Construction Law Today : Construction Lawyer & Attorney : Joshua Glazov : Design Build Contracts, Construction Bankruptcy

Holder of What?

To be a holder in due course you must hold something. What is that something? That something must be a "negotiable instrument":

• A promissory note, or
• A check

• For value - you pay cash, or give something of value in kind, in exchange for the note
• In "good faith" - you don't get the note as part of a scam or in some collusive scheme designed to evade the borrower's defenses and make them pay regardless
• In the regular course of business - you don't get the note in a bulk sale or at a foreclosure sale
• Without "notice" - you don't have any notice of defenses the borrower may have against payment on the note, or claims the borrower could setoff against payment on the note. For example:
  • Payment is already past due
  • Misrepresentations to the borrower in the transaction that generated the note, a/k/a fraud in the inducement
  • Failure of the original note holder to perform as promised to the borrower in exchange for the borrower giving the note, a/k/a failure of consideration

• Bad faith
• Fraud, fraudulent inducement, and material alteration of the note
• Violation of unfair and deceptive trade practice statutes
• Usury
• Tortious interference
• Failure of consideration (i.e., the other side didn't perform their part of the contract as promised)
• Waiver, estoppel, and unjust enrichment
• Accord and satisfaction, laches, release, and breach of fiduciary duty

Example of an HDC In Action

Imagine a demolition contractor who buys a truck for $100,000 to haul debris. The buyer pays the seller $40,000 in cash; they pay the rest by giving the seller a $60,000 promissory note with a $5,000 payment due on the first day of each month for the next 12 months after the sale.

The seller's sales representative assures the buyer that the truck is brand new. And the seller warrants to the buyer that the truck will work fine for at least 5 years or 50,000 miles, whichever comes first.

The seller doesn't want to wait a year for the buyer to payoff $60,000 under the note. So the seller sells the note to their bank for $50,000 - about a 17% discount. The bank satisfies each of the four requirements I mentioned above, so they take the buyer's note as an HDC.

But six months after the sale, the truck's engine block cracks and the transmission breaks. The buyer takes it back to the seller for repair. But the repairs aren't successful. And along the way the buyer also finds out that the truck wasn't new when they bought it. It's factory reconditioned.

The now outraged buyer sues:

• The bank for (a) a declaration that they needn't make the next six payments on the note and (b) a refund of the six payments they already made
• The seller for fraudulently inducing them to buy the truck and breaching the warranty to repair it. The buyer asks for at least a refund of the $40,000 cash they paid

But because the bank is an HDC, the bank is immune from the buyer fraud and failure of consideration defenses. The buyer loses against the bank. They must continue to pay the bank on the note, regardless of: (a) the seller's fraudulent misrepresentations about the truck being brand new and (b) the seller's breach of warranty. If the seller still held the note, those things would probably be good defenses. But they don't work against an HDC like the bank. The buyer must still pay the bank the full $60,000 under the note.

All's not lost for the buyer however. They can add the $60,000 they must pay to the bank to the damages they're seeking in their fraud claim against the seller. Whether the seller's around to collect from is another story.

Now that you've seen how this works out for the bank, I bet you'll agree: "It's good to be a holder in due course."

Limits of HDC Immunity

HDCs aren't immune from all defenses to payment on a note. What lawyers call the "real" defenses are outside of an HDC's immunity. Some of the real defenses:

• Forgery - someone forges your signature on a note and sells it to a bank. Even if the bank is an HDC, the note isn't enforceable against you. Of course you'll have to prove that the signature on the note isn't yours. And that doesn't come cheap or easy

• Fraud in the factum - someone convinces you to sign a promissory note, but you don't recognize it as a note and, being reasonably careful, you couldn't have recognized it as a note. You take it for something else: a tax form, a Christmas card. Well, if you want to use this real defense, you'd better have a really good explanation for why you didn't recognize what you signed as a promissory note before you signed it.
  Fraud in the factum is rare, maybe even unprecedented, in commercial development and construction. First National Bank of Odessa v. Fazzari is a prime example of how hard it is to invoke this defense. But anecdotal evidence suggests its success rate is almost ten percent better than "the dog ate my homework." And if you've already made payments on the note, don't even try it

• Infancy - you were too young to be bound by a contract when you signed the note. If you've managed to read this far down in this post, this real defense doesn't apply to you

Keep in mind this post is just a miniature primer on holder in due course law. Lawyers, judges, and professors have written volumes more. If you're interested, try starting with The ABCs of the UCC: Articles 3 and 4 published by the American Bar Association.

Upcoming Posts

Now that we've gotten the holder in due course basics out of the way, we're ready to move on to the special rules that allow the FDIC and their loan buyers to qualify as HDCs where ordinary mortals wouldn't. That's the topic for the next bank insolvency post.