Tennessee Business Litigation Law Blog

Becoming a  "holder in due course" of a note or check usually entitles the payee to enforce the instrument without regard to the claims or defenses that other entities may have against the payor.  In short, the payee, if considered a holder in due course, is entitled to payment on the note regardless of whether the payor breached some obligation to a third party by making the payment.

However, the Court of Appeals issued an opinion yesterday reaffirming the fact that the holder in due course doctrine does not apply in the typical situation involving only a two party transaction and a claim by the payee against the payor.  The case, Fleenor v. American Title Co., involved a mortgage loan agreement between two non-parties.  The closing agent handling the loan issued a check to one of the mortgagee’s debtors, but subsequently placed a stop order on the check when the loan fell through.  The payee of the check sued the closing agent claiming that she was a holder in due course and therefore entitled to payment on the check regardless of the disposition of the third party loan arrangement.  Both the Circuit Court and the Court of Appeals disagreed with this argument.

Both Court's noted that the defenses to the payee's claim were not those of some third party, but those held directly by the closing agent.  Namely, any agreement between the closing agent and the payee was subject to a condition precedent that the mortgage not being rescinded.  Because this condition was not fulfilled, and because the parties were operating under the mutual mistake that it would be fulfilled, the agreement did not become a binding contract.  Because this is a defense that was held directly by the payor against the payee, both courts held that whether the payee was a holder in due course was irrelevant.  Accordingly, the closing agent was not liable for payment on check.

This is the long way of reiterating that becoming a holder in due course does not equate to an unassailable right to payment.

Most businesses deal with negotiable instruments every day. Checks, notes, CD’s…all are vital components of how businesses negotiate payment for their goods and services. Accordingly, it is important that holders of these instruments attempt to establish themselves as “holders in due course” or HDC’s. This status provides important protections to the holder where liability on the instrument becomes an issue. The U.C.C. provides that an HDC must take the instrument (1) for value, (2) in good faith, and (3) without notice that the instrument is overdue, has been dishonored, contains an unauthorized signature, or is subject to a defense or claim of recoupment. U.C.C. §3-302.

As to the second element of HDC status, good faith, Tennessee has deviated from the U.C.C. in its definition. The U.C.C. states that “good faith” means honesty in fact and the observance of reasonable commercial standards and fair dealing. U.C.C. §1-201(b)(20). Note that use of “reasonable commercial standards” injects an element of objectivity into the test. By contrast, Tennessee law defines “good faith” as meaning only that a person acts with subjective “honesty in fact” in the conduct or transaction concerned. T.C.A. §47-1-201(19).

Liability on negotiable instruments is a frequent topic of litigation. The “good faith” distinction can be important when evaluating whether or not your business will be protected by HDC status for purposes of such liability.