In the last case we looked at we saw how the purchaser of a business was forced to pay off the notes he gave to the company’s seller even though the seller, at the time of the sale, may have fraudulently concealed many of the business’ outstanding debts. This result came about because the notes were no longer held by the seller but instead had been transferred by him to another person. This other person was described as a “holder in due course.”

What is a “holder in due course,” and why cannot the buyer withhold payment from him for notes which he claimed were fraudulently obtained? The Uniform Commercial Code (UCC) provides the following definition:

“A negotiable instrument is an unconditional promise or order in writing, signed by the maker or drawer to pay to the order of a designated person or to the bearer of the instrument on demand, or at a fixed time, a certain sum of money.”

There are two major types of negotiable instruments which fit this definition. One is a promissory note such as the one this case was concerned with and the other is the standard check with which we are all familiar.

The typical promissory note, similar to the one here simply states: I, John Doe, one year from today promise to pay to the order of Richard Roe the sum of $1,000 plus interest at the annual rate of 10%. It is then dated and signed.

A form note of this type meets all the requirements necessary to make it a negotiable instrument because it is an unconditional promise in writing.

The next logical question is, how is it negotiated? The term negotiation is defined by the UCC as “the transfer of an instrument in such form that the transferee (the one it’s being transferred to) becomes a “holder.”

There are two ways this is easily accomplished. If the instrument is similar to the one described above and is made payable “to the order of” a named person, that person simply has to endorse it and hand it over to the person he is transferring it to. If the instrument simply says “pay to the bearer”; then it is negotiated by delivery alone. In any event the person to whom the note is transferred becomes a “holder.”

If, in addition to the above, the transfer meets certain other requirements of the UCC, the new owner of the note will become not merely a “holder” but will instead become a “holder in due course” and will then be insulated from most of the defenses that the original maker of the note may have against payment.

A holder in due course is, according to the UCC, one who becomes a holder of a negotiable instrument under the following conditions:

• For value;
• In good faith, and
• Without notice that is overdue or has been dishonored or of any defense against or claim to it on the part of any person.
If the note is transferred under these conditions the “holder in due course” receives it free from all claims and free from all defenses of a party with whom he has not dealt except for what are described as “real defense.” There are
four types of real defenses described by the code:
• Infancy, the maker was under the legal age;
• Incapacity, duress or illegality. This includes insanity, intoxication, etc.;
• Misrepresentation, if the signature was obtained unknowingly or if the note was materially altered after it was signed, and
• Discharge; either of the maker of the note by bankruptcy or any other type that the holder has notice of when he takes the instrument.
In this case, the note was given by the buyer to his seller as a part of the company’s purchase price. It was then transferred by the seller to a third party as payment for an old debt. The buyer then refused to pay the note claiming the seller defrauded him by concealing certain debts. He also claimed, after he was sued on the note by the holder, that at the time the note was negotiated, the new holder knew of the concealment.

The judge first determined the defense, as claimed by the buyer, was not a real one as defined by the UCC and so could not defeat the claim if the person suing was in fact a “holder in due course.”

The prior debt easily satisfied the fair value requirements. The mere allegations of the buyer that this third party had actual notice of any defenses to the note without any facts to back it up was not enough, according to this judge, to defeat the holder in due course status. Thus, the buyer was required to pay off the note.

Of course, he can still sue against the person who sold him the business…if he can find him.