knowledge on the subject of completion because of a belief or a fear

that an inquiry would disclose a failure of consideration of the note.

Absence of inquiry under the circumstances amounts to an intentional

closing of the eyes and mind to any defects in or defenses to the

transaction. In our judgment the evidence in its totality and the infer-

ences fairly drawn therefrom establish convincingly that plaintiff did not

acquire the note in ‘‘good faith’’ and cannot claim the status of a holder

in due course. Consequently it holds the instrument as an assignee and

is subject to the defense of failure of consideration. The trial court’s

holding to the contrary is so opposed to the weight of the evidence as to

constitute a manifest injustice . . .

The judgment is reversed . . .

44 3. Holders in Due Course

PROBLEM 24

The corporate treasurer of the Business Corporation was having major

troubles paying his personal bills, so finally he decided to embark on a life

of crime. He used a corporate check to pay his American Express bill,

making the check out to ‘‘Amerex Corp., 770 Broadway, N.Y., N.Y. 10003’’

(the actual address of American Express). On the corporate check requi-

sition form he wrote a phony explanation that this check represented

shipping expenses. This caused no suspicions at Business Corporation and,

thus encouraged, he did it every month for two years. When Business

Corporation finally figured out what had happened, it sued American

Express in quasi-contract for all the money it had received in this fashion.

American Express replied that it was a holder in due course of these

checks and, as such, was not amenable to this suit. Business Corporation

pointed to the suspicious circumstances and to UCC §§3-302(a) and 3-307

(arguing that the corporate treasurer was a fiduciary). How should this be

resolved? See Hartford Accident & Indem. Co. v. American Express Co., 74

N.Y.2d 153, 542 N.E.2d 1090, 544 N.Y.S.2d 573, 8 U.C.C. Rep. Serv. 2d

865 (1989); Grand Rapids Auto Sales, Inc. v. MBNA American Bank, 227

F. Supp. 2d 721, 49 U.C.C. Rep. Serv. 2d 862 (W.D. Mich. 2002).

Any Kind Checks Cashed, Inc. v. Talcott

District Court of Appeal of Florida, 2002

830 So. 2d 160, 48 U.C.C. Rep. Serv. 2d 800

GROSS,J.

The issue in this case is whether a check cashing store qualifies as a

holder in due course so that it can collect on a $10,000 check written by

an elderly man who was fraudulently induced to issue the check by the

person who cashed it.

We hold that the check cashing store was not a holder in due course,

because the procedures it followed with the $10,000 check did not

comport with reasonable commercial standards of fair dealing.

The case is the story of John G. Talcott, Jr., a ninety-three-year-old

Massachusetts resident, D.J. Rivera, a ‘‘financial advisor’’ to Talcott, and

Salvatore Guarino, a cohort of Rivera. In the mid-1990’s, Rivera sold

Talcott an investment for ‘‘somewhere in the amount of $75,000.’’ The

investment produced no returns.

On December 7, 1999, Guarino established check cashing privileges

at Any Kind Checks Cashed, Inc. (‘‘Any Kind’’) by filling out a customer

card. The card included his social security number and identification by

I. Acquiring Holder in Due Course Status 45

driver’s license. On the card, Guarino listed himself as a broker. That day,

he cashed a $450 check without incident.

On January 10, 2000, Rivera telephoned Talcott and talked him into

sending him a check for $10,000 made out to Guarino, which was to be

used for travel expenses to obtain a return on the original $75,000 in-

vestment. Talcott understood that Guarino was Rivera’s partner. Rivera

received the check on January 11.

Talcott spoke to Rivera on the morning of January 11. Rivera indi-

cated that $10,000 was more than what was needed for travel. He said that

$5,700 would meet the travel costs. Talcott called his bank and stopped

payment on the $10,000 check.

In spite of what Rivera told Talcott, Guarino appeared at Any Kind’s

Stuart, Florida office on January 11 and presented the $10,000 check to

Nancy Michael. She was a supervisor with the company with the authority

to approve checks over $2,000. Guarino showed Michael his driver’s

license and the Federal Express envelope from Talcott in which he

received the check. She asked him the purpose of the check. Consistent

with the information on the customer card, he told her that he was a

broker and that the maker of the check had sent it as an investment. She

was unable to contact the maker of the check by telephone. Based on her

experience, Michael believed the check was good; the Federal Express

envelope was ‘‘very crucial’’ to her decision, because it indicated that the

maker of the check had sent it to the payee trying to cash the check.

After deducting the 5 percent check cashing fee, Michael cashed the

check and gave Guarino $9,500. The next day she deposited the check in

the company’s bank.

On January 15, 2000, Rivera called Talcott and asked about the

$5,700, again promising to send him a return on his investment. The

same day, Talcott sent a check for $5,700. He assumed that Rivera knew

that he had stopped payment on the $10,000 check.

On January 17, 2000, Guarino went into the Stuart Any Kind store

and presented the $5,700 check to the teller, Joanne Kochakian. He

showed her the Federal Express envelope in which the check had come.

Company policy required a supervisor to approve a check over $2,000.

Kochakian noticed that Michael had previously approved the $10,000

check. She called Michael, who was working at another location, and told

her about Guarino’s check.

Any Kind had no written procedures that a supervisor was required

to follow in deciding which checks over $2,000 to cash. Michael had the

discretionary ‘‘decision-making power as a supervisor to decide whether

or not the check [was] any good.’’ She relied on ‘‘instinct and judgment’’

in deciding what inquiry to make before cashing a check. In the brief

46 3. Holders in Due Course

non-jury trial, there was no evidence concerning the general practice of

the check cashing industry.

Michael instructed the cashier not to cash the check until she con-

tacted the maker, Talcott, to obtain approval. On her first attempt,

Kochakian received no answer, using the number on the back of Guar-

ino’s check cashing card. When she told Guarino that she would not cash

his check, he gave her another number to call, which was the same as the

first number except that two numbers were reversed. On the second call,

a woman answered the phone. Kochakian identified herself and asked for

Talcott. Talcott approved cashing the $5,700 check. There was no dis-

cussion of the $10,000 check. Any Kind cashed the second check for

Guarino, from which it deducted a 3 percent fee.

On January 19, Rivera called Talcott to warn him that Guarino was a

cheat and a thief. Talcott immediately called his bank and stopped pay-

ment on the $5,700 check. Talcott’s daughter called Any Kind and told it

of the stop payment on the $5,700 check. There was no dispute at trial

that Guarino and Rivera had pulled a scam on Talcott to get him to issue

the checks. Any Kind filed a two-count complaint against Guarino and

Talcott, claiming that it was a holder in due course. Talcott’s defense was

that Any Kind was not a holder in due course and that his obligation on

the checks was nullified because of Guarino’s illegal acts.

The trial court entered final judgment in favor of Any Kind for only

the $5,700 check. On the $10,000 check, the judge found for Talcott. The

court found that the circumstances surrounding the cashing of the

$10,000 check

were sufficient to put [Any Kind] on notice of potential defenses and/or

infirmities. The best evidence of this is that the plaintiff attempted to

contact the maker but was unable to do so on the first check, and did so on

the second. The circumstances of a person describing himself as a broker,

receiving funds in the amount of $10,000 and negotiating the check for

those funds at a $500 discount are sufficient to put [Any Kind] on inquiry

notice that some confirmation or explanation should be obtained.

Using the terminology of the Uniform Commercial Code, Talcott was

the maker or ‘‘drawer’’ of the check, the person who signed the draft ‘‘as

a person ordering payment.’’ §3-103(a)(3). By Federal Expressing the

check to Guarino, Talcott issued the check to him. See §3-105(a) (de-

fining ‘‘issue’’ as ‘‘the first delivery of an instrument by the maker or

drawer . . . for the purpose of giving rights on the instrument to any

person’’). Guarino indorsed the check and cashed it with Any Kind. See

§3-204(a) (defining ‘‘indorsement’’). Any Kind immediately made the

funds available to Guarino, less its fee. Talcott stopped payment on the

I. Acquiring Holder in Due Course Status 47

check with his bank, so the check was returned to Any Kind. See §4-403

(regarding a customer’s right to stop payment).

When Guarino negotiated the check with Any Kind, it became a

holder of the check, making it a ‘‘person entitled to enforce’’ the in-

strument. See §§1-201(20), 3-301. As the drawer of the check dishonored

by his bank, Talcott’s obligation was to pay the draft to a person entitled

to enforce the draft ‘‘[a]ccording to its terms at the time it was

issued. . . .’’ §3-414(b).

Unless Any Kind is a holder in due course, its right to enforce Tal-

cott’s obligation to pay the draft is subject to (1) all defenses Talcott

could raise ‘‘if the person entitled to enforce the instrument were

enforcing a right to payment under a simple contract,’’ and (2) a claim of

‘‘ecoupment’’ Talcott could raise against Guarino. §3-305(a)(2) and (3).

Because Talcott was fraudulently induced to issue the checks, this case

turns on Any Kind’s entitlement to holder in due course status.

A ‘‘holder in due course’’ is a holder who takes an instrument

without ‘‘apparent evidence of forgery or alteration’’ for value, in good

faith, and without notice of certain claims and defenses. See §3-302(a). As

the party claiming that it was a holder in due course, Any Kind had

the burden to prove that status by a preponderance of the evidence. See

§3-308(b); Seinfeld v. Commercial Bank & Trust Co., 405 So. 2d 1039,

1041 (Fla. 3d DCA 1981).

The question for this court is whether the trial court erred in finding

that Any Kind was not a holder in due course of the $10,000 check based

on the findings of fact made at trial, keeping in mind that Any Kind

bore the burden of proof. That question turns on whether Any Kind

acted ‘‘[i]n good faith’’ within the meaning of §3-302(a).

The good faith requirement of the holder in due course doctrine

‘‘has been the source of an ancient and continuing dispute.’’ White &

Summers, Uniform Commercial Code §17-6 (4th ed. 1995). On the one

hand,

[s]hould the courts apply a so-called objective test, and ask whether a

reasonably prudent person, behaving the way the alleged holder in due

course behaved, would have been acting in good faith? Or should the

courts instead apply a subjective test and examine the person’s actual be-

havior, however stupid and irrespective of the reaction a reasonably pru-

dent person would have had in the same circumstance? The legal

establishment has steered a crooked course through this debate.

Id.; see Patricia L. Heatherman, Comment, Good Faith in Revised Article 3

of the Uniform Commercial Code: Any Change? Should There Be?, 29

Willamette L. Rev. 567 (1993).

48 3. Holders in Due Course

Prior to 1992, section §1-201(19) defined ‘‘good faith’’ as ‘‘honesty in

fact in the conduct of the transaction concerned.’’ Florida courts inter-

preted this definition as creating a subjective test. See Cash-A-Check of

S. Fla., Inc. v. Sunshine Elec. Contractors, Inc., 26 Fla. Supp. 2d 17, 19

(Fla. Palm Beach County Ct. 1987). For example, we wrote in Barnett

Bank of Palm Beach County v. Regency Highland Condo. Ass’n, 452 So.

2d 587, 590 (Fla. 4th DCA 1984), that ‘‘good faith’’ under the holder in

due course doctrine did ‘‘not include due care; rather lack of good faith

must be the result of actual, not constructive, knowledge of the wrong-

doing tantamount to dishonesty or bad faith.’’ In another case, Judge

Schwartz wrote that the ‘‘Florida version of the holder in due course

provision of the U.C.C. does seem to protect the objectively stupid so

long as he is subjectively pure of heart.’’ Seinfeld, 405 So. 2d at 1042.

Application of Barnett Bank’s ‘‘honesty in fact’’ standard to Any Kind’s

conduct in this case would clothe it with holder in due course status. It is

undisputed that Any Kind’s employees were pure of heart, that they acted

without knowledge of Guarino’s wrongdoing.

However, in 1992, the legislature adopted a new definition of ‘‘good

faith’’ that applies to the §3-302’s definition of a holder in due course:

‘‘‘[g]ood faith’ means honesty in fact and the observance of reasonable

commercial standards of fair dealing.’’ Ch. 92-82, §2, at 759, Laws of

Fla. — U.C.C. §3-103(a)(4). To the old, subjective good faith, ‘‘honesty in

fact’’ standard, the legislature added an objective component — the ‘‘pure

heart of the holder must now be accompanied by reasoning that assures

conduct comporting with reasonable commercial standards of fair deal-

ing.’’ Maine Family Fed. Credit Union v. Sun Life Assurance Co. of

Canada, 727 A.2d 335, 342 (Me. 1999). No longer may a holder of an

instrument act with ‘‘a pure heart and an empty head and still obtain

holder in due course status.’’ Id.

Comment 4 to §3-103 attempts to shed light on how to interpret the

new standard:

Although fair dealing is a broad term that must be defined in context, it is

clear that it is concerned with the fairness of conduct rather than the care

with which an act is performed. Failure to exercise ordinary care in con-

ducting a transaction is an entirely different concept than failure to deal

fairly in conducting the transaction.

The Code does not define the term ‘‘fair dealing.’’ As the Maine Su-

preme Court has observed, the ‘‘most obvious question arising from the use

of the term fair is: fairness to whom?’’ Maine Family, 727 A.2d at 343.

Application of holder in due course status is the law’s value judgment

that certain holders are worthy of protection from certain types of claims.

I. Acquiring Holder in Due Course Status 49

For example, it has been argued that application of the old subjective

standard facilitated the transfer of checks in the stream of commerce;

arguably one would be ‘‘more willing to accept the checks if ...she

knows . . . she can be a holder in due course of that instrument and take it

free of defenses that might have existed between the buyer and the seller

in the underlying transaction.’’ White & Summers, §17-1. In applying the

new standard, ‘‘fairness’’ should be measured by taking a global view of

the underlying transaction and all of its participants. A holder ‘‘must act

in a way that is fair according to commercial standards that are themselves

reasonable.’’ Maine Family, 727 A.2d at 343.

To apply the law requiring ‘‘good faith’’ under §3-302(a), we adopt

the analysis set forth by the Supreme Court of Maine:

The factfinder must . . . determine, first, whether the conduct of the holder

comported with industry or ‘‘commercial’’ standards applicable to the

transaction and, second, whether those standards were reasonable standards

intended to result in fair dealing. Each of those determinations must be

made in the context of the specific transaction at hand. If the factfinder’s

conclusion on each point is ‘‘yes,’’ the holder will be determined to have

acted in good faith even if, in the individual transaction at issue, the result

appears unreasonable. Thus a holder may be accorded holder in due

course status where it acts pursuant to those reasonable commercial stan-

dards of fair dealing — even if it is negligent — but may lose that status,

even where it complies with commercial standards, if those standards are

not reasonably related to achieving fair dealing.

Id.

There was no evidence at trial concerning the check cashing indus-

try’s commercial standards. Even assuming that Any Kind’s procedures for

checks over $2,000 met the industry’s gold standard, we hold that in this

case the procedures followed were not reasonably related to achieve fair

dealing with respect to the $10,000 check, taking into consideration all of

the participants in the transaction, Talcott, Guarino, and Any Kind.

Check cashing businesses are regulated by Chapter 560, Florida

Statutes (2001), the Money Transmitters’ Code. See §560.101, Fla. Stat.

(2001). Among the purposes of Chapter 560 are to provide for and

promote:

(b) The maintenance of public confidence in the money transmitter

industry.

system . . .

(e) The opportunity for money transmitters to be and remain compet-

itive with each other and with other business organizations . . .

50 3. Holders in Due Course

(f) The opportunity for money transmitters to effectively serve the

convenience and needs of their customers and the public . . .

(g) The opportunity for the management of money transmitter busi-

nesses to exercise its business judgment within the framework of the code.

§560.102(2). Nothing in Chapter 560 purports to alter or amend any of

the provisions of Chapter 673, leading to a conclusion that the legislature

did not intend to bend the holder in due course provision of the Uni-

form Commercial Code — Negotiable Instruments to specially accommo-

date check cashing businesses.

Check cashing businesses occupy a special niche in the financial

industry. They are part of the ‘‘alternative financial services’’

or ‘‘fringe

banking’’

sector, a part of the market that ‘‘has become a major source

of traditional banking services for low-income and working poor con-

sumers, residents of minority neighborhoods, and people with blemished

credit histories.’’ Lynn Drysdale & Kathleen E. Keest, The Two-Tiered

Consumer Financial Services Marketplace: The Fringe Banking System

and its Challenge to Current Thinking About the Role of Usury Laws in

Today’s Society, 51 S.C. L. Rev. 589, 591 (2000). Check cashing involves

‘‘charging a service fee for providing instant cash to unbanked custo-

mers.’’ Joseph R. Falasco, Who’s Getting Used in Arkansas: An Analysis of

Usury, Check Cashing, and the Arkansas Check-Cashers Act,’’ 55 Ark. L.

Rev. 149, 156 (2002); see Drysdale & Keest, at 626. Check cashing cus-

tomers ‘‘generally have limited resources available to access immediate

cash.’’ Falasco, at 155.

Check cashing stores are often in locations where traditional banks

fear to tread. Drysdale and Keest report the research that demonstrates

that check cashing outlets are usually located in lower income neigh-

borhoods:

For example, the Federal Reserve Bank of Boston looked at multi-census

tract areas in cities in New England where check cashers were most densely

clustered — Boston, Hartford, and Providence. The Boston study found that

the cities with high [check cashing outlet] clusters tended ‘‘to have high

percentages of low- and moderate-income census tracts and households,’’

high percentages of households below the poverty level, and higher shares

of households on fixed incomes (either public assistance or social security).

More dramatic is the Woodstock Institute’s study of the relative distribution

of banks and [check cashing outlets and currency exchanges] in Chicago,

3. See, e.g., John Burton et al., The Alternative Financial Sector: Policy Implications

for Poor Households, 42 Consumer Interests Ann. 279, 279 (1996).

4. See John P. Caskey, Fringe Banking: Check Cashing Outlets, Pawnshops, and the

Poor (1994).

I. Acquiring Holder in Due Course Status 51

which examines specific census tracts. This study found that the currency

exchanges are predominately located in lower income, minority commu-

nities. The currency exchange to bank ratio in five predominately minority

communities with median household incomes below $22,000 exceeded ten

to one. The lowest income communities, with median incomes of $7908

and $12,570, each had twelve check cashers for every one or two banks.

Drysdale & Keest, at 629 (footnotes omitted). In such areas, the

typical check presented for cashing is not a large one — a paycheck, child

support, social security, or public assistance check. Section 560.309(4)(b)

contemplates that such checks will be presented at check cashing outlets;

it limits the fee charged for the payment of ‘‘any kind of state public

assistance or federal social security benefits payable to the bearer.’’

Attractions of check cashing outlets are convenience and speed. As

the amicus points out, many check cashing businesses are open twenty-

four hours a day, seven days a week. Unlike banks, check cashing stores

cannot place a hold on a check before releasing funds. The Florida Ad-

ministrative Code requires payment to be made ‘‘immediately in currency

for every payment instrument received by a person engaging in the ac-

tivities of a check casher.’’ Fla. Admin. Code R. 3C-560.804(1). The stat-

ute and administrative rules also contemplate that a check cashing

business will engage in various types of ‘‘verification’’ of a check.

§560.309. Rule 3C 560.801 of the Florida Administrative Code permits a

check casher to collect the ‘‘direct costs associated with verifying a pay-

ment instrument holder’s identity, residence, employment, credit history,

account status, or other necessary information.’’ (Italics supplied). ‘‘Other

necessary information’’ could include long distance or telephone charges

incurred to contact the drawer of a check.

Against this backdrop, we cannot say that the trial court erred in

finding that the $10,000 check was a red flag. The $10,000 personal check

was not the typical check cashed at a check cashing outlet. The size of the

check, in the context of the check cashing business, was a proper factor

to consider under the objective standard of good faith in deciding

whether Any Kind was a holder in due course. See Maine Family, 727 A.2d

at 344.

Guarino was not the typical customer of a check cashing outlet. As

the trial judge observed, because of the 5 percent fee charged, it is un-

usual for a small businessman such as a broker to conduct business

5. The two studies referred to in this paragraph are Lesly Jean Paul & Luxman

Nathan, Check Cashers: Moving from the Fringe to the Financial Mainstream,

Communities & Banking (Federal Reserve Bank of Boston) 5, 8 (1999), and Woodstock

Inst., Reinvestment Alert: Currency Exchanges Add to Poverty Surcharge for Low Income

Residents (1997).

52 3. Holders in Due Course

through a check cashing store instead of through a traditional bank.

Guarino did not have a history with Any Kind of cashing checks of similar

size without incident. The need for speed in a business transaction is

usually less acute than for someone cashing a paycheck or welfare check

to pay for life’s necessities. The need for speed in cashing a large business

check is consistent with a drawer who, for whatever reason, might stop

payment. Fair dealing in this case required that the $10,000 check be

approached with a degree of caution.

If a drawer has a right to stop payment of a check, and a traditional

bank usually places a hold on uncollected funds after a payee deposits a

check into an account, then the legal dispute after a stop payment will

usually be between the drawer of the check and the payee, the two parties

that had the dealings leading to the payment. Thus, where a check is

cashed at a bank or savings and loan, the law will often place the loss on

the wrongdoer in the underlying transaction. This is a desirable goal.

Where a check cashing store releases funds immediately, the holder

in due course doctrine steps in, frequently putting the loss on a wronged

maker, in furtherance of the policy that facilitating the transfer of checks

benefits the economy. In this case, the policy reasons behind easy nego-

tiability do not outweigh the reasons for caution. Very loose application

of the objective component of ‘‘good faith’’ would make check cashing

outlets the easy refuge of scam artists who want to take the money and

run. The concept of ‘‘fair dealing’’ includes not being an easy, safe har-

bor for the dishonest.

To affirm the trial court is not to wreak havoc with the check cashing

industry. Verification with the maker of a check will not be necessary to

preserve holder in due course status in the vast majority of cases arising

from check cashing outlets. This was neither the typical customer, nor the

typical transaction of a check cashing outlet.

We disagree with the amicus, who worries that requirement of veri-

fication by the maker in this case ‘‘would inhibit the long standing policy

of the free negotiation of instruments.’’ Again, this is not the usual case.

Also, as White and Summers have written, ‘‘there has been debate about

the importance of the holder in due course doctrine in facilitating’’

check transactions. The Federal Trade Commission’s abolition of the

holder in due course doctrine in most consumer credit transactions has

‘‘not had the catastrophic impact upon the consumer market that some

predicted. Indeed, twenty years from now we may conclude that it caused

barely a ripple on the consumer credit pond.’’ White & Summers, §17-1.

The legislature’s addition of an objective standard of conduct may

well have the effect of ‘‘slowing the ‘wheels of commerce’’’ in some

transactions. Maine Family, 727 A.2d at 344. However, by adopting changes

to the ‘‘good faith’’ standard in the holder in due course doctrine, the

I. Acquiring Holder in Due Course Status 53

legislature ‘‘necessarily must have concluded that the addition of the

objective requirement to the definition of ‘good faith’ serves an impor-

tant goal. The paramount necessity of unquestioned negotiability has

given way, at least in part to the desire for reasonable commercial fairness

in negotiable transactions.’’ Id. In this case, reasonable commercial fair-

ness required Any Kind to approach the $10,000 check with some caution

and to verify it with the maker if it wanted to preserve its holder in due

course status.

Affirmed.

QUESTION

Would a check cashing business be in good faith if it acquired a

postdated check before the date of the check? See Buckeye Check

Cashing, Inc. v. Camp, 159 Ohio App.3d 784, 825 N.E.2d 644 (2005).

Winter & Hirsch, Inc. v. Passarelli

Illinois Appellate Court, 1970

122 Ill. App. 2d 372, 259 N.E.2d 312, 7 U.C.C. Rep. Serv. 1210

MCCORMICK,J.

This appeal is taken from an order denying a motion to vacate a

judgment by confession. The judgment was entered against the defen-

dants, Dominic and Antoinette Passarelli, on behalf of the plaintiff,

Winter & Hirsch, Inc. Defendants made a motion before the trial court to

vacate the judgment; the motion was denied, and from that order of the

trial court this appeal is taken. The questions before this court are: 1)

whether the loan entered into between the parties provided for a usuri-

ous rate of interest, and 2) whether the plaintiff was a holder in due

course of the note evidencing the loan in question.

The defendants first contacted the Equitable Mortgage & Investment

Corporation (hereinafter referred to as Equitable), attempting to secure a

loan. Equitable is a brokerage firm which makes its profit by selling loan

contracts to finance companies at a discount. In this case Equitable was to

lend the defendants $10,000. Of the several provisions in the note, we will

consider the following: 1) a provision whereby the defendants agreed ‘‘for

value received’’ to repay a total of $16,260 over a period of 60 monthly

payments of $271 each; and 2) a confession of judgment clause. The

promissory note signed by the defendants provided for payment to the

bearer and was secured by a trust deed.

54 3. Holders in Due Course

The maximum legal rate of interest which could have been charged

the defendants was exceeded by Equitable, and it is uncontested that

Equitable charged a usurious rate of interest. The question to be resolved

by this court, however, is whether the defense of usury is available for use

against the plaintiff, who claims to be holder in due course of the prom-

issory note and therefore claims to have taken it free from the defense of

usury. In the trial court the defense of usury was rejected and judgment

was entered against the defendants based on the court’s conclusion that

the plaintiff was a holder in due course of the promissory note.

In this appeal the defendants pray that the trial court’s order be

reversed and that the loan be held to be usurious. Defendants further ask

that the trial court be directed to enter an order allowing them twice the

rate of interest, plus attorney’s fees and court costs. They seek this relief

based on Ill. Rev. Stat. 1965, c.74, 6. At the time of the original trans-

action that section allowed one aggrieved by the imposition of a usurious

rate of interest to be freed of the obligation to pay any interest at all, but

an amendment to the statute, in effect at the time of trial, granted one

the right to a penalty in the amount of double the usurious interest

charged, plus attorney’s fees and court costs.

Defendants defaulted on the note and the plaintiff obtained a judg-

ment by confession. At the trial the defendants attempted to show that

before the plaintiff purchased the note it knew of the usurious interest

being charged, and consequently could not have become a holder in due

course. Defendants point out that the loan application which the defen-

dants filled out on January 7, 1963, has on it the name of the plaintiff.

They also call attention to the testimony of Dominic Passarelli that he had

been told by an agent of Equitable that Winter & Hirsch might give them

$10,000. By the terms of the promissory note the monthly payments were

to be made at the office of Ralph E. Brown, an attorney for plaintiff.

The most compelling fact presented to the court is that plaintiff issued

a check to Equitable for $11,000 on February 18, 1963, with the notation on

the stub that the funds were for ‘‘the Passarelli deal,’’ but the defendants did

not receive the $10,000 until February 28, 1963, ten days later. In other

words, the plaintiff had extended the money to Equitable for the Passarelli

loan prior to the time the defendants executed the note which plaintiff

claims to have bought from Equitable. This fact renders inapposite an entire

series of cases upon which plaintiff relies. Those cases hold that a loan may

be discounted at more than the usury rate if the purchaser is without

knowledge that the note was originally tainted with usury. Stevenson v.

Unkefer, 14 Ill. 103; Sherman v. Blackman, 24 Ill. 345; Colehour v. State Sav.

Institution, 90 Ill. 152. The critical factual distinction between those cases

and the one before us is that the plaintiff in the instant case provided the

money for the usurious loan before the loan was actually made, whereas in

I. Acquiring Holder in Due Course Status 55

the cited cases the party claiming to be the innocent holder of the usurious

note had purchased it subsequent to its execution.

On oral argument counsel for plaintiff argued that there must have

been a clerical error in the dates, and that no loan company would have

given out money without the loan contract in its possession. The insur-

mountable difficulty with counsel’s argument is that the date of the check

issued to Equitable (February 18) and the date of the note executed by

the defendants (February 28) are clearly established through the admis-

sion into evidence, without objection, of the check issued to Equitable

and the note signed by the defendants. This court must accept those

dates as accurate.

From these dates it appears that the plaintiff was a co-originator of

the note since it advanced the funds for the usurious loan before the loan

was formalized. As a co-originator it is charged with the knowledge of the

terms of the loan, and that knowledge includes information regarding

anticipated return on its investment. Such information should have made

it clear that a usurious rate of interest was being charged the defendants;

nevertheless, the plaintiff still elected to consummate the transaction, and

it must now accept the consequences.

We note, however, that the plaintiff has argued that it did not give

the $11,000 to Equitable until after it saw the loan contract; in other

words, that it was a purchaser of the note after it had already been exe-

cuted. Although the facts do not sustain this contention because of the

respective dates on which the check to Equitable was issued and the note

signed by the defendants, even if that version were correct, we would hold

for the defendants.

If the note was seen, as alleged by plaintiff, prior to its giving Equitable

$11,000, then the plaintiff also saw that the defendants had signed a note

promising to repay $16,260. From the face of the note one cannot ascer-

tain the principal amount the defendants had received; it can only be

known that ‘‘for value received’’ the defendants agreed to repay $16,260.

We feel, however, that as reasonable businessmen, assuming arguendo that

plaintiff did not know the truth, it should have raised the question of why

Equitable was willing to sell a $16,260 note for $11,000. The difference

between what the plaintiff was paying Equitable and the amount of the

note was a charge beyond that permitted under the usury statute, and

plaintiff should, therefore, have inquired how much money the defendants

were receiving. We cannot permit parties to intentionally keep themselves

in ignorance of facts which, if known, would defeat their unlawful purpose.

The Uniform Commercial Code (Ill. Rev. Stat. 1965, c.26, §3-304(1))

provides that when an instrument is so incomplete as to call its validity into

question, a purchaser of that instrument is on notice of the possibility of a

claim against it [in the Revision see §3-302(a)(1) — Ed.]. In this case we

56 3. Holders in Due Course

feel that the instrument, without the information as to the principal sum of

the loan extended to the defendants, was ‘‘so incomplete’’ as to call its

validity into question after plaintiff learned that it was able to buy it for

only $11,000.

In Springer v. Mack, 222 Ill. App. 72, the court said at p.75:

The question of usury was discussed exhaustively and the authorities

reviewed in the case of Clemens v. Crane, 234 Ill. 215, where it was held in

substance, that in determining whether the essential elements of usury are

present in a particular case, the intention of the parties, as the same

appears from the facts and circumstances of the case, may be considered in

connection with other evidence. The court also said, p.230:

‘‘The form of the contract is not conclusive of the question. The desire

of lenders to exact more than the law permits and the willingness of bor-

rowers to concede whatever may be demanded to obtain temporary relief

from financial embarrassment have resulted in a variety of shifts and cun-

ning devices designed to evade the law. The character of a transaction is

not to be judged by the mere verbal raiment in which the parties have

clothed it, but by its true character as disclosed by the whole evidence. If,

when so judged, it appears to be a loan or forbearance of money for a

greater rate of interest than that allowed by law, the statute is violated and

its penalties incurred, no matter what device the parties may have employed

to conceal the real character of their dealings.’’

By failing to include the principal amount loaned to the borrower on

the face of the loan contract or note, a subsequent purchaser of that

contract is able to say ‘‘I had no idea that usury was involved. I simply

bought the paper because it was a good buy.’’ If the principal amount

were shown, however, all subsequent purchasers would be put on notice if

usury were involved, and they could not avoid their own involvement in

the charging of a usurious rate by the purchase of such paper.

We feel we are justified in saying that where it appears from the facts

and circumstances of the particular transaction under review that a rea-

sonably prudent businessman would have found the purchase suspicious,

he should inquire as to the truth. One should become suspicious when,

as here, he is himself able to purchase paper at a price which is in itself so

far below the amount to be repaid from the borrower that because of that

differential the contract would have been usurious had it been the orig-

inal transaction. The suspicion should be all the more compelling when

the paper is bought from a broker or other company that is in the

business of selling such paper. Since brokers are in the business of selling

loan contracts for a profit, they are likely to have loaned out less than the

amount for which they are willing to sell the contract to another. Thus, if

one is able to buy a loan contract from a broker for $11,000, it is more

I. Acquiring Holder in Due Course Status 57

than likely that the broker had loaned some figure less than the $11,000,

and the broker’s profit then becomes the difference between the amount

he actually loaned and that for which he sold the contract. It would then

appear likely that when this difference is itself usurious, the original

transaction was also. Stevenson v. Unkefer, 14 Ill. 103, and similar cases

do not dictate a contrary result . . .

Under the circumstances, if the plaintiff was a purchaser, as it claims

to be, it was on notice of a defense, since section 3-304 [in the Revision,

§3-302(a)(1) — Ed.], chapter 26 of Ill. Rev. Stat. 1965 provides:

(1) The purchaser has notice of a claim or defense if

(a) the instrument is so incomplete, bears such visible evidence of

forgery or alteration, or is otherwise so irregular as to call into question its

validity, terms or ownership or to create an ambiguity as to the party to

pay. . . .

This code provision is consistent with the earlier definition of ‘‘no-

tice’’ found in section 1-201(25), chapter 26, providing:

A person has ‘‘notice’’ of a fact when . . .

question he has reason to know that it exists.

The intendment of these provisions would seem to be an attempt to

prevent those dealing in the commercial world from obtaining various

rights when, from a reasonable inquiry into the true facts that person

would have discovered that a fact existed which prevented him from

obtaining the rights which he was seeking. Under the circumstances in

the present case, it is fair to say that the plaintiff had ‘‘reason to know’’

there was a good defense against the note in question. Even the earlier

cases point out that notice of usury destroyed one’s rights in the note. . . .

The judgment of the Circuit Court is reversed, and the cause is

remanded with directions to enter a judgment for defendants and for

further proceedings in conformity with this opinion.

Reversed and remanded with directions.

LYONS, J. concurs. [The dissenting opinion of BURKE, J., is omitted.]

QUESTION

Would the Federal Trade Commission holder in due course rule (see

page 24) apply to the promissory note signed in this case if the transac-

tion had taken place after May 14, 1976 (the effective date of that rule)?

58 3. Holders in Due Course

PROBLEM 25

Fred wrote a check on January 5, 2012, but mistakenly put down

‘‘2011’’ as the year. He saw his error, crossed out the last digit, and wrote

‘‘2’’ above it. Can anyone become a holder in due course of this instru-

ment?

PROBLEM 26

Ace Finance Company was the payee on a promissory note signed

by John Maker. On its face, the note calls for John to make 12 monthly

interest payments before the note matures. Ace sold the note at a dis-

count to Big Town Bank (BTB). If the note has written on it, in big letters,

a penciled notation, ‘‘Missed Paying First Installment,’’ can BTB ever

qualify as a holder in due course? See §3-304(b) and (c) and its Official

Comment 2.

PROBLEM 27

Dan Drawer wrote a check dated April 30 to Dr. Paine, his dentist, for

$80, in payment for services rendered. Dr. Paine was not aware that the

check fell to the floor behind his desk, where it lay until the end of August,

when the janitor found it. Dr. Paine then indorsed the check over to his

local grocery store on August 31, and it bounced on September 3, when

the drawee bank informed the manager of the grocery store that Dan had

stopped payment because the dental work had been done badly. Is the

grocery store a holder in due course? See §3-304(a)(2).

PROBLEM 28

When Ellen Brown found out that the computer she had purchased

didn’t work, she was furious and decided not to pay the promissory note

she had signed. The note stated that it was ‘‘payable at Busy State Bank’’

(which in this case means that the bank would pay the note when pre-

sented and then expect reimbursement from the maker; cf. §4-106(b)).

Harold Slow, the head cashier at the bank, took Ellen’s phone call and

promised not to pay the note when it was presented. Four months went by,

and, on one hectic afternoon, the bank paid the note by accident. Slow

I. Acquiring Holder in Due Course Status 59

said he had forgotten the request not to pay. The bank now demands

payment, claiming to be a holder in due course. Is it?

Problem 28 involves the forgotten notice doctrine, which under the NIL

permitted a holder to forget notice and thus become a holder in due

course if sufficient time passed between the notice and the acquisition of

the instrument. See First Natl. Bank of Odessa v. Fazzari, 10 N.Y.2d 394,

179 N.E.2d 493, 233 N.Y.S.2d 483 (1961) (‘‘[W]e think that the doctrine

should be applied with great caution in the case where a simple prom-

issory note is involved. A lapse of memory is too easily pleaded and too

difficult to controvert to permit the doctrine to be applied automatically

irrespective of the circumstances surrounding each transaction and the

relationship of the parties.’’). Does the UCC retain the forgotten notice

doctrine? See §1-201(25), and in particular the last sentence and Official

Comment 25 thereto; McCook County Natl. Bank v. Compton, 558 F.2d

871, 21 U.C.C. Rep. Serv. 1360 (8th Cir. 1977).

PROBLEM 29

Giant Earthmovers bought some machinery from Tractors, Inc., and in

payment executed a promissory note payable to the order of Tractors for

$2,000. Tractors sold the note without indorsement to the Friendly Finance

Company for $1,500. The maker of the note refused to pay the note when

it matured, stating that the machinery did not operate properly. Friendly

decided to sue Giant Earthmovers, and the day before the lawsuit was

filed, Friendly’s lawyer noticed that the note had never been indorsed by

Tractors, Inc. He had Tractors’ president specially indorse the note over to

Friendly right away, and then the suit was filed. Is Friendly a holder in due

course? See §3-203(c) and its Official Comment 3, and Case #4 in Official

Comment 4; Ballengee v. New Mexico Fed. Sav. & Loan Assn., 109 N.M.

423, 786 P.2d 37, 11 U.C.C. Rep. Serv. 2d 124 (N.M. 1990).

Jones v. Approved Bancredit Corp.

Delaware Supreme Court, 1969

256 A.2d 739, 6 U.C.C. Rep. Serv. 1001

HERRMANN, J.

The dispositive question in this appeal is whether the plaintiff

finance company is a holder in due course of the defendant’s note. We

hold that the finance company was not a holder in due course under the

party-to-the-transaction rule.

60 3. Holders in Due Course

The relevant facts are undisputed for present purposes.

The defendant, Myrtle V. Jones, owned a lot of land in Delaware and

wished to have a house built on it. She responded to a newspaper ad-

vertisement by Albee Dell Homes, Inc. (hereinafter ‘‘Dell’’), a sales

agency for pre-cut homes in Elkton, Maryland. After selecting a type of

house from various plans presented, Mrs. Jones signed a purchase order

contract and credit application and made a deposit. Several weeks later,

Dell’s representative presented to Mrs. Jones for signature a series of

documents evidencing an obligation of $3,250,

to be paid by Mrs. Jones

in monthly installments over a period of years for the house. The docu-

ments evidencing the obligation included the following papers: a mort-

gage; a judgment bond and warrant; a promissory note; a construction

contract; a request for insurance; an affidavit that the masonry work and

foundation were completed and paid for (when in fact none of the work

had been commenced); and an affidavit that no materials were delivered

or work started as of the date of the mortgage.

Mrs. Jones demurred to the signing of the mass of documents thus

placed before her and stated that she would like to consult her attorney

before signing because she did not understand the documents. Dell’s

representative objected, stating that it was not necessary for Mrs. Jones to

have an attorney; that it would be a waste of money to do so; that he

would advise her. Although Mrs. Jones reiterated her wish for an attorney

several times, Dell’s representative insisted upon her signing the papers

then and there, stating that it was necessary to do so if the work was to

start seasonably. He assured her that Dell would take care of the entire

situation to her satisfaction. Mrs. Jones finally acquiesced and signed all

the documents. Immediately thereafter, the paper was endorsed and

assigned by Dell to the plaintiff Approved Bancredit Corp. (hereinafter

‘‘Bancredit’’) which paid Dell $2,250.00 for the $3,250.00 note.

During the construction, an employee of the builder drove a bull-

dozer into the side of the partially completed house and knocked it off its

foundations. Thereafter, the builder refused to go forward with the work.

Dell disclaimed responsibility on the ground that the damage to the

structure was a result of a ‘‘cave-in’’ and was ‘‘a work of God.’’ The

structure was left in a dangerous condition with the water-filled basement

constituting an attractive nuisance to children. The County authorities

6. The principal amount of the obligation was $2,500. The balance consisted of

‘‘charges.’’

I. Acquiring Holder in Due Course Status 61

demanded that this unsafe condition be rectified. Mrs. Jones consulted an

attorney who notified Dell and Bancredit that Mrs. Jones would be

obliged to remove the remnants of the building and fill the basement, in

order to make the area safe, unless another satisfactory course of action

was suggested. There was no reply and the demolition was accomplished

at Mrs. Jones’ expense. Later, Dell closed its office and terminated its

business except for the servicing of certain contracts through a repre-

sentative in Delaware.

Thereafter, Bancredit brought this action against Mrs. Jones,

seeking foreclosure on the mortgage and collection of an unpaid bal-

ance of $2,560.23, with interest. Mrs. Jones interposed several defenses,

mainly that of fraud by Dell. During pretrial proceedings, the action

developed into a suit upon the promissory note, which Bancredit

contended was secured by the mortgage and was negotiable in its

hands as a holder in due course by assignment of Dell. Thereupon,

Bancredit moved for summary judgment on the ground that the

defenses claimed against Dell were not available against it as a holder

in due course. The Superior Court denied summary judgment, stating

that Mrs. Jones should have the opportunity to ‘‘demonstrate the pre-

cise relationship’’ between Dell and Bancredit. Thereafter, depositions

were taken and the following facts, inter alia, appeared regarding that

relationship:

Dell and Bancredit were both wholly owned subsidiaries of Albee

Homes, Inc. (hereinafter ‘‘Homes’’). The business of the parent corpo-

ration was to process pre-cut lumber and sell pre-cut homes. It had be-

tween 50 and 70 sales agencies in 19 states. Dell was its Maryland sales

agency. Ninety-nine percent of Bancredit’s business came from Dell and

the other wholly owned sales agency subsidiaries of Homes; it was orga-

nized for this purpose. Bancredit examined into the laws of the various

states in which the sales agencies operated and prescribed the forms of

contracts and financing documents to be used by each agency, including

Dell, in concluding a transaction. Homes and Bancredit had the same

officers and directors; Homes named the directors and officers of Dell.

Checks of Bancredit, issued to consummate a financing transaction like

that entered into by Mrs. Jones and Dell, were countersigned by Homes.

During the construction of a house, Bancredit routinely requested and

received progress reports. Specifically, the manager of Bancredit testified

on deposition that Bancredit was a ‘‘finance department’’ of Homes; that

each transaction of Dell, like the transactions of each of the other sales

agencies, was approved in advance by Bancredit; that the first paper re-

ceived was the application of the purchaser for extension of credit which

was reviewed and passed upon in advance by Bancredit, with directions

back to Dell as to any special condition to be imposed upon the

62 3. Holders in Due Course

purchaser in connection with the loan under consideration. Bancredit

had the exclusive power of approval, condition, or rejection of a trans-

action tendered by the sales agency.

As the result of a pretrial conference, the trial judge stated that with

a full understanding of the evidence to be adduced by each side at trial,

he had concluded that a directed verdict in favor of Bancredit must

necessarily result because, in his opinion, Bancredit was a holder in due

course and the defenses sought to be interposed by Mrs. Jones were not

available to it. Each of the parties then made a detailed offer of proof on

the record and, thereupon, the Superior Court entered judgment for

Bancredit on the ground that it was a holder in due course. Mrs. Jones

appeals.

The question before us has not been heretofore answered by this

court. It is a difficult question, as to which the authorities are in sharp

conflict.

In dealing with the holder in due course status, a basic problem has

been recognized by the courts in cases involving the financing of in-

stallment sales, especially of consumer goods and household improve-

ments. The problem arises from the increasingly apparent need for a

balancing of the interest of the commercial community in the unre-

stricted negotiability of commercial papers, on the one hand, against the

interest of the installment buyers of the community, on the other hand,

in the preservation of their normal remedy of withholding payment

whenever there has been misrepresentation, failure of consideration, or

other valid reason for refusal to pay. This problem and this need have

given rise to this concept: The more the holder knows about the un-

derlying transaction which is the source of the paper, the more he con-

trols or participates in it, the less he fits the role of good faith purchaser

for value, and the less justification there is for according to him the

protected status of holder in due course considered necessary for the free

flow of paper in the commercial world.

The rule, balancing the needs of the installment-buying community

and the commercial community, has evolved in various ways. Many courts

have solved the problem by denying holder in due course status to the

finance company where it maintains a close business relationship with the

dealer whose paper it buys; where the financier is closely connected with

the particular credit transaction under scrutiny; or where the financier

prescribes to the dealer the forms of the papers, the buyer signs the

purchase agreement and the note concurrently, and the dealer endorses

the note and assigns the contract immediately thereafter. In such

I. Acquiring Holder in Due Course Status 63

situations, many courts look upon the transaction as a species of

tri-partite transaction; and the tenor of the cases is that the finance

company, in such situation, should not be permitted to hide behind ‘‘the

fictional fence’’ of the UNIL or the UCC and thereby achieve an unfair

advantage over the purchaser. See Unico v. Owen, 50 N.J. 101, 232 A.2d

405 (1967); Buffalo Industrial Bank v. DeMarzio, 162 Misc. 742, 296 N.Y.S.

738 (1937).

The rule of balance thus evolved is exemplified by Mutual Finance

Co. v. Martin, 63 So. 2d 649 (Fla. 1953). There a finance company was

held not to be a holder in due course where it appeared that the finance

company furnished to the payee electrical appliance dealer the form of

conditional sales contract and promissory note with its name imprinted

thereon; that before the sales transaction occurred the finance company

had investigated the purchaser’s credit standing, had approved the pro-

posed terms and agreed to purchase the contract and note in the event

the transaction was consummated; that over a period of years immediately

prior to the transaction, the finance company had provided much fi-

nancing for the dealer in other transactions. In holding that, under those

circumstances, the finance company was sufficiently a party to the trans-

action to deprive it of holder in due course status, the Supreme Court of

Florida stated:

. . . It may be that our holding here will require some changes in business

methods and will impose a greater burden on the finance companies. We

think the buyer — Mr. & Mrs. General Public — should have some protec-

tion somewhere along the line. We believe the finance company is better

able to bear the risk of the dealer’s insolvency than the buyer and in a far

better position to protect his interests against unscrupulous and insolvent

dealers. . . .

If this opinion imposes great burdens on finance companies it is a

potent argument in favor of a rule which will afford protection to the gen-

eral buying public against unscrupulous dealers in personal property. . . .

Another leading case supporting the rule of balance is Commercial Credit

Co. v. Childs, 199 Ark. 1073, 137 S.W.2d 260 (1940), wherein the auto-

mobile sales contract, note, and assignment forms were attached together,

were furnished by the finance company, and were all executed on the

same day. The Supreme Court of Arkansas there stated:

We think appellant was so closely connected with the entire transac-

tion or with the deal that it can not be heard to say that it, in good faith,

was an innocent purchaser of the instrument for value before maturity. . . .

Rather than being a purchaser of the instrument after its execution it was

64 3. Holders in Due Course

to all intents and purposes a party to the agreement and instrument from

the beginning. . . .

See also Commercial Credit Corporation v. Orange County Machine

Works, 34 Cal. 2d 766, 214 P.2d 819 (1950), where the Supreme Court of

California held:

When a finance company actively participates in a transaction . . . from

its inception, counseling and aiding the future vendor-payee, it cannot be

regarded as a holder in due course. . . .

And in Unico v. Owen, 50 N.J. 101, 232 A.2d 405 (1967), wherein the

finance company was formed expressly to handle the financing of sales by

the dealer exclusively, the Supreme Court of New Jersey summarized its

position on the question before us as follows:

For purposes of consumer goods transactions, we hold that where the

seller’s performance is executory in character and when it appears from the

totality of the arrangements between dealer and financier that the financier

has had a substantial voice in setting standards for the underlying trans-

action, or has approved the standards established by the dealer, and has

agreed to take all or a predetermined or substantial quantity of the nego-

tiable paper which is backed by such standards, the financier should

be considered a participant in the original transaction and therefore not

entitled to holder in due course status. . . .

The factual situation in the Unico case is especially analogous to the

instant case.

The divergent line of cases, reflecting an underlying conflict in policy

considerations, accords determinative importance to the maintenance of

a free flow of credit. These cases protect the finance company from

purchaser defenses on the ground that this is an overriding consideration

in order to assure easy negotiability of commercial paper and the resul-

tant availability of the rapid financing methods required by our present-

day economy. The cases of both lines of authority are collected at

Annots., 128 A.L.R. 729 (1940), 44 A.L.R.2d 8, 134-157 (1955), 4 A.L.R.2d

Later Case Serv. 929 (1965). See also Swanson v. Commercial Acceptance

Corporation (9th Cir.), 381 F.2d 296 (1967); 39 S. Cal. L. Rev. 48, 68-74

(1966); 10 Vill. L. Rev. 309 (1965); 65 Colum. L. Rev. 733 (1965); 53

Harv. L. Rev. 1200 (1940); 1958 Wash. U.L.Q. 177; 35 U. Chi. L. Rev. 739

(1968); 939 Minn. L. Rev. 775 (1954).

Under the totality of facts and circumstances of this case, we hold

that the rule of balance should be adopted and applied; that it should

operate in favor of the installment buyer for the reason that, in our

I. Acquiring Holder in Due Course Status 65

opinion, Bancredit was so involved in the transaction that it may not be

treated as a subsequent purchaser for value. By reason of its sister cor-

poration relationship to Dell and the established course of dealing be-

tween them, Bancredit was more nearly an original party to the

transaction than a subsequent purchaser of the paper; and, for the rea-

sons of fairness and balance stated in the foregoing authorities, Bancredit

should be denied the protected status of holder in due course which

would prevent Mrs. Jones from having her day in court on the defenses

she would have otherwise had against Dell.

The rule we here adopt must be applied carefully because of the

delicate balance of the interests of the installment buying community and

the commercial community. But the need for special care in application

should not foreclose the adoption of the rule and its application in a

proper case. In this day of demonstrated need for emphasis upon con-

sumer protection and truth in lending, special consideration must be

given to preventing the misuse of negotiable instruments to deprive in-

stallment purchasers of legitimate defenses. In a proper case, such as the

one before us, this becomes the controlling consideration.

For the reasons stated, we conclude that the Superior Court erred in

holding that Bancredit was a holder in due course. Accordingly, the

judgment below is reversed and the cause remanded for further pro-

ceedings consistent herewith.

This decision is typical of a large number of cases in which the courts

have held that the buyer-transferee of the paper is too ‘‘closely con-

nected’’ with the seller-transferor to be permitted to obtain holder in due

course status. The doctrine has been chiefly of benefit to consumers, but

it has been applied in purely commercial settings. See, e.g., St. James v.

Diversified Commercial Fin. Corp., 102 Nev. 23, 714 P.2d 179, 1 U.C.C.

Rep. Serv. 2d 121 (1986). Following are some of the tests the courts use

to assess the connection.

(1) Is the buyer-transferee the alter ego of the seller-transferor? Do

they have the same officers, same personnel, same location?

(2) Who drafted the original promissory note?

(3) Is the buyer-transferee mentioned in the note?

(4) Does the seller-transferor sell paper to other buyers, or is the

buyer-transferee the only market?

(5) Did the buyer-transferee get involved in the transaction by which

the note was created? Did it, for instance, conduct a credit in-

vestigation of the maker?

66 3. Holders in Due Course

(6) Did the buyer-transferee have some knowledge of the seller-

transferor’s poor past performance of similar contracts?

If the court concludes that the buyer-transferee is too closely connected

to the seller-transferor, the court has a variety of ways to deny holder in

due course status to the plaintiff. It can say that the plaintiff was not

acting in good faith, that the plaintiff had notice of underlying defenses, or

that the plaintiff is the same entity as the seller-transferor and can stand

in no better situation.

In light of this problem, what would you advise Bancredit to do in

the future to become a holder in due course of notes that pass through

the hands of payees like Dell?

Lest you get the idea that in promissory note lawsuits the finance

company always loses (which is not even vaguely true), read the following

case. It makes the important point that knowledge of the underlying

transaction is not the same thing as notice of a claim or a defense arising

out of that transaction.

Sullivan v. United Dealers Corp.

Kentucky Court of Appeals, 1972

486 S.W.2d 699, 11 U.C.C. Rep. Serv. 810

REED,J.

The sole issue presented is whether appellee, United Dealers Cor-

poration, a finance company, was a holder in due course of a promissory

note executed and delivered by appellants, James Earl Sullivan and

Norma Jean Sullivan, his wife, in payment for building materials and

labor furnished by Memory Swift Homes, Inc., the payee of the note.

Memory Swift Homes, Inc., contracted with the Sullivans to construct

a prefabricated dwelling house for them. The contract was dated March

26, 1963, and on April 9, 1963, the Sullivans executed and delivered to

Memory Swift, the contractor, their promissory negotiable note in the

sum of $18,224.64 secured by a mortgage on the real property and the

improvement to be located thereon. On the same day, the contractor

negotiated the note and assigned the mortgage to the finance company.

On June 25, 1963, the finance company negotiated the note to a bank

which took the instrument with right of recourse. After the negotiation of

the note to the finance company but prior to its negotiation by the finance

company to the bank, the Sullivans delivered written statements to the fi-

nance company that the foundation of the house had been properly

installed and also certified that all framing members in the house were

I. Acquiring Holder in Due Course Status 67

properly and sufficiently nailed to make it a sound and sturdy structure and

that all work had been performed in a workmanlike manner.

Beginning in August 1963, the Sullivans made several monthly pay-

ments according to the terms of the note but then defaulted. The last

monthly payment was made in April 1966, but this covered the monthly

installment due in August 1965. On April 25, 1966, the bank transferred

the note back to the finance company, for value, without recourse. The

finance company then instituted action against the Sullivans for collection

of the note and foreclosure of the mortgage. The Sullivans pleaded that

the finance company was not a holder in due course of the note and that

the contractor had constructed the house in an unworkmanlike manner

by reason of which they had been damaged; they sought to assert their

claim against the contractor as a defense against the finance company.

The parties to the action failed to demand a jury trial and, with their

consent, the factual issues were tried by the court without a jury.

The trial court found from the evidence that the finance company

was a holder in due course of the note; therefore, the defenses arising

from the alleged breaches of contract by the contractor and payee of the

note were held nonassertable against the finance company. Judgment was

entered for the unpaid balance of the note and foreclosure of the

mortgage was ordered. The Sullivans appeal and argue the single prop-

osition that the finance company did not become a holder in due course

at the time the note was transferred and negotiated to it by the payee. We

affirm the judgment of the circuit court.

The entire case for the Sullivans may be summarized by the following

quotation from the brief filed on their behalf:

The testimony shows that the appellee [the finance company] was

cognizant and knew about this contract. The appellee [the finance com-

pany] had done around $500,000 with Memory Swift Homes, Inc., over a

period of a number of years beginning in 1951. The appellee also knew at

the time they purchased this note and mortgage that no work had been

performed on the construction of the house. The appellee [the finance

company] knowing about this contract, they were put on notice that there

might be a defense on the note because of the faulty construction of the

dwelling house and is, therefore, not a holder in due course and did not

take the instrument in good faith — that is the note and mortgage. [Par-

enthetical expressions and emphasis supplied.]

Notice, in order to prevent one from being a bona fide holder under

the law merchant, or a holder in due course under the NIL or the

Commercial Code, means notice at the time of the taking or at the time the

instrument is negotiated, and not notice arising subsequently. The time

68 3. Holders in Due Course

when value is given for the instrument is decisive. The moment value is given

without notice the status as a holder in due course generally is definitely and

irrevocably fixed. The Commercial Code, which has been adopted in Ken-

tucky, provides that to be effective notice to a purchaser must be received at

such time and in such manner as to give a reasonable opportunity to act on

it. K.R.S. §3-304(6) [in the Revision see §3-302(f) — Ed.]. See 11 Am. Jur. 2d,

Bills and Notes, §428, pp. 458, 459.

Where a close business association between the payee and one who

purchases an instrument from him implies the knowledge of such facts as

to show bad faith or renders himself a participant in the transaction

between the payee and the maker, a finding that such purchaser is not a

holder in due course has been regarded as supportable. See 44 A.L.R.2d

154. In Massey-Ferguson v. Utley, Ky., 439 S.W.2d 57 (1969), we discussed

several aspects of the basic problem. Therein we expressed the thought

that the policy of the Commercial Code was to encourage the supplying

of credit for the buying of goods by insulating the lender from lawsuits

over the quality of the goods. The insulation provided, however, appears

intended primarily for finance institutions acting independently to supply

credit, rather than to protect a manufacturer who finances his own sales

either in his own name or by a dominated and controlled agency.

In the case before us, there is no allegation of fraud involving the

payee of the note and the finance company. There is no claim any fact

existed that the finance company could have discovered at the time of the

transfer of the instrument and that would have indicated any deficiency

or defect. The maker of the note represented that the state of facts at that

time was one of compliance by the contractor with the duties imposed by

the contract. The evidence failed to demonstrate any direct connection

between the contractor and the finance company except a frequent

course of dealing between them. In short, the evidence failed to dem-

onstrate any bad faith on the part of the finance company at the time of

the negotiation and transfer of the note to it. All of the evidence dem-

onstrated a complete lack of notice to the finance company that would

justify a finding that it failed to acquire the status of a holder in due

course.

The judgment is affirmed.

All concur.

D. The Shelter Rule

It has always been a basic rule of the common law that the unqual-

ified transfer of a chose in action places the transferee in the transferor’s

shoes and gives the transferee all the rights of the transferor. This rule is

I. Acquiring Holder in Due Course Status 69

codified in §3-203(b), where it is made clear that even holder in due

course rights can pass to a person not otherwise entitled to them. Because

the transferee of a holder in due course takes shelter in the status of the

transferor, §3-203(b) is called the shelter rule. Read §3-203(b) and its

Official Comments, paying particular attention to Comment 4 and the

examples therein. (Similar shelter rules abound throughout the UCC: for

sales of goods, see §2-403(1); for documents of title, see §7-504(1); and

for investment securities, see §8-302(a).)

PROBLEM 30

Happy Jack, the used car salesman, sold Manny a lemon car for his

business, taking in payment a promissory note for $2,000 made payable to

the order of Happy Jack. Jack discounted the note with Alfred, a local

licensed money broker, who paid him $1,700 and took the note without

knowledge of the underlying transaction. Alfred’s daughter Jessica had a

birthday shortly thereafter, so Alfred indorsed the note in blank and gave it

to her as a present. When the note matured, Manny refused to pay it to

Jessica — the car had fallen apart, and he felt that he shouldn’t have to pay

for a pile of junk. Is Jessica a holder in due course?

PROBLEM 31

If in the above Problem Jessica had thereafter made a gift of the note

to her husband, Lorenzo, would Lorenzo have holder in due course rights?

Does it matter if Lorenzo, prior to the gift, knows of Manny’s problems

with the car? If Manny won’t pay, is Alfred liable to Lorenzo? See §§3-305

(a)(2) and 3-303.

PROBLEM 32

After Lorenzo (from the last Problem) acquired the note, he sold it for

$1,800 to Portia, a local attorney. She had no notice of problems with the

instrument. When she presented it to Manny for payment, he refused to pay

and instead filed for bankruptcy. May she recover from Alfred? See §3-305

(b). If she does and prevails, Alfred will reacquire the instrument. Does the

shelter rule give him Portia’s holder in due course rights? Does Alfred re-

acquire his original holder in due course status when he gets the instrument

back? Could he sue Jessica or Lorenzo? See the following discussion.

70 3. Holders in Due Course

Reacquisition of an instrument. If Alfred is forced to pay Portia, he will

get the instrument back into his possession. In such a case, §121 of the

now-repealed NIL provided that on reacquisition a holder ‘‘is remitted to

his former rights as regards all prior parties.’’ See Chafee, The Reacqui-

sition of a Negotiable Instrument by a Prior Party, 21 Colum. L. Rev. 538

(1921).

Thus, if Alfred used to be a holder in due course, on reacquiring

the instrument he would get that status back vis-a´-vis parties prior to his

first holding. Although the UCC never expressly states the same rule, the

idea is implicit throughout the Code, and the NIL rule is therefore still

the law. As to the issue of whether Alfred can sue Jessica and Lorenzo, we

will explore the liability of an indorser in the next chapter.

Section 3-207 provides that when a previous holder reacquires the

instrument, he or she has the power to strike the intervening indorse-

ments. As one court explained:

Intervening indorsements simply vanish from the chain of title when

called by a reacquirer. That concept is the obvious product of the principle

that permits the current holder of a negotiable instrument to sue its pre-

decessor in the indorsement chain, in which event that party can in turn

look to its own predecessor. If those lawsuits up the chain would ultimately

lead back to the current holder, that pointless circular process is best

avoided by the cancellation of the intervening indorsements and the dis-

charge of those intermediate parties from liability.

Resolution Trust Corp. v. Juergens, 965 F.2d 149, 154, 18 U.C.C. Rep.

Serv. 2d 484, 491 (7th Cir. 1992).

Triffin v. Somerset Valley Bank

New Jersey Superior Court, Appellate Division, 2001

343 N.J. Super. 73, 777 A.2d 993, 44 U.C.C. Rep. Serv. 2d 1200

CUFF, J.A.D.

This case concerns the enforceability of dishonored checks against

the issuer of the checks under Article 3 of the Uniform Commercial Code

(UCC), as implemented in New Jersey in N.J.S.A. 12A:3-101 to 3-605.

Plaintiff purchased, through assignment agreements with check

cashing companies, eighteen dishonored checks, issued by defendant

Hauser Contracting Company (Hauser Co.). Plaintiff then filed suit in the

Special Civil Part to enforce Hauser Co.’s liability on the checks. The trial

7. Section 3-207 discusses reacquisition, but the rules therein are not relevant to the

issues raised by the preceding Problems.

I. Acquiring Holder in Due Course Status 71

court granted plaintiff’s motion for summary judgment. Hauser Co.

appeals the grant of summary judgment. It also argues, for the first time,

that plaintiff lacked standing to file suit against Hauser Co. We affirm.

In October 1998, Alfred M. Hauser, president of Hauser Co., was

notified by Edwards Food Store in Raritan and the Somerset Valley Bank

(the Bank), that several individuals were cashing what appeared to be

Hauser Co. payroll checks. Mr. Hauser reviewed the checks, ascertained

that the checks were counterfeits and contacted the Raritan Borough and

Hillsborough Police Departments. Mr. Hauser concluded that the checks

were counterfeits because none of the payees were employees of Hauser

Co., and because he did not write the checks or authorize anyone to sign

those checks on his behalf. At that time, Hauser Co. employed Automatic

Data Processing, Inc. (ADP) to provide payroll services and a facsimile

signature was utilized on all Hauser Co. payroll checks.

Mr. Hauser executed affidavits of stolen and forged checks at the

Bank, stopping payment on the checks at issue. Subsequently, the Bank

received more than eighty similar checks valued at $25,000 all drawn on

Hauser Co.’s account.

Plaintiff is in the business of purchasing dishonored negotiable instru-

ments. In February and March 1999, plaintiff purchased eighteen dishonored

checks from four different check cashing agencies, specifying Hauser Co. as

the drawer. The checks totaled $8,826.42. Pursuant to assignment agree-

ments executed by plaintiff, each agency stated that it cashed the checks for

value, in good faith, without notice of any claims or defenses to the checks,

without knowledge that any of the signatures were unauthorized or forged,

and with the expectation that the checks would be paid upon presentment to

the bank upon which the checks were drawn. All eighteen checks bore a red

and green facsimile drawer’s signature stamp in the name of Alfred M.

Hauser. All eighteen checks were marked by the Bank as ‘‘stolen check’’ and

stamped with the warning, ‘‘do not present again.’’ Each of the nine payees

on the eighteen checks are named defendants in this case.

Plaintiff then filed this action against the Bank, Hauser Co., and each

of the nine individual payees. Plaintiff contended that Hauser Co. was

negligent in failing to safeguard both its payroll checks and its authorized

drawer’s facsimile stamp, and was liable for payment of the checks.

The trial court granted plaintiff’s summary judgment motion, con-

cluding that no genuine issue of fact existed as to the authenticity of the

eighteen checks at issue. Judge Hoens concluded that because the check

cashing companies took the checks in good faith, plaintiff was a holder in

due course as assignee. Judge Hoens also found that because the checks

appeared to be genuine, Hauser Co. was required, but had failed, to show

that plaintiff’s assignor had any notice that the checks were not validly

drawn. . . .

72 3. Holders in Due Course

As to the merits of the appeal, Hauser Co. argues that summary judg-

ment was improperly granted because the court failed to properly address

Hauser Co.’s defense that the checks at issue were invalid negotiable instru-

ments and therefore erred in finding plaintiff was a holder in due course. . . .

As a threshold matter, it is evident that the eighteen checks meet the

definition of a negotiable instrument. N.J.S.A. 12A:3-104. Each check is

payable to a bearer for a fixed amount, on demand, and does not state

any other undertaking by the person promising payment, aside from the

payment of money. In addition, each check appears to have been signed

by Mr. Hauser, through the use of a facsimile stamp, permitted by the

UCC to take the place of a manual signature. N.J.S.A. 12A:3-401(b)

provides that a ‘‘signature may be made manually or by means of a device

or machine . . . with present intention to authenticate a writing.’’ It is

uncontroverted by Hauser Co. that the facsimile signature stamp on the

checks is identical to Hauser Co.’s authorized stamp.

Hauser Co., however, contends that the checks are not negotiable

instruments because Mr. Hauser did not sign the checks, did not au-

thorize their signing, and its payroll service, ADP, did not produce the

checks. Lack of authorization, however, is a separate issue from whether

the checks are negotiable instruments. Consequently, given that the

checks are negotiable instruments, the next issue is whether the checks

are unenforceable by a holder in due course, because the signature on

the checks was forged or unauthorized.

N.J.S.A. 12A:3-203 and N.J.S.A. 12A:3-302 discuss the rights of a

holder in due course and the rights of a transferee of a holder in due

course. Section 3-302 establishes that a person is a holder in due course 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 for value, in good faith, 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, without notice that the instrument contains an

unauthorized signature or has been altered, without notice of any claim to

the instrument described in 12A:3-306, and without notice that any party has

a defense or claim in recoupment described in subsection a. of 12A:3-305.

Section 3-203 deals with transfer of instruments and provides:

a. An instrument is transferred when it is delivered by a person other

than its issuer for the purpose of giving to the person receiving delivery the

right to enforce the instrument.

I. Acquiring Holder in Due Course Status 73

b. Transfer of an instrument, whether or not the transfer is a negoti-

ation, vests in the transferee any right of the transferor to enforce the

instrument, including any right as a holder in due course, but the trans-

feree cannot acquire rights of a holder in due course by a transfer, directly

or indirectly, from a holder in due course if the transferee engaged in fraud

or illegality affecting the instrument.

The official comment to N.J.S.A. 12A:3-203 adds that in situations

where a transferee does not take the instrument by indorsement (as in

this case), the transferee still assumes the rights of the transferor, so long

as the transferee can show that the transferor had valid rights to the

instrument, and that the transferee acquired the instrument in accor-

dance with section 3-203’s requirements. Specifically, Comment 2 reads:

Subsection (b) states that transfer vests in the transferee any right of

the transferor to enforce the instrument ‘‘including any right as a holder in

due course.’’ If the transferee is not a holder because the transferor did not indorse,

the transferee is nevertheless a person entitled to enforce the instrument under Section

3-301 if the transferor was a holder at the time of transfer. Although the transferee is

not a holder, under subsection (b) the transferee obtained the rights of the transferor

as holder. Because the transferee’s rights are derivative of the transferor’s rights, those

rights must be proved. Because the transferee is not a holder, there is no

presumption under Section 3-308 that the transferee, by producing the

instrument, is entitled to payment. The instrument, by its terms, is not

payable to the transferee and the transferee must account for possession of

the unindorsed instrument by proving the transaction through which the

transferee acquired it. Proof of a transfer to the transferee by a holder is

proof that the transferee has acquired the rights of a holder. At that point

the transferee is entitled to the presumption under Section 3-308.

Under subsection (b) a holder in due course that transfers an in-

strument transfers those rights as a holder in due course to the purchaser.

The policy is to assure the holder in due course a free market for the

instrument.

[N.J.S.A. 12A:3-203, Comment 2 (emphasis added).]

The record indicates that plaintiff has complied with the require-

ments of both sections 3-302 and 3-203. Each of the check cashing

companies from whom plaintiff purchased the dishonored checks were

holders in due course. In support of his summary judgment motion,

plaintiff submitted an affidavit from each company; each company swore

that it cashed the checks for value, in good faith, without notice of any

claims or defenses by any party, without knowledge that any of the sig-

natures on the checks were unauthorized or fraudulent, and with the

expectation that the checks would be paid upon their presentment to the

74 3. Holders in Due Course

bank upon which the checks were drawn. Hauser Co. does not dispute

any of the facts sworn to by the check cashing companies.

The checks were then transferred to plaintiff in accordance with

section 3-203, vesting plaintiff with holder in due course status. Each

company swore that it assigned the checks to plaintiff in exchange for

consideration received from plaintiff. Plaintiff thus acquired the check

cashing companies’ holder in due course status when the checks were

assigned to plaintiff. See N.J.S.A. 12A:3-203, Comment 2. Moreover,

pursuant to section 3-203 (a)’s requirement that the transfer must have

been made for the purpose of giving the transferee the right to enforce

the instrument, the assignment agreements expressly provided plaintiff

with that right, stating that ‘‘all payments [assignor] may receive from any

of the referenced Debtors . . . shall be the exclusive property of [assign-

ee].’’ Again, Hauser Co. does not dispute any facts relating to the

assignment of the checks to plaintiff.

Hauser Co. contends, instead, that the checks are per se invalid be-

cause they were fraudulent and unauthorized. Presumably, this argument

is predicated on section 3-302. This section states a person is not a holder

in due course if the instrument bears ‘‘apparent evidence of forgery or

alteration’’ or is otherwise ‘‘so irregular or incomplete as to call into

question its authenticity.’’ N.J.S.A. 12A:3-302(a)(1).

In order to preclude liability from a holder in due course under

section 3-302, it must be apparent on the face of the instrument that it is

fraudulent. The trial court specifically found that Hauser Co. had pro-

vided no such evidence, stating that Hauser Co. had failed to show that

there was anything about the appearance of the checks to place the check

cashing company on notice that any check was not valid. Specifically, with

respect to Hauser Co.’s facsimile signature on the checks, the court stated

that the signature was identical to Hauser Co.’s authorized facsimile sig-

nature. Moreover, each of the check cashing companies certified that

they had no knowledge that the signatures on the checks were fraudulent

or that there were any claims or defenses to enforcement of the checks.

Hence, the trial court’s conclusion that there was no apparent evidence

of invalidity was not an abuse of discretion and was based on a reasonable

reading of the record.

To be sure, section 3-308 (a) does shift the burden of establishing the

validity of the signature to the plaintiff, but only if the defendant specifically

denies the signature’s validity in the pleadings. The section states:

In an action with respect to an instrument, the authenticity of, and authority to

make, each signature on the instrument is admitted unless specifically denied in

the pleadings. If the validity of a signature is denied in the pleadings, the

burden of establishing validity is on the person claiming validity, but the

I. Acquiring Holder in Due Course Status 75

signature is presumed to be authentic and authorized unless the action is to

enforce the liability of the purported signer and the signer is dead or

incompetent at the time of trial of the issue of validity of the signature.

[N.J.S.A. 12A:3-308(a) (emphasis added).]

Comment 1 explains that a specific denial is required

to give the plaintiff notice of the defendant’s claim of forgery or lack of

authority as to the particular signature, and to afford the plaintiff an op-

portunity to investigate and obtain evidence. ...In the absence of such

specific denial the signature stands admitted, and is not in issue. Nothing in

this section is intended, however, to prevent amendment of the pleading in

a proper case.

[N.J.S.A. 12A:3-308, Comment 1.]

Examination of the pleadings reveals that Hauser Co. did not specif-

ically deny the factual assertions in plaintiff’s complaint.

Even if Hauser Co.’s general denial was sufficient, the presumption

that the signature is valid still remains, unless Hauser Co. satisfies the

evidentiary requirements of N.J.S.A. 12A:3-308. Comment 1 to that sec-

tion explains that even when the defendant has specifically denied the

authenticity of a signature, the signature is still presumed to be authentic,

absent evidence of forgery or lack of authorization. Comment 1 states:

The burden is on the party claiming under the signature, but the sig-

nature is presumed to be authentic and authorized except as stated in the second

sentence of subsection (a). ‘‘Presumed’’ is defined in Section 1-201 and means

that until some evidence is introduced which would support a finding that the

signature is forged or unauthorized, the plaintiff is not required to prove that it is

valid. The presumption rests upon the fact that in ordinary experience

forged or unauthorized signatures are very uncommon, and normally any

evidence is within the control of, or more accessible to, the defendant. The

defendant is therefore required to make some sufficient showing of the grounds for the

denial before the plaintiff is required to introduce evidence. The defendant’s evi-

dence need not be sufficient to require a directed verdict, but it must be

enough to support the denial by permitting a finding in the defendant’s

favor. Until introduction of such evidence the presumption requires a

finding for the plaintiff.

[N.J.S.A. 12A:3-308, Comment 1 (emphasis added).]

Here, Hauser Co. has not provided any evidence of the invalidity of

the signature. Hauser Co.’s reliance on conclusory statements does not

76 3. Holders in Due Course

constitute such a ‘‘sufficient showing.’’ See Coupounas v. Madden, 401

Mass.125, 514 N.E.2d 1316, 1320 (1987) (defendant disputing validity of

notes ‘‘had to do more than ‘call into question’ the ‘integrity’ of the

notes’’).

In addition, as a matter of summary judgment, Hauser Co.’s reliance

on its answer, amended answer and Mr. Hauser’s affidavit as material,

disputed facts is inadequate. In order to defeat a motion for summary

judgment, a party must show that there are genuine issues of material

fact. Brill, supra, 142 N.J. at 540, 666 A.2d 146. ‘‘Bare conclusions in the

pleadings, without factual support in tendered affidavits, will not defeat a

meritorious application for summary judgment.’’ United States Pipe and

Foundry Co. v. American Arbitration Ass’n, 67 N.J. Super. 384, 399-400, 170

A.2d 505 (App. Div. 1961); see also Brae Asset Fund v. Newman, 327 N.J.

Super. 129, 134, 742 A.2d 986 (App. Div. 1999). Hauser Co. provided no

factual evidence tending to disprove the authenticity of the signature,

relying instead on self-interested and conclusory statements. Conse-

quently, the trial court did not err in finding that Hauser Co. had failed

to provide any evidence of the invalidity of the checks.

In conclusion, we hold that Judge Hoens properly granted summary

judgment. There was no issue of material fact as to: (1) the status of the

checks as negotiable instruments; (2) the status of the check cashing

companies as holders in due course; (3) the status of plaintiff as a holder

in due course; and (4) the lack of apparent evidence on the face of the

checks that they were forged, altered or otherwise irregular. Moreover,

Hauser Co.’s failure to submit some factual evidence indicating that the

facsimile signature was forged or otherwise unauthorized left unchal-

lenged the UCC’s rebuttable presumption that a signature on an instru-

ment is valid. Consequently, the trial court properly held, as a matter of

law, that plaintiff was a holder in due course and entitled to enforce the

checks.

Affirmed.

It may seem unfair to give holder in due course status to non-pur-

chasers and those who take with notice of defenses, but on reflection the

unfairness disappears. If the rule were otherwise, the current holder

would simply pass the instrument back up the chain until it reached a

former holder in due course, who would then reacquire that status, sue

the instrument’s creator, and prevail. The shelter rule accomplishes the

same result without all these maneuvers and has the further benefit of

promoting commercial confidence in the soundness of the instrument

once it has floated through the hands of multiple purchasers.

I. Acquiring Holder in Due Course Status 77

II. REAL AND PERSONAL DEFENSES/CLAIMS

A. Defenses Against a Holder in Due Course

Holder in due course status has as its primary attribute the ability to

enforce the instrument free from the usual legal excuses that could be

raised in an ordinary contracts action. The key Uniform Commercial

Code section reaching this extraordinary result is §3-305, to which we now

turn.

Section 3-305 is difficult to read, primarily because a number of the

concepts therein are complicated to sort out. Let’s take it a point at a

time.

First of all, the obligor mentioned throughout §3-305 is the party to

the instrument who is being sued by the holder of the instrument. Thus,

the obligor could be the drawer of a draft, the maker of a note, or

someone who indorsed the instrument. In the next chapter, we shall

discuss the nature of the obligations these parties incur by virtue of

having signed the instrument in one of the above capacities.

A ‘‘defense,’’ of course, is the legal excuse the obligor may have to

avoid paying the obligation. Subsection (b) tells us that a holder in due

course takes subject to the defenses listed in subsection (a)(1), meaning

that these defenses, if true, defeat the right of the holder in due course to

enforce the instrument. Defenses that are good against a holder in due

course are commonly called real defenses, a label you might wish to write

next to §3-305(a)(1). Subsection (b) tells us that a holder in due course

is not subject to the defenses raised in subsection (a)(2), the so-called

personal defenses.

Subsection (b) also states that a holder in due course holds free of

‘‘claims in recoupment’’ per §3-305(a)(3), but what does that mean? Re-

coupment is the legal ability to subtract from any payment due the

amount the person trying to collect the debt (or that person’s prede-

cessor) happens to owe the debtor. For example, if I owe you $500

pursuant to our contract, and, as a result of your breach of that same

contract, you have caused me $200 worth of damages, my claim in re-

coupment permits me to subtract those damages and only pay you $300.

A claim in recoupment is so similar to a defense that the original version

of Article 3 seemed to lump it in with the other personal defenses, but

the revised version of Article 3 gives it its own special treatment (leading

to awkward references throughout to a ‘‘defense or claim in recoup-

ment’’). Read Official Comment 3 to §3-305.

78 3. Holders in Due Course

PROBLEM 33

Stephen Maturin bought a sailboat from Jack Aubrey, paying $500

down and signing a $1,000 promissory note for the balance due. Maturin

loved everything about the boat except its color, and he promptly repainted

it his favorite color, black. Prior to the sale Aubrey had told Maturin that the

boat was constructed so that it wouldn’t sink even in the roughest weather.

This proved to be untrue when the sailboat went down in the first storm that

came along, and it cost Maturin $300 to have it dredged from the bottom

and restored. In the meantime, Aubrey had given the promissory note to his

father as a birthday gift, and the father presented it to Maturin for payment

at maturity. May Maturin assert his damages against the father’s demand for

payment? Same result if the boat never sank, but Aubrey’s dog bit Maturin

on the leg one week after the delivery of the sailboat, and Maturin incurred

$100 in medical bills as a consequence? See Zener v. Velde, 135 Idaho

352, 17 P.3d 296, 42 U.C.C. Rep. Serv. 2d 1073 (Idaho App. 2000).

Federal Deposit Insurance Corp. v. Culver

United States District Court, District of Kansas, 1986

640 F. Supp. 725, 1 U.C.C. Rep. Serv. 2d 1585

O’CONNOR,J.

This matter comes before the court on defendant’s motion to dismiss

for lack of personal jurisdiction, on plaintiff’s motion for summary

judgment, and on defendant’s motion for leave to file a demand for jury

trial out of time. After reciting the material facts (construed most favor-

ably to defendant), we will address these pending motions.

In 1984, defendant entered into a business arrangement with a

Mr. Nasib Ed Kalliel. Kalliel was to assume control over the financial

aspects of defendant’s farm, while defendant was to manage the farming

operation — receiving both a salary and a share of the profits. In July or

August of that year, defendant informed Kalliel that he urgently needed

money in order to stave off foreclosure. One week later, $30,000.00 was

wire-transferred from the Rexford State Bank in Rexford, Kansas, to

defendant’s bank in King City, Missouri. Although defendant knew that

the money had come from the Rexford State Bank, he thought that

Kalliel would be responsible for its repayment.

About one week later, defendant was approached by a Mr. Jerry

Gilbert, whom defendant believed was working for Kalliel. Gilbert told

defendant that ‘‘Rexford State Bank wanted to know where the

$30,000.00 went, . . . for their records.’’ Gilbert presented defendant with

a document and asked defendant to sign it. Apparently, Gilbert either

II. Real and Personal Defenses/Claims 79

told defendant, or at least led him to believe, that the document was

merely a receipt for the $30,000.00 he had received. In any event, de-

fendant signed the document without thereby intending to commit

himself to the repayment of any money.

The document defendant signed was a preprinted promissory note

form. As might be expected, the form contained a number of blanks into

which the parties were expected to insert terms specific to their own

transaction. At the time defendant signed the document, none of those

blanks had been completed. Thus, the note contained no execution date,

no maturity date, no principal amount, and no interest rate. The name of

the payee, ‘‘THE REXFORD STATE BANK, Rexford, Kansas,’’ was printed

on the note at that time. Moreover, the note did provide that the prin-

cipal and accrued interest were to be paid to the payee ‘‘at its offices.’’

Although defendant assumed that the figure $30,000.00 would

eventually be written on the document, some unknown individual com-

pleted the note as follows:

(1) The principal amount was shown as $50,000.00;

(2) the execution date was shown as August 2, 1984;

(3) the maturity date was shown as February 2, 1985; and

(4) the interest rate was shown as 14½ percent per annum until

maturity, and 18½ percent per annum thereafter.

Although defendant received only $30,000.00, the Rexford State

Bank did deposit the full $50,000.00 in an account controlled by Kalliel.

The $30,000.00 apparently came from that account.

Eventually, the note was returned to the Rexford State Bank. When that

bank became insolvent, the Federal Deposit Insurance Corporation

[‘‘FDIC’’] was appointed as its receiver. In its corporate capacity, the FDIC

then purchased a number of the bank’s assets from the receiver — including

the note at issue here. At that time, the FDIC had no actual knowledge of the

events that had transpired prior to its purchase of the note. As of yet, de-

fendant has made no payment of either principal or interest.

Other than receiving the $30,000.00 wire-transfer from the Rexford

State Bank, and then signing the note naming the bank as payee, de-

fendant has had no other relevant contact with the state of Kansas. . . .

II. PLAINTIFF’S MOTION FOR SUMMARY JUDGMENT

. . . Recognizing that ‘‘[t]here is no doubt that state and federal law

provide the Federal Deposit Insurance Corporation with holder in due

course status in the instant litigation’’ (Defendant’s Brief of May 2, 1986,

at 11), defendant concedes that the ‘‘personal’’ defenses of fraud in the

80 3. Holders in Due Course

inducement, estoppel, and failure of consideration would be ineffective

against plaintiff’s claim. See F.D.I.C. v. Vestering, 620 F. Supp. 1271

(D. Kan. 1985). Accordingly, defendant seeks to assert the ‘‘real’’ defense

of fraud in the factum. See K.S.A. 84-3-305(2)(c) [in the Revision see

§3-305(a)(l)(iii) — Ed.]. Plaintiff denies that the facts as alleged by de-

fendant constitute fraud in the factum. Alternatively, even assuming that

defendant can establish the elements of fraud in the factum, plaintiff

contends that such a defense is ineffective against the FDIC because of

the doctrine enunciated in D’Oench, Duhme & Co. v. F.D.I.C., 315 U.S.

447 (1942), and codified at 12 U.S.C. §1823(e). Because we conclude that

defendant cannot demonstrate fraud in the factum, we do not reach

plaintiff’s arguments regarding d’Oench, Duhme and section 1823(e).

The ‘‘fraud in the factum’’ defense is codified at K.S.A. 84-3-305(2)(c)

[in the Revision see 3-305(a)(1)(iii) — Ed.], which provides as follows:

Rights of a holder in due course. To the extent that a holder is a holder

in due course he takes the instrument free from . . .

(2) all defenses of any party to the instrument with whom the holder

has not dealt except ...

instrument with neither knowledge nor reasonable opportunity to

obtain knowledge of its character or its essential terms.

(Emphasis added.) As suggested by our factual summary, defendant con-

tends that he signed the note under the misapprehension that it was merely

a receipt. He thus denies having knowledge of the document’s ‘‘character’’

at the time he signed it. Moreover, because the note’s execution date, ma-

turity date, principal amount and interest rate were all blank at the time he

signed it, defendant contends that he had neither knowledge nor reason-

able opportunity to obtain knowledge as to the note’s ‘‘essential terms.’’

To determine whether these facts fit the definition of fraud in the

factum, we look elsewhere in the Kansas Uniform Commercial Code. For

instance, Official UCC Comment 7 to §3-305 provides this advice:

Paragraph (c) of subsection (2) is new. It follows the great majority of

the decisions under the original Act in recognizing the defense of ‘‘real’’ or

‘‘essential’’ fraud, sometimes called fraud in the essence or fraud in the

factum, as effective against a holder in due course. The common illustra-

tion is that of the maker who is tricked into signing a note in the belief that

it is merely a receipt or some other document. The theory of the defense is

that his signature on the instrument is ineffective because he did not

intend to sign such an instrument at all. Under this provision the defense

extends to an instrument signed with knowledge that it is a negotiable

instrument, but without knowledge of its essential terms.

II. Real and Personal Defenses/Claims 81

The test of the defense here stated is that of excusable ignorance of the contents

of the writing signed. The party must not only have been in ignorance, but

must also have had no reasonable opportunity to obtain knowledge.

(Emphasis added.) A portion of the 1983 Kansas Comment to this same

section offers guidance as to the proper construction of the term

‘‘excusable ignorance.’’ The Comment provides as follows:

Kansas decisional law would seem to be in accord on the possibility of

fraud in the factum as a real defense, the decision in Ort v. Fowler, 31 Kan.

478, 2 P. 580 (1884), being a good example of facts not satisfying the

defense because of the failure of the maker to satisfy a standard of conduct

comparable to that required by this subsection.

Given this Kansas Comment’s reference to Ort, an examination of the

facts and the holding in that case should be useful in determining

whether defendant showed ‘‘excusable ignorance’’ in mistaking the note

at issue here for a receipt.

In Ort, a farmer was working alone in his field. A stranger came up to him

and represented himself to be the state agent for a manufacturer of iron posts

and wire fence. After some conversation, the stranger persuaded the farmer

to accept a township-wide agency for the same manufacturer. The stranger

then completed two documents which he represented to be identical versions

of an agency contract. Because the farmer did not have his glasses with him

and, in any event, ‘‘could not read without spelling out every word,’’ 31 Kan.

at 480, the stranger purported to read the document to the farmer. No

mention was made of any note. Both men signed each document, with the

farmer not intending to sign anything but a contract of agency. Ultimately, it

was established that at least one of those documents was a promissory note. A

bona fide purchaser of that note brought suit against the farmer, and the

farmer attempted to defend the action on the basis of fraud in the factum.

After the trial court rejected that defense, the farmer appealed.

The Kansas Supreme Court, in an opinion by Justice David Brewer

(later a United States Supreme Court Associate Justice), phrased the issue

on appeal as follows: ‘‘A party is betrayed into signing a bill or note by the

assurance that it is an instrument of a different kind. Under what cir-

cumstances ought he to be liable thereon?’’ 31 Kan. at 482. Three al-

ternative answers were then suggested:

One view entertained is, that as he never intended to execute a bill or

note, it cannot be considered his act, and he should not be held liable

thereon any more than if his name had been forged to such an instrument.

A second view is, that it is always a question of fact for the jury whether

under the circumstances the party was guilty of negligence. A third is the

82 3. Holders in Due Course

view adopted by the trial court, that as [a] matter of law, one must be

adjudged guilty of such negligence as to render him liable who, possessed

of all his faculties and able to read, signs a bill or note, relying upon the

assurance or the reading of a stranger that it is a different instrument.

Id. Defendant herein would obviously prefer either the first or sec-

ond alternative. The court, however, made its preference clear:

We approve of the latter doctrine. It presents a case, of course, of which

one of two innocent parties must suffer; but the bona fide holder is not

only innocent, but free from all negligence. He has done only that which a

prudent, careful man might properly do, while on the other hand the

maker of the note has omitted ordinary care and prudence. A party cannot

guard against forgery; but if in possession of his faculties and able to read,

he can know the character of every instrument to which he puts his sig-

nature; and it is a duty which he owes to any party who may be subsequently

affected by his act, to know what it is which he signs. By his signature he

invites the credence of the world to every statement and promise which is in

the instrument he has subscribed; and he is guilty of negligence if he omits

to use the ordinary means of ascertaining what those provisions and state-

ments are. If he has eyes and can see, he ought to examine; if he can read,

he ought to read; and he has no right to send his signature out into the

world affixed to an instrument of whose contents he is ignorant. If he relies

upon the word of a stranger, he makes that stranger his agent. He adopts

his reading as his own knowledge. What his agent knows, he knows; and he

cannot disaffirm the acts of that agent done within the scope of the

authority he has intrusted to him.

Id., 31 Kan. at 482-483 (emphasis added). Although Ort is of rather an-

cient vintage, this aspect of the decision has been cited with approval as

recently as 1966. See Mid Kansas Federal Savings & Loan Assn. v. Binter,

197 Kan. 106, 110, 415 P.2d 278, 282 (1966).

It is obvious from reading defendant’s deposition that he is able to

read and understand the English language. Thus, under the rule an-

nounced in Ort, defendant was negligent in relying on Gilbert’s assurance

that the note was only a receipt. Given the 1983 Kansas Comment re-

ferring to the Ort absence-of-negligence standard as ‘‘comparable to that

required by [K.S.A. 84-3-305(2)(c)],’’ we must also conclude that defen-

dant has failed to show the ‘‘excusable ignorance’’ necessary to establish

fraud in the factum. In the words of the statute, we conclude as a matter

of law that defendant had a ‘‘reasonable opportunity to obtain knowledge

of [the document’s] character’’ before he signed it.

Defendant’s second argument, assuming that we reject his conten-

tion that he neither knew nor had reasonable opportunity to know

II. Real and Personal Defenses/Claims 83

the ‘‘character’’ of the document he signed, is that he had no such

opportunity to learn of the note’s ‘‘essential terms.’’ Because the note’s

execution date, maturity date, principal amount and interest rate were all

blank when defendant signed the note, he asserts that he had no (let

alone a reasonable) opportunity to learn of those terms. On its face, this

argument has great appeal; but defendant’s reliance thereon is foreclosed

by other Code provisions.

Questions arising from incomplete instruments and material altera-

tions are governed by K.S.A. 84-3-115 and -407, respectively. The former

provides as follows:

(1) When a paper whose contents at the time of signing show that it is

intended to become an instrument is signed while still incomplete in any

necessary respect it cannot be enforced until completed, but when it is

completed in accordance with authority given it is effective as completed.

(2) If the completion is unauthorized the rules as to material alteration apply

(section 84-3-407).

K.S.A. 84-3-115 (emphasis added). Because defendant claims not to have

authorized anyone to complete the note as it now reads, we are referred

by part (2) of this section to K.S.A. 84-3-407. The latter statute provides,

in part, as follows:

(3) A subsequent holder in due course may in all cases enforce the

instrument according to its original tenor, and when an incomplete instrument

has been completed, he may enforce it as completed.

K.S.A. 84-3-407(3) (emphasis added). As a holder in due course, plaintiff

is thus entitled to enforce this note as it was eventually completed — and

not merely as defendant would have authorized it to be completed.

The fraud allegedly committed by Gilbert does not affect this con-

clusion. We learn from Official UCC Comment 4 to K.S.A. 84-3-407 that

‘‘this result is intended even though the instrument was stolen from the

maker or drawer and completed after the theft.’’ In other words, one who

signs an instrument before all essential terms have been completed creates

a ‘‘blank Check’’ that may be enforced by a subsequent holder in due

course according to any terms that are completed by an intervening holder.

See K.S.A. 84-3-305, Kansas Comment 1983. That was precisely what hap-

pened here. Defendant executed the note in blank; an intervening holder

completed the note as it reads today; and plaintiff, as a holder in due

course, is entitled to enforce the note according to its present terms.

Defendant’s only legal recourse is against the intervening holder who ac-

tually completed the note without defendant’s authorization. As between

84 3. Holders in Due Course

the parties now before the court, we must grant plaintiff’s motion for

summary judgment. . . .

See Annot., Fraud in the Factum, 78 A.L.R.3d 1020.

PROBLEM 34

When Ronald Rube, newly rich, moved to New York City, he was

impressed by the Brooklyn Bridge when first he saw it. Simon Mustache, a

con man, told Rube that he was the owner of the bridge (a lie, of course),

and offered to sell it to Rube for $2,000,000 (described as ‘‘a bargain’’).

Rube paid $20,000 cash as a down-payment and signed a promissory

note, payable to Mustache, for the rest. Mustache negotiated the note to a

finance company, which claimed to be a holder in due course. When

Rube discovered that Mustache lacked title to the bridge, he refused to pay

the note. Does he have a real defense of fraud here?

PROBLEM 35

A child prodigy, Thomas Minor, had been playing the piano since he

was three and making professional tours of the world since he was twelve.

He looked much older than his seventeen years. He signed a promissory

note for $800 payable to the order of Merry Music Company as payment

for a piano, planning to tour with it. The company was unaware of Minor’s

age. The payee indorsed the note over to the Big National Bank for $725.

When the first payment came due, Minor refused to pay. He told the bank

to come pick up the piano — he was disaffirming the sale. Who wins?

PROBLEM 36

Childe Harold, also age 17, received a check for $1,000 from his

employer and decided to use it to buy a car from Byron Auto Sales, a used

car dealership. He picked out the car he wanted, indorsed the check in

blank, and handed it over to the salesman. Byron Auto Sales indorsed the

check on the back and cashed it at its own bank, the Crusaders National

Bank. Before this bank could present the check to the drawee bank, Childe

Harold decided to buy a horse instead of an automobile, so he returned

the car to the dealer and asked for the check back. Informed that the bank

II. Real and Personal Defenses/Claims 85

had it, Childe Harold called up the bank and informed it of his rescission

of the contract. When the bank refused to return the check to Childe

Harold, he filed suit, asking the court to restrain the bank from presenting

the check to the drawee and to order replevin of the check. How should

the court rule? It is clear that a holder in due course takes subject to the

defense of infancy, but does he take subject to a claim to the instrument

based on infancy? See §§3-202, 3-305(a) and (b), and 3-306.

Mental incapacity. Notes signed by those who are mentally incompe-

tent are void or voidable depending on the equities of the situation (i.e.,

the knowledge of the person dealing with the incompetent, the benefit

received by the incompetent, the degree of incompetency, etc.). If

someone has been judicially declared incompetent, his or her instru-

ments are more likely to be declared void (hence a nullity) than if no

adjudication has taken place. See Annot., Insanity as Defense Against

Holder in Due Course, 24 A.L.R.2d 1380.

Sea Air Support, Inc. v. Herrmann

Nevada Supreme Court, 1980

613 P.2d 413, 29 U.C.C. Rep. Serv. 918

PER CURIAM.

Ralph Herrmann wrote a check for $10,000 payable to the Ormsby

House, a hotel-casino located in Carson City, Nevada, and exchanged it

for three counter checks he had written earlier that evening to acquire

gaming chips. The Ormsby House was unable to collect the proceeds

from the check because Herrmann had insufficient funds in his account.

The debt evidenced by the check was assigned to Sea Air Support, Inc.,

dba Automated Accounts Associates, for collection. Sea Air also was un-

successful in its attempts to collect and, therefore, filed this action against

Herrmann to recover $10,567.

The district judge dismissed the action on the ground that Sea Air’s

claim is barred by the Statute of Anne. Sea Air appeals the dismissal. We

are asked to reconsider the long line of Nevada cases refusing to enforce

gambling debts. We refuse to do so, and affirm the dismissal.

Nevada law incorporates the common law of gambling as altered by the

Statute of 9 Anne, c.14, 1, absent conflicting statutory or constitutional

provisions. N.R.S. 1.030; West Indies v. First National Bank, 67 Nev. 13, 214

P.2d 144 (1950); Burke v. Buck, 31 Nev. 74, 99 P. 1078 (1909). The Statute

provides that all notes drawn for the purpose of reimbursing or repaying any

money knowingly lent or advanced for gaming are ‘‘utterly void, frustrate,

and of none effect.’’ Despite the fact that gambling, where licensed, is legal

86 3. Holders in Due Course

in Nevada, this court has long held that debts incurred, and checks drawn,

for gambling purposes are void and unenforceable. Corbin v. O’Keefe, 87

Nev. 189, 484 P.2d 565 (1971); Wolpert v. Knight, 74 Nev. 322, 330 P.2d 1023

(1958); Weisbrod v. Fremont Hotel, 74 Nev. 227, 326 P.2d 1104 (1958); West

Indies, 67 Nev. at 31; Burke, 31 Nev. at 80; Evans v. Cooke, 11 Nev. 69 (1876);

Scott v. Courtney, 7 Nev. 419 (1872).

In this case, Herrmann’s $10,000 check clearly was drawn for the pur-

pose of repaying money knowingly advanced for gaming. See Craig v. Har-

rah, 66 Nev. 1, 201 P.2d 1081 (1949). The check is void and unenforceable in

this state. If the law is to change, it must be done by legislative action.

Sea Air seeks to avoid the defense that the check is void and unen-

forceable because of gaming purpose by claiming to be a holder in due

course, immune to most defenses. N.R.S. 3-305. ‘‘A holder in due course

is a holder who takes the [negotiable] instrument (a) For value; and (b)

In good faith; and (c) Without notice that it is overdue or has been

dishonored or of any defense against or claim to it on the part of any

person.’’ N.R.S. 3-302(1). Sea Air promised to take ‘‘such legal action as

may be necessary to enforce collection’’ of the $10,000. The promise to

perform services in the future does not constitute taking for value under

N.R.S. 3-303. Anderson, 2 Uniform Commercial Code (2d ed.) §3303:3.

In addition, Sea Air had at least constructive notice of a defense against

collection because the check was payable to a casino, and Sea Air knew

the check had been dishonored. Consequently, Sea Air is not a holder in

due course. The action was properly dismissed.

Affirmed.

QUESTION

If Sea Air had been a holder in due course, would it have been able

to enforce the check? See §3-305(a); Casanova Club v. Bisharat, 189

Conn. 591, 458 A.2d 1, 35 U.C.C. Rep. Serv. 1207 (1983). It should be

noted that following the decision in Sea Air Support, the Nevada legislature

amended its gaming laws to permit casinos to sue on credit instruments

received in payment of gambling debts. Nev. Rev. Stat. 463.368.

Kedzie & 103rd Currency Exchange, Inc. v. Hodge

Illinois Supreme Court, 1993

156 Ill. 2d 112, 619 N.E.2d 732, 21 U.C.C. Rep. Serv. 2d 682

FREEMAN,J.

We consider here whether a holder in due course of a check is

precluded from payment as against the drawer where the check was given

II. Real and Personal Defenses/Claims 87

in exchange for contract services for which the provider was required to

be, but was not, a licensed plumber. We conclude such a claim is not

precluded.

BACKGROUND

Pursuant to a written ‘‘work order,’’ Fred Fentress agreed to install a

‘‘flood control system’’ at the home of Eric and Beulah Hodge of Chicago

for $900. In partial payment for the work, Beulah Hodge drafted a per-

sonal check payable to ‘‘Fred Fentress — A-OK Plumbing’’ for $500 from

the Hodges’ joint account at Citicorp Savings.

The system’s components were not delivered to the Hodges’ home as

scheduled. And, when Fentress failed to appear on the date set for in-

stallation, Eric Hodge telephoned him to announce the contract ‘‘can-

celled.’’ Hodge also told Fentress that he would order Citicorp Savings

not to pay the check Fentress had been given.

Records of Citicorp Savings confirm acknowledgment of a stop-pay-

ment order entered the same day.

Nevertheless, Fentress presented the check at the Kedzie & 103rd

Street Currency Exchange (Currency Exchange), endorsing it as ‘‘sole

owner’’ of A-OK Plumbing, and obtained payment. However, when the

Currency Exchange later presented the check for payment at Citicorp

Savings, payment was refused in accordance with the stop-payment order.

The Currency Exchange, alleging it was a holder in due course (see

Ill. Rev. Stat. 1989, ch. 26, par. 3-302), then sued Beulah Hodge, as

drawer of the check, and Fentress for the amount stated. Hodge, in turn,

filed a counterclaim against Fentress. Hodge also moved to dismiss the

Currency Exchange’s action against her (see Ill. Rev. Stat. 1989, ch. 110,

par. 2-619). The disposition of Hodge’s motion gives rise to this appeal.

Hodge asserted a defense provided by 3-305 of the Uniform Com-

mercial Code (UCC) (Ill. Rev. Stat. 1989, ch. 26, par. 3-305). Under that

section, the claim of a holder in due course of a negotiable instrument

may be barred based on ‘‘illegality of the transaction.’’ (Ill. Rev. Stat.

1989, ch. 26, par. 3-305(2)(b).)

Hodge contended Fentress was not a

licensed plumber as was required under the Illinois Plumbing License

Law (see Ill. Rev. Stat. 1989, ch. 111, pars. 1101 through 1140). The

director of licensing and registration of the Chicago department of

buildings and the keeper of plumbing licensing records of the Illinois

Department of Public Health provided affidavits supporting that con-

tention. Hodge asserted that, because Fentress was in violation of the

Illinois Plumbing License Law, his promised performance under the

8. [Now §3-305(a)(1)(ii) — Ed.]

88 3. Holders in Due Course

contract gave rise to the requisite ‘‘illegality’’ to bar the Currency

Exchange’s claim for payment.

The circuit court granted the motion and dismissed the Currency

Exchange’s action against Hodge. The appellate court, with one justice

dissenting, affirmed. (234 Ill. App. 3d 1017.) Pursuant to Supreme Court

Rule 315(a) (134 Ill. 2d R. 315(a)), we allowed the Currency Exchange’s

petition for leave to appeal.

DISCUSSION

. . . The Illinois Plumbing License Law requires that all plumbing, in-

cluding ‘‘installation . . . or extension’’ of ‘‘drains,’’ be performed by plum-

bers licensed under the Act. (Ill. Rev. Stat. 1989, ch. 111, pars. 1102(5), (8),

1103.) The affidavits establish that Fentress was not licensed either by the

City of Chicago or the State of Illinois. That failure is a violation of the Illinois

Plumbing License Law and is punishable as a misdemeanor. Ill. Rev. Stat.

1989, ch. 111, pars. 1103, 1128. . . .

. . . The concern is whether noncompliance by Fentress with the

Illinois Plumbing License Law gives rise to ‘‘illegality of the transaction’’

with respect to the contract for plumbing services so as to bar the claim of

the Currency Exchange, a holder in due course of the check initially

given Fentress.

The issue of ‘‘illegality’’ arises ‘‘under a variety of statutes.’’ (Ill. Ann.

Stat., ch. 26, par. 3-305, Uniform Commercial Code Comment, at 66

(Smith-Hurd Supp. 1992).) In view of the diverse constructions to which

statutory enactments are given, ‘‘illegality’’ is, accordingly, a matter ‘‘left

to the local law.’’ (Ill. Ann. Stat., ch. 26, par. 3-305, Uniform Commercial

Code Comment, at 66 (Smith-Hurd Supp. 1992).) Even so, it is only when

an obligation is made ‘‘entirely null and void’’ under ‘‘local law’’ that

‘‘illegality’’ exists as one of the ‘‘real defenses’’ under 3-305 to defeat a

claim of a holder in due course. (Ill. Ann. Stat., ch. 26, par. 3-305, Uni-

form Commercial Code Comment, at 66 (Smith-Hurd Supp. 1992).) In

effect, the obligation must be no obligation at all. If it is ‘‘merely void-

able’’ at the election of the obligor, the defense is unavailable. Ill. Ann.

Stat., ch. 26, par. 3-305, Uniform Commercial Code Comment, at 66

(Smith-Hurd Supp. 1992).

Historically, this court has recognized ‘‘illegality’’ to arise only in view

of legislative declaration affecting both the underlying contract or trans-

action and the instrument exchanged upon it. (Pope v. Hanke (1894),

155 Ill. 617, 628-30; Town of Eagle v. Kohn (1876), 84 Ill. 292, 295-96.) A

contract or transaction which is void must certainly negate the obligation

to pay arising from it as between the contracting parties. (Pope, 155 Ill. at

626; Kohn, 84 Ill. at 296.) But, unless an instrument memorializing the

II. Real and Personal Defenses/Claims 89

obligation is also made void, an innocent third party who has no

knowledge of the circumstances of the initial contract or transaction may

yet claim payment of it against the drawer or maker. Pope, 155 Ill. at 626;

Kohn, 84 Ill. at 296.

Thus, ‘‘illegality’’ has been held to defeat the claims of holders in

due course in cases involving contracts of a gaming nature or for retire-

ment of gambling debts. [Citations omitted.] Owing to a deep-seated

hostility toward nongovernmental-sanctioned gambling, our legislature

has declared that any instrument associated with such activity is void,

independent of the status of who may possess it. [Citations omitted.] The

absence of similar legislative declaration as for an instrument given upon

a usurious contract must account, in part, for the conclusion that usury

has not been held to give rise to ‘‘illegality’’ as a defense against a holder

in due course. [Citations omitted.]

That the existence or absence of legislative declaration controls the

issue was recognized by our appellate court in McGregor v. Lamont

(1922), 225 Ill. App. 451, a case involving circumstances similar to those

here. John T. Lamont was the maker of a note used to pay for shares of

stock issued by the Corn Belt Farmers’ Cooperative Association (Associ-

ation). Lamont’s note subsequently came into the possession of Robert

Roy McGregor, a holder in due course. When Lamont failed to pay on

the note, McGregor filed suit and obtained a judgment against him.

Lamont moved to vacate the judgment. Lamont asserted that the

purchase of the shares of stock was void under the Illinois Securities Law

because the Association had not complied with its requirements. Because

the transaction was void, Lamont concluded, the note given in payment

must also be void despite McGregor’s status as a holder in due course.

The appellate court noted that the Illinois Securities Law did, in-

deed, make transactions for the sale of shares of stock void based on

noncompliance with the Law’s requirements. (McGregor, 225 Ill. App. at

453-454, 455.) But the court noted that only the ‘‘sale and contract of

sale’’ of shares of stock were expressly made void, not instruments ex-

changed upon such contracts. (McGregor, 225 Ill. App. at 455.) Absent

legislative declaration making such instruments void, the court declined

to recognize a defense to McGregor’s action for payment on the note.

McGregor, 225 Ill. App. at 455.

The same rule obtains in New Jersey. In New Jersey Mortgage &

Investment Corp. v. Berenyi (App. Div. 1976), 140 N.J. Super. 406, 356

A.2d 421, a holder in due course of a note was permitted to maintain a

claim for its payment even though the note had been initially obtained by

a corporation in a transaction which violated an injunctive order. No

statute rendered the note void, and the holder in due course had no

knowledge or notice of the injunction. (Berenyi, 140 N.J. Super. at 408,

90 3. Holders in Due Course

356 A.2d at 423.) But in Westervelt v. Gateway Financial Service (Ch. Div.

1983), 190 N.J. Super. 615, 464 A.2d 1203, the ‘‘illegality’’ defense was

held to bar the claim of a holder in due course of a secondary mortgage

and note because New Jersey’s Secondary Mortgage and Loan Act spe-

cifically made void ‘‘[a]ny obligation on the part of the borrower arising

out of a secondary mortgage loan.’’ (Westervelt, 190 N.J. Super. at 620, 464

A.2d at 1205.) Westervelt involved what Berenyi did not: applicability of a

direct statutory expression that an instrument, itself, arising from a par-

ticular contract or transaction was void. Westervelt, 190 N.J. Super. at 623,

464 A.2d at 1207.

Several other jurisdictions also find reason to draw a distinction be-

tween the voidness of a negotiable instrument and the underlying con-

tract or transaction upon which it is exchanged. (See Annot., 80 A.L.R.2d

465, 472-476 (1961) (summarizing several state decisions in which holders

in due course were permitted to claim payment of instruments executed

in favor of foreign corporations doing business in states without com-

plying with local licensing requirements).) Although recognition of that

distinction is not universal (see Columbus Checkcashiers v. Stiles (1990),

56 Ohio App. 3d 159, 565 N.E.2d 883; Wilson v. Steele (1989), 211 Cal.

App. 3d 1053, 259 Cal. Rptr. 851 (holding that ‘‘illegality’’ need only be

present in the underlying contract between an unlicensed contractor and

the drafter of a negotiable instrument to bar the claim of a holder in due

course)), we are convinced it remains the better rule.

A plaintiff is precluded from recovering on a suit involving an illegal

contract because the plaintiff is a wrongdoer. (See Bankers Trust Co. v.

Litton Systems, Inc. (2d Cir. 1979), 599 F.2d 488, 492 (citing the

Restatement of Contracts and Restatement (Second) of Contracts).)

Enforcement of the illegal contract makes the court an indirect partici-

pant in the wrongful conduct. See Litton, 599 F.2d at 493.

But a holder in due course is an innocent third party. (Litton, 599

F.2d at 492-493.) Such a holder is without knowledge of the circum-

stances of the contract upon which the instrument was initially

exchanged. (Ill. Rev. Stat. 1989, ch. 26, par. 3-302(1)(c) (defining a

holder in due course, in part, as a holder who is ‘‘without notice . . . of

any defense against or claim to [the instrument] on the part of any

person’’).) The same rationale that precludes recovery by a wrongdoing

plaintiff is inapplicable in determining such a holder’s right to claim

payment. (Litton, 599 F.2d at 492-493.) Enforcement of that claim does

not sully the court. Litton, 599 F.2d at 492-493.

The holder in due course concept is intended to facilitate commer-

cial transactions by eliminating the need for ‘‘elaborate investigation’’ of

the nature of the circumstances for which an instrument is initially ex-

changed or of its drafting. (Litton, 599 F.2d at 494.) If ‘‘illegality’’ means

II. Real and Personal Defenses/Claims 91

simply negation of the initial obligation to pay, a holder in due course

enjoys no more protection than a party to the original contract or

transaction. The ‘‘real’’ defense of ‘‘illegality’’ is reduced to a ‘‘personal’’

one. See Vedder v. Spellman (1971), 78 Wash. 2d 834, 839-840, 480 P.2d

207, 210 (Neill, J., concurring).

It is, therefore, not enough simply to conclude that the initial obli-

gation to pay arising from a void contract or transaction is void. Negation

of that obligation as between the contracting parties has little bearing on

whether a holder in due course of an instrument arising from the con-

tract or transaction should nevertheless be permitted to make a claim for

payment.

The ‘‘local law’’ (Ill. Ann. Stat., ch. 26, par. 3-305, Uniform Com-

mercial Code Comment, at 66 (Smith-Hurd Supp. 1992)) of this state has

been formulated upon this court’s recognition, in cases predating the

UCC, of legislative prerogative regarding negotiable instruments. In

adopting the UCC and, in particular, 3-305, our legislature chose to

confer upon a holder in due course of a negotiable instrument consid-

erable protection against claims by persons to it. Our legislature also

continues to declare certain obligations void because of the circumstances

of the agreements from which they arise and without regard to the status

of who may claim ownership. (Ill. Rev. Stat. 1989, ch. 38, par. 28-7(b)

(subjecting ‘‘[a]ny obligation’’ made void by reason of gambling to be

‘‘set aside and vacated’’ by any court).) The selective negation of obli-

gations reflects a legislative aim to declare what will and will not give rise

to ‘‘illegality’’ in cases now governed by the UCC. As legislative direction

indicates which obligations are always void, legislative silence indicates

when the protection afforded a holder in due course must be honored.

We therefore reaffirm, today, the view this court has consistently

recognized in cases predating the UCC. Unless the instrument arising

from a contract or transaction is, itself, made void by statute, the ‘‘ille-

gality’’ defense under §3-305 is not available to bar the claim of a holder

in due course.

CONCLUSION

To determine whether Hodge is entitled to a judgment of dismissal,

we need not engage in an analysis aimed at characterizing the contract

between Fentress and the Hodges. Whether the underlying contract

should be considered void because Fentress was not licensed as required

by the Illinois Plumbing License Law is not dispositive of the Currency

Exchange’s right, as a holder in due course, to claim payment of the

check. It is relevant only to determine whether the Illinois Plumbing

License Law provides that any obligation arising from a contract

92 3. Holders in Due Course

for plumbing services made in violation of its requirements is void. It

does not.

For the reasons stated, the judgments of the appellate and circuit

courts are reversed, and the cause is remanded to the circuit court for

further proceeding. Judgments reversed; cause remanded.

BILANDIC, J., dissenting . . .

The plain language of §3-305 and the comments to §3-305 make it clear

that where the illegality of a transaction renders the obligation of the maker

of an instrument a nullity, the illegality of the transaction can be raised as a

defense by the maker of the instrument, even against a holder in due

course. Section 3-305 does not state that illegality is a defense only where the

instrument arising from a contract or transaction has been expressly

declared void by the legislature due to the illegality of the transaction. Had

the legislature intended for illegality to be a defense only where it had

expressly declared an instrument void due to the illegality of the underlying

transaction, it could easily have said so in §3-305. It did not say so, however.

The only inquiry necessary to resolve the issue presented in this case,

then, is whether the contract between Hodge and Fentress is void on the

grounds of illegality. The comments to the UCC instruct that one must

look to Illinois statutory and case law to determine whether the under-

lying contract was illegal and, as a result of that illegality, void. (Ill. Ann.

Stat., ch. 26, par. 3-305. Uniform Commercial Code Comment, at 66

(Smith-Hurd Supp. 1992).) An examination of the statute providing for

the licensing of plumbers, the public policy behind that statute, and

Illinois case law concerning the illegality of contracts made in contra-

vention of professional licensing laws establishes that the contract be-

tween Hodge and Fentress is illegal and void.

The Illinois Plumbing License Law (Ill. Rev. Stat. 1989, ch. 111, par.

1101 et seq.) specifically prohibits the performance of plumbing work by

nonlicensed plumbers. Pursuant to the Act, ‘‘all plumbing shall be per-

formed only by plumbers licensed under the provisions of this Act.’’

(Ill. Rev. Stat. 1989, ch. 111, par. 1103(1).) The Act imposes criminal

penalties on anyone performing plumbing services without a license. (Ill.

Rev. Stat. 1989, ch. 111, par. 1128.) The rationale behind the prohibition

of plumbing work by nonlicensed plumbers is set forth in the Plumbing

License Law. The portion of the Law setting forth its purpose and

underlying policy states:

It has been established by scientific evidence that improper plumbing

can adversely affect the health of the public. . . . Faulty plumbing is

potentially lethal and can cause widespread disease and an epidemic of

disastrous consequences.

II. Real and Personal Defenses/Claims 93

To protect the health of the public it is essential that plumbing be

installed by persons who have proven their knowledge of the sciences of

pneumatics and hydraulics and their skill in installing plumbing.

Consistent with its duty to safeguard the health of the people of this

State, the General Assembly therefore declares that individuals who plan,

inspect, install, alter, extend, repair and maintain plumbing systems shall be

individuals of proven skill. . . . [T]his Act is therefore declared to be es-

sential to the public interest. (Ill. Rev. Stat. 1989, ch. 111, par. 1101.)

Here, the contract between Hodge and Fentress presents the kinds of

dangers the Illinois Plumbing License Law was intended to guard against.

Affidavits attached to Hodge’s 2-619 motion to dismiss, which were not

contradicted by the plaintiff, establish that Fentress was not a licensed

plumber. The affidavits also establish that Hodge and her husband, Eric,

believed that Fentress was a licensed plumber at the time they contracted

with him for plumbing services. Had Fentress performed the work re-

quired of him pursuant to the contract with Hodge, it is likely that his

work would not have conformed to acceptable plumbing standards and

would have posed the kinds of dangers which the Plumbing License Law

was intended to prevent. . . .

The majority asserts that to bar recovery by the Currency Exchange

in this case would be unfair because the Currency Exchange is an inno-

cent third party which had no knowledge of the circumstances of the

contract between Hodge and Fentress. However, section 3-305 clearly

provides that the general policy favoring free negotiability is not absolute.

There is a competing policy disfavoring certain transactions, such as those

involving infancy, duress, illegality or misrepresentation as to the true

nature of an instrument (i.e., fraud in the factum). (Ill. Rev. Stat. 1989,

ch. 26, par. 3-305.) Pursuant to §3-305, the Currency Exchange takes a

check subject to these and certain other real defenses. The Illinois leg-

islature has provided that, by definition, a holder in due course is one

who does not have notice of any of the real defenses listed in §3-305. (See

Ill. Rev. Stat. 1989, ch. 26, par. 3-302(1)(c).) By statute, the innocence of

the holder in due course cannot defeat any of the real defenses listed in

§3-305, including illegality. Accordingly, the argument that the Currency

Exchange could not have known that the underlying transaction was

illegal is simply misplaced. Such reasoning would lead to the conclusion

that all of the defenses listed in §3-305 should be unavailable to defeat

the claim of a holder in due course, a conclusion obviously contrary to

the provisions of §3-305.

For the above reasons, I dissent. I would affirm the judgment of the

appellate court which affirmed the circuit court’s dismissal of the Cur-

rency Exchange’s action against Hodge.

94 3. Holders in Due Course

PROBLEM 37

When she heard her creditors fighting over priorities on her doorstep,

Elsie Maynard knew that she had no choice but bankruptcy. Among the

debts that she reported to the bankruptcy court was the loan she had taken

from Point National Bank, which was evidenced by a promissory note she

had signed. In due course the bankruptcy proceeding culminated in the

judge’s ordering that Elsie be discharged from all her scheduled debts. Two

years later, the promissory note surfaced in the possession of Shadbolt

State Bank, which claimed quite convincingly to be a holder in due

course. Must Elsie pay? See §3-305(a)(1) and (b).

A Little Lecture on Discharge as a Real Defense. Subsection (b) to §3-302

tells us that:

Notice of discharge of a party, other than discharge in an insolvency pro-

ceeding, is not notice of a defense under subsection (a), but discharge is

effective against a person who becomes a holder in due course with notice

of the discharge. . . .

What does this mean? Well, first of all, as the above Problem illustrates,

discharge in bankruptcy is always a real defense, regardless of what the

subsequent holder knows or doesn’t know at the time of acquisition of

the instrument. Any other discharge that the Code or common law cre-

ates is not effective against a holder in due course unless that holder, at

the time of acquisition, knew of the discharge, in which case the dis-

charge is, in effect, a real defense and assertable against the holder in due

course. For example, suppose that there are four sureties who have signed

their names as indorsers on a promissory note. The current holder of the

note decides to excuse one of them from future liability, and so draws a

line through that surety’s name, thus discharging that person from all

liability (see §3-601 and its Official Comment). Even a later holder in due

course of the note, seeing the line drawn through the former surety’s

name, would know that that surety is no longer liable on the note, and

therefore could only enforce it against the other obligors.

PROBLEM 38

Malvolio, a traveling salesman, bought a new car from Valentine Auto

Sales, signing a note for $18,000. The payee discounted the note for $16,800

to the Orsino Finance Company, which notified Malvolio that he should

make all future payments to them. Malvolio immediately sent them a check

II. Real and Personal Defenses/Claims 95

for the outstanding balance (he had come into some money when his aunt

died). He asked for the note back, but Orsino was evasive. A week later

Malvolio received a note from the Olivia Finance Company saying that his

note had been assigned to them and that he should direct his payments to

their office. When Malvolio protested, they made holder in due course

noises and became quite nasty. Malvolio, worried, comes to you for advice.

What should he do? See §3-501(b)(2); read §§3-601 and 3-602. For the result

in the 2002 version of Article 3, see §3-602(b). Does Malvolio have reme-

dies outside the Code? Think back to your course in Contracts.

B. A Special Note on Forgery

Forgery creates very complicated problems under the Code, and

these will be dealt with later. The important issue for now is whether

forgery is a real defense under the Code, so that it can be raised against a

holder in due course, or a personal defense, so that it cannot. The answer

to this question lies in §3-401(a): ‘‘A person is not liable on an instrument

unless (i) the person signed the instrument . . .’’ and in §3-403(a):

Unless otherwise provided in this Article or Article 4, an unauthorized

signature is ineffective except as the signature of the unauthorized signer in

favor of a person who in good faith pays the instrument or takes it for

value . . .

Consider the following Problem.

PROBLEM 39

Jimmy Slick, an expert con man, went into John’s Jewelers and told

John, the owner, that he was Milton Money, the richest man in town. John

was too awed to ask for identification. Slick then picked out several very

expensive pieces of jewelry and signed Money’s name to a promissory

note to pay for them. Slick skipped town with the jewelry. When the note

matured, the Tenth National Bank (a holder in due course to whom John

has negotiated the paper) presented it to Milton Money for payment. May

Money refuse to pay a holder in due course?

The answer to this Problem is obviously that Money is not liable, but

as an attorney how do you get away from the all encompassing language

of §3-305(a) and (b)? Read §3-305(a) and (b) again and see if you can

determine how Money’s forgery defense fits into the statute.

96 3. Holders in Due Course

Additionally, if the forgery is of a name necessary to a valid negoti-

ation, there can be no holder in due course following the forgery because

no later transferee will qualify as a holder. See the discussion supra at

pages 32-34.

PROBLEM 40

When Barbara Shipek was off to Las Vegas for a fun weekend, she

bought a traveler’s check for $3,000 from Octopus National Bank (ONB).

The payee line on the traveler’s check was blank, but the bank had her

sign a line on the check indicating the name of the remitter (see §3-103

(a)(11)). The check contained another blank for a countersignature, under

which was printed a statement that the bank would pay the traveler’s

check only if the remitter re-signed the check on this blank at the time of

negotiation to the payee. On Ms. Shipek’s first night in Las Vegas a thief

stole her purse, getting the traveler’s check as part of the booty. The thief

apparently forged Ms. Shipek’s name on the countersignature line and

negotiated the check to Vegas Check-Cashing City, an entity listed as

payee when the check was presented by Vegas Check-Cashing City to

ONB for payment, by which time Ms. Shipek had phoned the bank and

told them what had happened. You are the attorney for the bank. Should it

pay the traveler’s check to Vegas Check-Cashing City? See §§3-104(i) and

3-106(c) with its Official Comment 2.

C. Procedural Issues

One does not have to be a holder in due course in order to sue on

the instrument; a ‘‘person entitled to enforce the instrument,’’ a phrase

defined in §3-301, may do so. Generally a ‘‘person entitled to enforce the

instrument’’ means the holder of the instrument (someone in possession

pursuant to a valid negotiation), though the phrase does include some

non-holders — namely, someone who gets holder rights under the shelter

rule (or a depositary bank per §4-205), the rightful owner of a lost

instrument (§3-309), or the defendant in a successful restitution action

(§3-418(d), yet to be discussed). Only if a defense or claim to the in-

strument arises will the holder’s due course status become relevant, at

which time the holder has the burden of establishing the position as a

holder in due course. Read §3-308(b).

As mentioned above, and elaborated on later in the forgery discus-

sion, a holder must take through a chain of indorsements that is free of

II. Real and Personal Defenses/Claims 97

forgeries affecting the title. When the genuineness of signatures becomes

an issue, §3-308(a) allocates the procedural burdens. Read it.

Virginia National Bank v. Holt

Virginia Supreme Court, 1975

216 Va. 500, 219 S.E.2d 881, 18 U.C.C. Rep. Serv. 440

COMPTON,J.

...InMay1974, the plaintiff, Virginia National Bank, filed a motion

for judgment against the defendants, Edgar M. Holt and Gustava H. Holt,

his wife, jointly and severally, seeking recovery of the face amount of a

‘‘Homestead Waiving Promissory Note,’’ plus interest and attorney’s fees.

The instrument, payable to the order of the Bank and allegedly made by

the Holts to evidence an indebtedness, was dated December 12, 1973, was

due 90 days after date, and was in the amount of $6,000.

Edgar M. Holt was duly served with process, but failed to appear on

file pleadings in response. A default judgment in the amount sued for was

entered against him in August 1974.

In her pleadings, Gustava H. Holt generally denied liability and

specifically denied that the instrument was signed by her. On November

20, 1974, judgment was entered on a jury verdict in her favor and we

granted the Bank a writ of error.

The dispositive issue is whether the evidence relating to the genu-

ineness of Mrs. Holt’s signature on the instrument presented a question

of fact to be decided by the jury. We hold that it did not and reverse.

We will summarize only the evidence pertinent to the issue we de-

cide. Testifying for the Bank was one of its commercial loan officers, who

did not handle the Holt transaction but through whom the instrument in

question was introduced into evidence, and two other witnesses, one of

whom was an expert in handwriting analysis, whose statements supported

the Bank’s position that the signature on the note was in fact the

defendant’s.

Mrs. Holt did not appear at the trial, but her attorney endeavored to

show that his client did not execute the instrument. During cross-exam-

ination, the loan officer, over the Bank’s objection based on the hearsay

rule, was required to answer whether he was present during the taking of

Mrs. Holt’s discovery deposition in July 1974 when she ‘‘denied that she

signed the note.’’ The record shows that the witness responded, ‘‘Yes, I

was. Somewhat surprised.’’ No other statement was elicited by defendant’s

counsel from any of the Bank’s witnesses which would support the

defendant’s claim that she did not sign the writing.

98 3. Holders in Due Course

The only evidence offered in the defendant’s behalf was a set of

answers previously filed by the Bank to six interrogatories propounded by

her attorney. Those responses indicated that the Bank did not know of

any witness who saw the defendant sign the note or who heard her admit

that she signed it. They further indicated that the Bank had no infor-

mation that she ever authorized her husband to sign her name to any

promissory note or that she ever ratified any act of his in signing her

name to such a writing.

By a motion to strike at the conclusion of the evidence, and again by

a motion to set aside after the verdict, the Bank moved for judgment in

its favor contending, as it does on appeal, that the foregoing hearsay

testimony on cross-examination was erroneously admitted and, in the al-

ternative, that even if such evidence was properly received, the defendant

had failed, as a matter of law, to overcome the presumption established

by §3-307 [§3-308 in the Revision — Ed.] that her signature was genuine

and authorized. The trial court, in refusing to sustain the motion to strike

and in overruling the motion to set aside, ruled that the question of

whether the signature was genuine was for the jury. This was error.

Section 3-307, inter alia, sets out the burden of proof in an action

which seeks recovery upon an ‘‘instrument’’ and deals with issues arising,

in such a suit, from a challenge of the genuineness or authorization of

signatures. 2 R. Anderson, Uniform Commercial Code §3-307:3 (2d ed.

1971). Under that section, each signature on an instrument is admitted

unless, as in this case, the ‘‘effectiveness’’ of the signature is put in issue

by a specific denial. The burden of establishing the genuineness of the

signature is then upon the party claiming under the signature and relying

on its ‘‘effectiveness,’’ but such party is aided by a presumption that it is

genuine or authorized. In this context, ‘‘presumption’’ means that ‘‘the

trier of fact must find the existence of the fact presumed unless and until

evidence is introduced which would support a finding of its nonexis-

tence.’’ Code §1-201(31).

The effect of the presumption is to eliminate any requirement that

the plaintiff prove the signature is authentic until some evidence is in-

troduced which would support a finding that the signature is forged or

unauthorized. §3-307, Official Comment 1. It is based upon the fact that

in the normal course of events forged or unauthorized signatures are very

uncommon, and that evidence of such is usually within the defendant’s

control or more accessible to him. Id. Therefore, under §3-307, the party

denying a signature must make some sufficient showing of the grounds

for the denial before the plaintiff is put to his proof. The evidence need

not be sufficient to require entry of summary judgment in the defen-

dant’s favor, ‘‘but it must be enough to support his denial by permitting

a finding in his favor.’’ Id. ‘‘Until the party denying the signature

II. Real and Personal Defenses/Claims 99

introduces such sufficient evidence, the presumption requires a finding

for the party relying on the effectiveness of the signature.’’ §3-307, Vir-

ginia Comment. See 2 F. Hart & W. Willier, Commercial Paper Under the

Uniform Commercial Code §2.07(2) (1975).

An application of the foregoing analysis of the statute to the facts of

this case demonstrates that the Bank was entitled to entry of summary

judgment in its favor at the conclusion of all the evidence, since

no material issue of fact requiring resolution by a jury was presented.

Rule 3:18.

The defendant’s specific denial put the genuineness of the defen-

dant’s signature in issue. Because of the foregoing presumption, the

signature, which appeared to be that of Gustava H. Holt, was presumed to

be genuine and the defendant was thus required to present ‘‘sufficient

evidence’’ in support of the denial of genuineness. This she failed to do.

We will assume, but not decide, that the disputed answer during cross-

examination was properly admitted in evidence. Nonetheless, we con-

clude that this bit of testimony is insufficient to sustain a finding that the

signature was forged or unauthorized. Furthermore, the answers to in-

terrogatories furnish no support to the defendant’s claimed defense. A

forgery or an unauthorized signature may not be shown by merely

demonstrating the plaintiff’s apparent lack of evidence on that issue.

We hold, therefore, that the defendant has failed, as a matter of law,

to make a sufficient showing to support a finding that she, or her au-

thorized representative, did not in fact write her name on the instrument.

The presumption then requires a finding that the signature on the in-

strument is genuine and effective. Accordingly, production of the in-

strument entitled the Bank to recover, because the defendant established

no defense, 3-307(2), and it was error to submit the case to the jury. For

these reasons, the judgment in favor of Gustava H. Holt will be reversed

and final judgment will be entered here in favor of the Bank.

Reversed and final judgment.

QUESTION

Would it have been sufficient to overcome the presumption if Mrs.

Holt had taken the stand and denied the signature? See Metropolitan

Mortgage Fund v. Basiliko, 407 A.2d 773, 28 U.C.C. Rep. Serv. 100 (Md.

App. 1979); Freeman Check Cashing, Inc. v. State, 97 Misc. 2d 819, 412

N.Y.S.2d 963, 26 U.C.C. Rep. Serv. 1186 (Ct. Cl. 1979); Bates & Springer,

Inc. v. Stallworth, 56 Ohio App. 2d 223, 382 N.E.2d 1179, 26 U.C.C. Rep.

Serv. 1181 (1978).

100 3. Holders in Due Course

D. Defenses Against a Non-Holder in Due Course

Read §§3-305(a) and (b) and 3-306 carefully. Note the legal result: all

claims and both real and personal defenses may be asserted against anyone

who does not qualify as a holder in due course.

The most common

personal defenses are want of consideration (no consideration) and failure

of consideration (breach of contract, called a claim in recoupment in the

Revision).

Herzog Contracting Corp. v. McGowen Corp.

United States Court of Appeals, Seventh Circuit, 1992

976 F.2d 1062, 18 U.C.C. Rep. Serv. 2d 1170

POSNER, Circuit Judge.

The district judge granted summary judgment in favor of Herzog

Contracting Corporation in its diversity suit to enforce two promissory

notes, aggregating $400,000, against the issuer, McGowen Corporation.

The appeal raises a tangle of jurisdictional and substantive questions, the

latter governed, the parties agree, by Indiana Law. . . .

The next jurisdictional issue requires us to delve into the facts. In

1989 Herzog, the plaintiff, bought the assets of Tru-Flex Metal Hose

Corporation from McGowen, the defendant, and formed a wholly owned

subsidiary of Herzog (also called Tru-Flex) to hold them, to which Her-

zog assigned the asset purchase agreement. The agreement called for

annual payments from Tru-Flex to McGowen of $500,000 for five years.

The two promissory notes, both demand notes, were issued by McGowen

to Tru-Flex later in 1989. The parties have radically different positions on

the purpose of the notes. Herzog claims that it loaned McGowen

$400,000 and the notes are McGowen’s promises to repay the loan.

McGowen acknowledges having received the $400,000 but denies that it

was a loan, contending instead that it was partial prepayment of the next

year’s installment due under the asset purchase agreement and that the

only purpose of the notes that it gave Tru-Flex was to enable it (that is,

McGowen) to postpone the realization of taxable income to the following

year by making the $400,000 payment look like a loan.

The parties soon fell to squabbling and Herzog refused to make

further payments under the asset purchase agreement, precipitating a suit

9. The only claim a non-holder in due course takes free of is a perfected security

interest in non-negotiable instruments, and then only if they are purchased for value in

the ordinary course of business without notice of the security interest (§9-330). This is an

Article 9 matter, and at this point don’t worry what it means.

II. Real and Personal Defenses/Claims 101

by McGowen against Herzog in an Indiana state court for breach of

contract that remains pending. At about the same time that the state

court suit was brought, Tru-Flex assigned McGowen’s promissory notes to

Herzog, which shortly afterward brought this suit to enforce them. . . .

We come to the merits. The case was decided on summary judgment

and there has been no determination of the truth of McGowen’s claim

that the promissory notes were never intended to be presented for pay-

ment. So we must assume that the claim is true. The question is whether,

as the district judge held, solely on the basis that the notes are ‘‘clear and

unambiguous,’’ they are enforceable regardless of what the parties actu-

ally intended.

They would be if enforcement were being sought by a holder in due

course, UCC §3-305, Ind. Code §26-1-3-305, but Herzog concedes that it is

not that. It places its case on the parol evidence rule. The promissory

notes are unambiguous — they promise Herzog a specified sum of money

on demand — and their terms cannot be varied by extrinsic evidence. At

first glance Herzog’s argument seems a complete nonstarter. A holder of

a promissory note who is not a holder in due course takes the note

subject to ‘‘all defenses of any party which would be available in an action

on a simple contract,’’ UCC §3-306(b) [§3-305(b) in the Revision — Ed.],

and one of those defenses, notwithstanding the parol evidence rule, is

that the parties did not intend to create an enforceable contract. 2

E. Allan Farnsworth, Farnsworth on Contracts §7.4, at p.212 (1990); James

J. White & Robert S. Summers, Handbook of the Law under the Uniform

Commercial Code §2-10, at p.78 (1980). ‘‘It is well settled that whatever

the formal documentary evidence, the parties to a legal transaction may

always show that they understood a purported contract not to bind them;

it may, for example, be a joke, or a disguise to deceive others.’’ In re

H. Hicks & Son, Inc., 82 F.2d 277, 279 (2d Cir. 1936) (L. Hand, J.); see

also Nice Ball Bearing Co. v. Bearing Jobbers, Inc., 205 F.2d 841, 845 (7th

Cir. 1953). The deceived others may, of course, be able to object to the

attempt to prove the contract a sham, as in Central States, Southeast &

Southwest Areas Pension Fund v. Gerber Truck Service, Inc., 870 F.2d

1148 (7th Cir. 1989) (en banc), and FDIC v. O’Neil, 809 F.2d 350

(7th Cir. 1987), but that is not a factor here. More to the point, a mi-

nority of jurisdictions ‘‘have refused to admit such evidence [i.e., that the

purported contract was a joke, a disguise, in short a sham of some sort]

where the purpose of the sham agreement was offensive to public policy.’’

2 Farnsworth, supra, §7.4, at p.212 n.4; see Annot., ‘‘Admissibility of Oral

Evidence to Show That a Writing Was a Sham Agreement Not Intended

to Create Legal Relations,’’ 71 A.L.R.2d 382, 393-397 (1960); 67 A.L.R.2d

Later Case Service 555 (1984), and for an illustrative case Kergil v. Central

Oregon Fir Supply Co., 213 Or. 186, 323 P.2d 947 (1958).

102 3. Holders in Due Course

We prefer the majority rule, illustrated by our decision in Nice Ball

Bearing Co. v. Bearing Jobbers, Inc., supra, so will apply it here in default

of any Indiana cases on the question. Apart from the fact that the mi-

nority rule rewards a party to the sham agreement and imposes a pun-

ishment that may be disproportionate to the promisor’s misconduct, it

invites a collateral inquiry into the character of the alleged ‘‘sham.’’ Here

the party accused of shamming by his fellow shammer was angling for a

tax advantage. Did that make the transaction a ‘‘sham’’? Despite the

doctrine of tax law that substance prevails over form, Gregory v. Helver-

ing, 293 U.S. 465 (1935); Yosha v. Commissioner, 861 F.2d 494 (7th Cir.

1988), many transactions that would strike a nonspecialist as contrived

purely to avoid taxes are entirely lawful. Must we therefore, to resolve this

case, decide whether McGowen’s effort to postpone its tax liability for the

sale of Tru-Flex was one of them? We trust not.

But we are not done. In the face of the principle that any defenses to

a contract are available in a suit on a promissory note unless the plaintiff

is a holder in due course, some courts enforce the parol evidence rule

more broadly in such suits than in suits to enforce ordinary contracts.

Annot., ‘‘Admissibility of Parol Evidence to Show That a Bill or Note Was

Conditional, or Given for a Special Purpose,’’ 54 A.L.R. 702, 717-718

(1928). In Perez-Lizano v. Ayers, 695 P.2d 467, 469 (Mont. 1985), for

example, the court refused to allow the admission of parol evidence to

show that the note was a sham. One of the cases in this line is an Indiana

case, Highfield v. Lang, 394 N.E.2d 204, 206 (Ind. App. 1979). But it is

readily distinguishable from our case; and we have found two recent cases

from other jurisdictions in which courts admitted parol evidence to show

that a promissory note was not intended to be enforceable. American

Underwriting Corp. v. Rhode Island Hospital Trust Co., 303 A.2d 121, 125

(R.I. 1973); Simpson v. Milne, 677 P.2d 365, 368 (Colo. App. 1983). The

second was a case of a sham; the parol evidence was that the notes in suit

‘‘were executed as a fiction to satisfy plaintiff’s wife, who was near death,

and who strongly felt that [the defendant and his wife] still owed [the

plaintiff and his wife] money from prior business transactions.’’ Id.

Despite these last two cases and despite UCC §3-306(b), the parties

have tacitly agreed that the applicability of the parol evidence rule to this

case is governed not by general contract law but by a special doctrine that

allows parol evidence to show, against a plaintiff who is not a holder in

due course, that the delivery of the negotiable instrument that he is suing

to collect was ‘‘for a special purpose.’’ Brames v. Crates, 399 N.E.2d 437,

441 (Ind. App. 1980); UCC §3-306(c); Ind. Code §26-1-3-306(c). This

approach is understandable though not inevitable. While §3-306(b) sub-

jects the nonholder in due course to ‘‘all defenses’’ that the original

promisor would have had, implicitly including the defense that the

II. Real and Personal Defenses/Claims 103

promise was not intended to create enforceable rights, §3-306(c) deals

with some of these defenses in greater detail. This could be taken to

imply that the defense that no enforceable rights were intended to be

created is to be analyzed in accordance with the ‘‘special purpose’’ doc-

trine that predates the Code, though a likelier inference is that the

draftsmen wanted simply to make sure that no defense was overlooked.

However this may be, Herzog argues that the special-purpose doctrine

is limited to allowing the promisor (McGowen here) to defend by showing

that his obligation to make good on the note was subject to a condition

precedent, which is not the case here. For it is McGowen’s contention not

that something had to happen before Herzog could demand payment, but

that Herzog could never demand payment. Parol evidence is always ad-

missible to prove a fraud, Franklin v. White, 493 N.E.2d 161, 165 (Ind.

1986); In re Estate of Fanning, 333 N.E.2d 80, 85 (Ind. 1975); Kruse Classic

Auction Co. v. Aetna Casualty & Surety Co., 511 N.E.2d 326, 330 (Ind. App.

1987), but McGowen does not contend that when Herzog agreed to the

scheme for making the prepayment of the purchase installment look like a

loan it intended to double-cross McGowen by demanding payment of the

notes. If there was a fraud, it was against the Internal Revenue Service,

though no one is arguing this. With fraud out of the picture and the scope of

the parol evidence rule applicable to promissory notes conceded by

McGowen to be governed by §3-306(c) rather than §3-306(b), McGowen is

left with the special-purpose doctrine and Herzog concludes that a sham

case is outside that doctrine, which, as we have noted, he believes to be

limited to conditions precedent.

There are cases, none from Indiana, on both sides of the question

whether ‘‘delivery for a special purpose’’ is limited to conditions precedent,

although the majority view is that it is not. Compare Perez-Lizano v. Ayers,

supra, 695 P.2d at 469-470, with American Underwriting Corp. v. Rhode

Island Hospital Trust Co., supra, 303 A.2d at 125. Text and history can help

us choose between these positions, though history more than text. Section

3-306(c) expressly recognizes a defense of ‘‘nonperformance of any condi-

tion precedent,’’ making the ‘‘special purpose’’ defense redundant on

Herzog’s construal of it. But redundancy is built into §3-306(c), as we have

seen, and maybe this is another example of it. So let us turn to history.

Until sometime after the middle of the nineteenth century, courts

were highly reluctant to admit parol evidence, in suits on promissory

notes, for any purpose other than to prove fraud or mistake. John Bar-

nard Byles, A Treatise on the Law of Bills of Exchange 169 note I (4th

Am. ed. 1856). A little later, they were allowing such evidence in three

additional types of cases: delivery of the note together with a mortgage

deed, with the note as additional security for payment of the mortgage;

delivery of the note to escrow; and delivery contingent on the satisfaction

104 3. Holders in Due Course

of a condition precedent. Id. at 112-113 (14th ed. 1885). Some courts also

allowed the admission of parol evidence ‘‘to show that a contract signed

and delivered was never intended to be the real contract between the

parties.’’ Id. at 113 note o. One case — oddly enough it is factually similar

to ours — used the term ‘‘special purpose’’ to describe the defense in a

‘‘no obligation’’ or ‘‘sham’’ case. Juilliard v. Chaffee, 92 N.Y. 529, 534

(1883). And when the English codified their law of negotiable instru-

ments in 1882, they expressly allowed evidence (other than against a

holder in due course) that delivery had been ‘‘conditional or for a special

purpose only, and not for the purpose of transferring the property in the bill.’’

James W. Eaton & Frank B. Gilbert, A Treatise on Commercial Paper and

the Negotiable Instruments Law 697 (1903). The meaning brought out by

the words that we have italicized seems unmistakable: the ‘‘special pur-

pose’’ defense encompassed all cases in which the negotiable instrument

had not been intended to create an enforceable obligation. Byles, supra,

at 122 (17th ed. 1911).

The American Negotiable Instruments Law — the first statute drafted

by the National Conference of Commissioners on Uniform State

Laws — copied the English provision word for word. Joseph Doddrige

Brannan, The Negotiable Instruments Law Annotated 129 (4th ed. 1926);

see also id. at 135-41. Later, however, darkness descended, and we find

some authorities distinguishing among condition cases, no-obligation

cases, and special-purpose cases. Annot., ‘‘Admissibility of Parol Evidence

to Show That a Bill or Note Was Conditional, or Given for a Special

Purpose,’’ 20 A.L.R. 421, 490, 498-502 (1922); 4 William D. Hawkland &

Lary Lawrence, Uniform Commercial Code Series 3-306:07, at p.481

(1990). This proliferation of unhelpful distinctions was abetted by the fact

that the Uniform Commercial Code, in recodifying negotiable instru-

ments law, dropped the explanatory phrase ‘‘and not for the purpose of

transferring the property in the bill’’ from the formulation of the special

purpose defense. But this was done without any intention of changing the

meaning of the defense as it had appeared in the Negotiable Instruments

Law. ‘‘Notes and Comments to Tent. Draft No. 2 — Art. III,’’ 3 Uniform

Commercial Code: Drafts 186-187 (Elizabeth Slusser Kelly ed. 1984).

Certainly nothing in the history of the Uniform Commercial Code sug-

gests a purpose of abolishing the ‘‘no obligation’’ defense and returning

to the law as it existed before the Civil War. The tendency of our law for

almost a century has been to relax strict rules, perhaps because of

growing (though possibly misguided and even sentimental) confidence in

the ability of judges and juries to resolve factual questions (such as, What

was the purpose of McGowen’s notes?), with reasonable accuracy and at

reasonable cost, by sifting testimony. The legal realists who, led by Karl

Llewellyn, drafted the Uniform Commercial Code were leaders in the

II. Real and Personal Defenses/Claims 105

movement to soften the contours of strict common law rules. See, e.g.,

UCC §§2-103(1)(b), 2-204, 2-205.

It hardly matters whether the no-obligation cases are subsumed un-

der the special-purpose defense or set off by themselves or, as seems

simplest and therefore — no other values being at stake so far as we can

see — preferable, assimilated to the general contract doctrine that allows

parol evidence to show that a contractual-looking document was not

intended to be binding. The office of the parol evidence rule is to pre-

vent parties to a written contract from seeking to vary its terms by ref-

erence to side agreements, or tentative agreements reached in

preliminary negotiations. 2 Farnsworth, supra, §7.2, at p. 197. In the case

of a condition precedent the promisor is not trying to vary the terms, but

to deny the enforceability of the promise by pointing to some condition

that has not been fulfilled. The distinction may seem fine-spun and even

arbitrary, but it has been deemed consistent with the policy behind the

parol evidence rule, or at least a tolerable qualification of it. 2 id., §7.4, at

pp. 211-215. Two points can be made on behalf of the distinction. The

weaker, as it seems to us, is that without such an exception the rule would

work dramatic forfeitures, by preventing a party from showing not merely

that the terms were somewhat different from what they appeared to be

but that he had never agreed to do or pay anything. The stronger point is

that the parol evidence rule, properly understood, is not a rule imposed

on contracting parties from without but merely an inference, drawn from

the language of the document, that the parties intended it to be the

complete statement of their agreement, extinguishing any agreements

that might have emerged from the preliminary negotiations. Patton v.

Mid-Continent Systems, Inc., 841 F.2d 742, 745 (7th Cir. 1988); 2 Farns-

worth, supra, §§7.2, 7.3, at pp. 197-198. The document is unlikely to

reveal whether the parties intended it to be taken seriously, and if it does

not, there is no basis for applying the rule. In re H. Hicks & Son, Inc.,

supra, 82 F.2d at 279.

At all events, to allow parol evidence to expose a sham case such as

this is alleged to be would make no greater inroads into the parol evi-

dence rule than the cases on conditions precedent do. McGowen is not

trying to change the terms in the promissory notes, but to show that the

notes were not in fact intended to create a legally enforceable obligation.

They were, not to put too fine a point on it, intended to fool the Internal

Revenue Service. Herzog, perhaps fearing that it will be found to have

been a party to this little deception, does not argue that McGowen’s

unclean hands should forfeit its right to make a sham-transaction defense,

if there is such a defense, and we think there should be because we can

think of no principled distinction between it and the condition-precedent

defense that Herzog concedes is valid.

106 3. Holders in Due Course

The policy of the law is to facilitate negotiability by allowing assignees

of negotiable instruments to take free of defenses not obvious on the fact

of the note. Northwestern National Ins. Co. v. Maggie, No. 92-1037 (7th

Cir. Sept. 23, 1992). But that policy is expressed in the doctrine of

holders in due course. Id. Herzog made no effort to discount the notes to

one who would have been such a holder and therefore could have

enforced the notes against McGowen regardless of the oral agreement

not to enforce them on which McGowen relies in this suit.

The judgment is reversed and the case remanded for further pro-

ceedings consistent with this opinion.

QUESTION

How would this case be decided under the 1990 Revision? See §§3-

117 and 3-105(b), plus the latter’s Official Comment 2.

E. Jus Tertii

It is a basic rule of law that litigants must succeed or fail on the basis

of their own rights and not the rights of others. The rights of another,

called jus tertii, are available to other litigants only in special circum-

stances. Sureties, called ‘‘accommodation parties’’ in the Code, are per-

mitted, with some exceptions, to raise the defenses of their principals

(called ‘‘accommodated parties’’); see §3-305(d). And, as we shall see

when we get to the issue of restrictive indorsements, §3-206(f) permits an

obligor to refuse payment if doing so would violate the terms of a

restrictive indorsement.

The Code’s general prohibition against using jus tertii is found in

§3-305(c), which you should now read. Note two important things about

it. The first is that the claims of another may always be asserted if that

person joins the lawsuit. The second is that §3-305(c)’s last sentence

permits one jus tertii to be asserted against a non-holder in due course:

the instrument has been lost or stolen so that the current possessor is not

the true owner. If this latter jus tertii could not be raised, then the

obligor would be exposed to the possibility of double payment when the

true owner showed up.

PROBLEM 41

Craig Covey was the maker of the following promissory note, which

he signed in order to buy a computer:

II. Real and Personal Defenses/Claims 107

I, Craig Covey, promise to pay to bearer the sum of $5,000, on demand. I also

promise to buy the bearer lunch on the date of presentment.

The note was given to his uncle, who had loaned him the money for the

purchase. The uncle sold the note to the Stonewall Finance Company in

return for a check for $4,500. Stonewall Finance Company’s check bounced,

and the uncle was very angry. He went down to the finance company’s

office and found that there was a sign on the door saying ‘‘GONE OUT OF

BUSINESS.’’ The next day the note was stolen from the office of the Stone-

wall Finance Company and later surfaced in the hands of Jane Eleanor, an

innocent purchaser for value, who presented it to Craig for payment. In the

meantime both his uncle and the Stonewall Finance Company had con-

tacted Craig and asked him to refrain from paying the instrument, the uncle

pointing to the bounced check and Stonewall to the fact that the note had

been stolen from it. Is Jane a holder in due course? If not, can Craig raise the

suggested jus tertii against her? If Craig wants to pay Jane, can his uncle stop

him? See §3-602.

F. Conclusion

Reference has already been made to special statutes and rules (such

as the FTC regulation) that restrict the holder in due course doctrine in

consumer transactions. But these statutes do not cover the whole con-

sumer field; for example, a couple signing a promissory note to a bank

for a home improvement loan can still lose a lawsuit to a holder in due

course. Should the doctrine be wiped out completely in consumer

transactions? In commercial ventures? Professor Grant Gilmore, one of

the original drafters of the Uniform Commercial Code, has commented:

The ‘‘holder in due course’’ concept was worked out by Lord Mans-

field and his successors in the late eighteenth and early nineteenth cen-

turies against a business background in which bills of exchange and

promissory notes did in fact circulate and could be expected to pass

through a number of hands before being retired. As the modern banking

system developed, instruments gradually ceased to circulate. In this century

nothing is rarer than a true negotiation to a third party purchaser for

value — the use of negotiable notes which pass from dealer to finance

company in the attempt to carry out consumer frauds is hardly a ‘‘true

negotiation.’’ The whole ‘‘holder in due course’’ concept could usefully

have been abolished when negotiable instruments law was codified at the

end of the nineteenth century. In fact it was preserved like a fly in amber

both in the N.I.L. and in its successor, Article 3 of the Uniform Commercial

Code. Indeed our codifications typically preserve once vital but now

108 3. Holders in Due Course

obsolete concepts in much the same way that our museums preserve the

ancient artifacts of bygone civilizations.

G. Gilmore, The Death of Contract 108 n.18 (1974). Professor Gil-

more developed this idea more fully in a fascinating article: Gilmore,

Formalism and the Law of Negotiable Instruments, 13 Creighton L. Rev.

441 (1979). A leading article containing the same theme is Rosenthal,

Negotiability — Who Needs It?, 71 Colum. L. Rev. 375 (1971). However,

one wonders if this is still true in the twenty-first century where it is very

common for promissory notes to be bundled and placed in trusts (a form

of ‘‘securitization’’) and then sold to investors, who are certainly innocent

parties, the very sorts of entities needing holder in due course protection.

QUESTION

If Article 3 were amended to eliminate the concept of holding in due

course, commercial paper would legally resemble nothing more than

simple contracts. Would we then need Article 3 at all?

II. Real and Personal Defenses/Claims 109

PMPL_8e_2008 320 Whaley Chap 3 HIDC

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