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Limitations to the Shelter Principle

Limitations to the Shelter Principle

The shelter principle grants special protection to any holder of a negotiable instrument after that instrument has been held by a holder in due course (HDC). It is based on common property law, which ensures the transfer of the rights of a bona fide purchaser to the next purchaser, and is codified in the Uniform Commercial Code to ensure that it affects negotiable instruments as well. 
In terms of negotiable instruments, then, it affords every holder of the negotiable instrument the same rights as an HDC if a holder can trace back ownership of the negotiable instrument to an HDC. Such rights essentially guarantee the holder protection from prosecution from a previous holder under the Uniform Commercial Code. 
There are some limitations to the shelter principle, as explained in the Uniform Commercial Code, which are designed to prevent any overt manipulation of the principle. The shelter principle cannot be used to improve a holder’s rights or protections with regard to a negotiable instrument by repurchasing that negotiable instrument after an HDC has owned it.
This would prevent any holder who had previously obtained the negotiable instrument through fraudulent or deceptive practices from later receiving immunity from any repercussions for those practices. This would also ensure that any holder who acquired the negotiable instrument under any kind of violation of the requirements for being an HDC under the Uniform Commercial Code prior to obtaining it again after it had been held by an HDC would not be protected under the shelter principle. 
As an example, if Yolanda defrauds Nick and thereby obtains a check from Nick, Yolanda could then sell that check to an HDC, Liam. If Liam were then to negotiate the check back to Yolanda, Yolanda would not be a holder through an HDC, as she participated in the initial fraud. Under the Uniform Commercial Code, the shelter principle would not protect her.
These exemptions of the shelter principle should theoretically avoid any misuse of that principle, but their efficacy depends entirely on the presence of information regarding the holder of the negotiable instrument in question. If, in the previous example, Yolanda had a partner in crime, Harry, who had never personally held the negotiable instrument and who then obtained the check through Liam, Harry would similarly not be protected under the shelter principle as he had assisted in the initial fraud.
This would require information to that effect, however, and if one cannot obtain proof of Harry’s involvement, then Harry would be protected as a holder through an HDC under the shelter principle. The point of the exemptions is there, however, so that if such proof ever surfaces, Harry might be prosecuted appropriately for his involvement.
The shelter rule, in general, is designed to allow for easier, swifter commerce among parties interested in negotiable instruments. The Uniform Commercial Code for the shelter rule reflects this general notion with the limitations plugged into the Code in order to prevent holders from taking advantage of the protections offered by the shelter rule. The efficacy of these exemptions in actually preventing such deceptive practices is, however, somewhat uncertain.

The Fast Facts to Ordinary Holder Status

The Fast Facts to Ordinary Holder Status

This most basic definition of a holder does not afford the holder a great many rights or protections. The holder has only the rights to the instrument that the transferor has. The only exception is when rules concerning the holders through a holder in due course apply. 
Holders can achieve such status after the exchange, depending upon the exact nature of the negotiation for a given instrument, and the ways in which that negotiation corresponds to the rules for becoming a holder in due course. In almost all situations, the holder should want to fulfill the necessary conditions for being a holder in due course in order to have the protective status afforded by such a position.

An Guide to Being a Holder

An Guide to Being a Holder

Ordinary holders are simply those holders who have possession of the instrument and to whom the instrument is payable. Ordinary holders are afforded all the rights that were also afforded to the transferors of the instruments without any additional rights being included for the ordinary holder.
The effect of not having any additional rights afforded to an ordinary holder is that such a holder has no defense against the illegitimate actions of other previous holders. For example, if Leah sells goods to Eric in exchange for a negotiable instrument, like a check, and then Leah exchanges that check with Marissa for a promise from Marissa to perform some service in the future, then Marissa would be the ordinary holder of the check.
If Eric then refused to support the payment of the check because Leah’s goods were defective, Marissa would have no defense and would lose out on payment, as she was simply the ordinary holder. If she had been the holder in due course, then she would not lose out on the payment for the check she had received. To find out more about the rights of basic, ordinary holders, follow the link.
Status of a Holder in Due Course
A holder in due course (HDC), unlike an ordinary holder, is afforded some level of protection from the defenses and attempts at recoupment of prior holders. The status of holder in due course, as provided under the Uniform Commercial Code, is designed to protect those parties to a negotiable instrument who have performed no wrongdoing and who, therefore, should not be injured if another party defaults on payment or attempts to defend itself from the requirement to pay. Because this status would be easily manipulated for fraudulent purposes, however, commercial law puts relatively stringent requirements on holder in due course status.
If a given party does not fulfill these requirements with relation to its transaction regarding the negotiable instrument, then that party will not be given the status of a holder in due course and will then only have the rights and protections afforded to an ordinary holder.
The requirements for being considered a holder in due course under commercial law include: that the party took the negotiable instrument for value and not as a gift or for less than value; that the party took the negotiable instrument in good faith; and that the party did not take the negotiable instrument after having received any kind of reasonable notice informing the party of faults in the negotiable instrument, such as a notice informing the party of a forged signature or of a defaulted payment regarding the negotiable instrument.
Even with these requirements as an attempt to prevent any manipulative or deceptive uses of such status, there are still those who manipulate holder in due course doctrine in order to make money while injuring others. To find out more about what it means to be a holder in due course, what exactly the requirements are, and the ways in which HDC doctrine is unfairly manipulated, click the link. 

Holder Through HDC
While there are stringent requirements for any given holder of a negotiable instrument to be a holder in due course, there is actually a way around those requirements, designed to help facilitate commerce and prevent any lag in business caused by litigation. The shelter principle is a rule built into the Uniform Commercial Code to help smooth out transactions with negotiable instruments.
Essentially, the shelter principle allows for possessors of negotiable instruments to achieve status as holders through an HDC, which will then afford those possessors all the same rights that are afforded to an HDC. In other words, once a holder of the negotiable instrument in question has been granted status as a holder in due course, then every holder of that negotiable instrument from that point forward will be afforded the same rights.
This is based off the principle that when a given negotiable instrument is transferred, the transferee receives at least the same rights as were held by the transferor. Thus, if the transferor has the rights of an HDC, those rights are transferred.
There are some exceptions to this principle, designed to prevent its misuse in manipulative or deceptive practices. Specifically, any party which had previously possessed a given negotiable instrument cannot increase the rights afforded to it in relation to that instrument through the shelter principle.
This is designed to prevent a party which had previously forfeited any access to HDC status through fraudulent practices, or through purchasing practices without good faith, from then receiving protection for the repercussions of those actions. To find out more about the shelter principle, how one can become a holder through an HDC, and the exemptions to this principle, follow the link.

Know Your Methods of Taking for Value

Know Your Methods of Taking for Value

In order to qualify as a holder in due course (HDC), a holder must have taken the promissory note or other form of negotiable instrument for value. There are a number of
different ways in which a would-be HDC could have taken a promissory note for
value. These include: ensuring that the promise for which the promissory note
was negotiated is fulfilled; obtaining a security interest or a lien
 on the promissory note or negotiable
instrument; obtaining the promissory note or negotiable instrument as payment
of or security for a preexisting claim; obtaining the promissory note or
negotiable instrument as payment or in exchange for another negotiable
instrument; or exchanging an irrevocable obligation as payment for the
promissory note or negotiable instrument.

The first possible method of taking a promissory note for value would
require the would-be HDC to complete any promises he or she made in exchange
for the promissory note. Until such promises are fulfilled, the promissory note
would not have been taken for value and the would-be HDC would simply
be a holder without the protection offered by being a holder-in-due-course. A
simple promise to perform services at a later point is not enough to give one HDC status, and offering such a promise at the moment of exchange would
not imply taking the promissory note or negotiable instrument for value. 

The second method for taking a promissory note or other negotiable
instrument for value would require the would-be HDC to obtain a security
interest, or other lien, in the instrument. A security interest, as defined in
Article 1 of the Uniform Commercial Code, is a way of ensuring that the
beneficiary of the interest, who in this case would also be the recipient of
the promissory note, and the would-be HDC, has some right to property secured
by the security interest, such that the property can be used to settle the
debt. In other words, security interests and liens take a form similar to the
common understanding of “collateral,” under which the party owed a debt
is able to hold property of the debtor in order to settle the debt. Since a
security interest would provide value such that the exchange would be
equal, the introduction of a security interest in the negotiable instrument
would change a holder’s status into that of an HDC.

The third method of taking a negotiable instrument for value would
require the HDC obtaining a negotiable instrument, like a promissory note, as a
settlement for an antecedent claim. An exchange characterized in this fashion
would simply involve the transferor negotiating the promissory note to the
recipient in order to settle a debt owed by the transferor to the recipient. If
this is the case and the value of the note is such that it settles the debt and the promissory note is accepted by the recipient, then the recipient would
have HDC status, at least in terms of taking the negotiable instrument for
value.

The fourth method of taking a promissory note or other negotiable
instrument for value would involve taking the negotiable instrument in exchange
for another negotiable instrument of some kind. This would involve exchanging
one type of negotiable instrument for another of equal value in order to obtain
the payable amount more easily. As an example, if one person had a promissory
note from another ensuring payment of $300 in 8 months, then the holder of
that note could negotiate it to a new recipient in exchange for a check of $200
and $100 in cash. Because the check is a negotiable instrument (and,
technically, so is the cash), this would constitute an exchange of one
negotiable instrument for another of equal value. This would then give the new
recipient of the promissory note HDC status.

The fifth method of taking a negotiable instrument for value would
involve an irrevocable obligation on the part of the recipient of the
promissory note or other negotiable instrument to a third party. This is
similar to some of the other forms of exchange that could give a recipient HDC
status, as it involves an exchange of a promise to perform a service in
exchange for the value of the promissory note or negotiable instrument
exchanged.

Are You Taking in Good Faith?

Are You Taking in Good Faith?

Taking in good faith is a requirement for a given holder of a negotiable instrument to be considered a holder in due course (HDC), and is one of the simultaneously more moral elements of the Uniform Commercial Code. It is also one of the more debatable and troublesome elements. This is because an HDC who takes goods or negotiable instruments in good faith cannot be held accountable for those goods or instruments. 
The HDC can retain those goods and instruments even if it can be shown that they were transferred to the HDC from a party that did not obtain them in good faith. This is designed to protect the HDC from culpability for theft or other actions which it did not actually take, but profited from indirectly through a transaction in good faith. 
For a given party to be dealing in good faith, that party must exhibit a clear intent to perform a legitimate transaction without any knowledge of the potential illegitimacy of the goods or negotiable instruments being sold by another party.
If the party did bear any knowledge of the illegitimacy of the negotiable instrument or had any reason to suspect the overall legitimacy of the transaction, then it could not be held as an HDC, as it would not have been dealing in good faith. The only way for a given party to obtain status of dealing in good faith is for that party to have genuinely had no idea that there was any illegitimacy in the negotiable instruments.
As an example, if a given party attempting to purchase or otherwise obtain a negotiable instrument was presented with the desired negotiable instrument and it clearly seemed to feature a forged signature or other means of falsification, then a party dealing in good faith would be obligated not to go through with the deal. If the party did go through with the deal and purchase an obviously falsified negotiable instrument, that party would be forfeiting any status as an HDC.
The good faith of any given party can be taken advantage of, however. This is the primary means for manipulating the HDC doctrine for deceptive gain. A party which is sold a negotiable instrument in good faith could not be held responsible for the previous illegitimate dealings of the seller, and as a result, the HDC doctrine would kick in, insulating the buying party from any repercussions, while the seller is no longer involved with the negotiable instrument and cannot be sued for any form of restitution. That seller would likely not have been dealing in good faith when the seller originally obtained the negotiable instrument, either through theft or through deception. 
But there is no way for the buyer to know that unless the deceptive practices are clearly obvious or the situation is all too suspicious. For example, if someone steals a check out of someone else’s wallet and cashes it at a bank, then, assuming that the signatures on the check are not obviously forged, it will be very difficult for the bank to determine that the check is illegitimate. The bank will, thus, honor the check when presented.

Pay Close Attention to Taking without Notice

Pay Close Attention to Taking without Notice

Another major requirement for a negotiable instrument and being a holder in due course is that the holder take without notice.  
Here, commercial law is set up to prevent any individuals from knowingly obtaining negotiable instruments which might contain a flaw in them that would later cause problems for the holder in obtaining payment for those instruments. If the holder knew that the instruments bore such flaws at the time he or she obtained those instruments, then under commercial law he or she is no longer entitled to any kind of protection if another holder cannot obtain adequate payment later on.
The only way that a holder would be entitled to such protection would be if the holder had obtained status as a holder in due course under commercial law, which would require that holder received no notice warning of any possible such problems nor any such notice with enough time to take necessary action on the notice.
Commercial law provides for methods under which such notice could be presented to a potential new party to a negotiable instrument, which would then invalidate that party’s claims of being a holder in due course. These types of notice include financial statements and notices of debt.
Additionally, any notice regarding a defense that a prior party to the negotiable instrument might be making against paying off the negotiable instrument would suffice under commercial law as sufficient notice to prevent the recipient party from being a holder in due course. Knowledge of any such defense would inherently warn the new recipient that the negotiable instrument was being contested and would therefore result in a forfeiture of any exemption from such a defense under commercial law.
While this element of becoming a holder in due course is included in order to prevent any fraudulent dealings on the part of the new holder, the problem is that this clause can again be manipulated by the intermediary holder.
If one party issues a promissory note to a second, and then that second party sells the promissory note to the third, then the second party who might have all the notice necessary to remove the holder in due course status from the third party might not present such information in order to keep that party as a holder in due course and make the third party more likely to purchase the promissory note.
Thus, although this statute would prevent a party that has certain information from acting illegitimately even in the face of such information, it still allows for some manipulation of commercial laws.

Shelter Principle Defined

Shelter Principle Defined

The shelter principle refers to the principle that a party which does not and cannot qualify as a holder in due course (HDC) with regard to a given negotiable instrument can actually still obtain those rights and privileges if that party obtained the instrument through an HDC. In other words, if an HDC at some point possessed the negotiable instrument, then every possessor of that negotiable instrument after that point will have access to the same rights and privileges. 
The reasoning behind this shelter principle is actually a core reasoning of negotiation and basic ownership. Every time a negotiable instrument transfers to a new possessor, that new possessor is always accorded at least the rights of the previous possessor, the transferor. This means that if the transferor is an HDC, then the HDC’s rights and privileges are passed along with the negotiable instrument.
This might, at first glance, seem counter-intuitive and entirely against the point of an HDC. After all, if the shelter principle allows for parties to simply “inherit” the rights of an HDC through transfer of ownership of a negotiable instrument, then it nullifies the restrictive measures placed upon HDCs in commercial law. While this may be true, keeping the shelter principle is important for the functioning of negotiable instruments in general. 
The shelter principle allows any given HDC to dispose of a negotiable instrument with much greater ease, thereby increasing the overall flow of commerce. Without the shelter principle, then potential purchasers of a negotiable instrument might not be interested in doing so, as any one of those purchasers might not fulfill the requirements for becoming an HDC.
The shelter principle does allow a new holder to ignore the requirements for becoming an HDC. If a new holder received the negotiable instrument as a gift from an HDC, for example, then that new holder would still qualify as a holder through an HDC, even though that new holder was not taking the negotiable instrument for value.
This would also cover situations in which the transferee received notice of other claims or defenses regarding the negotiable instrument. So long as the transferee is receiving the negotiable instrument from an HDC, then the transferee will have the same rights as an HDC as given to him under the shelter principle.
The shelter principle is not actually solely focused on negotiable instruments and their place in commercial law. In actuality, the reason that the shelter principle is effective in terms of negotiable instruments is because negotiable instruments have been designed to fall under the same provisions as other forms of contract law. 
The shelter principle affects the transfer of real property just as much as it matters in terms of negotiable instruments. In real property transfers, the role of an HDC is essentially that of a bona fide purchaser and the shelter principle provides the same basic protections: that a new purchaser will receive the same status as the transferor.
The reason for the shelter principle in property law in general is that it helps to expedite the use and resale of property, instead of letting such use and resale become held up by litigation. The same reasoning applies to negotiable instruments and the shelter principle’s effects of creating holders through an HDC.

Status of a Holder in Due Course

Status of a Holder in Due Course

Because being a holder in due course offers a significant amount of protection from the actions of other parties in the chain of negotiations for a given negotiable instrument, there are a number of requirements which must be fulfilled in order for a party to qualify as a holder in due course. These requirements are mostly there so as to prevent the status of being a holder in due course from being overly abused by parties seeking to perpetrate fraud and protect themselves from any lawsuits or defenses. 
These requirements include stipulations that: the negotiable instrument cannot have clear evidence of forgery, alteration, or other elements that might make it inauthentic; it must have been taken for value; it must have been taken in good faith; it must have been taken without any notice that it is dishonored, or there is an “uncured default,” or that it is overdue; it does not contain an unauthorized signature or has not been altered significantly; it must have been taken without notice that another party has a claim to the instrument; and it must have been taken without notice that any other party has attempted to defend itself against recoupment.
Each of these requirements is designed to ensure that the party claiming holder in due course status is not obtaining the negotiable instrument for fraudulent purposes or with fraudulent intent. To find out more information about each of these requirements and exactly how they need to be fulfilled, follow the link. 

Violations of HDC Doctrine
The holder in due course (HDC) doctrine is designed to protect holders from culpability in situations where they performed no wrongdoing, but might be affected by another party’s attempt at a defense because they hold the negotiable instruments being contested. But HDC doctrine has been violated a number of times, as it has been turned to fraudulent purposes. 
The most common practice of the 20th Century involved sellers making deals with low-income customers that would require those customers to give the sellers some form of promissory note or negotiable instrument. The sellers would then sell those promissory notes to banks and would gain a profit on them.
Because the banks, then, would have acquired those promissory notes in good faith and would fulfill all the other important elements of being holders in due course, they would be protected when the low-income customers would be unable to pay off those debts. Even if those low-income customers attempted a defense based on the fact that they were deceived by the sellers into believing that they could afford these debts, the banks would be protected thanks to their HDC status. 
This is not violation of HDC doctrine in the sense of outright law-breaking, but is instead violation of HDC doctrine in that it is a manipulation of the point and purpose of HDC doctrine. The Federal Trade Commission has since taken steps to attempt to combat this type of manipulative, deceptive practice, but it continues in a different form in the modern world. Click the link for more information about these manipulative violations of HDC doctrine and their current form in America.


Taking for Value
One of the requirements for a given holder to be deemed a holder in due course is for he or she to have taken the negotiable instrument in question for value, instead of as a gift or otherwise without making equal compensation to the party from which the holder received the negotiable instrument. There are five different possible ways of taking for value. 
The first way is if the current holder fulfills the promise he or she made when he or she obtained the negotiable instrument. If a negotiable instrument is exchanged for some kind of promised service, then the transaction is not considered to be “taking for value” until such a time as the promise is fulfilled. Until that point, the transaction is unequal and the recipient cannot be deemed a holder in due course. 
The second way to take for value is to obtain a security interest or other lien in the negotiable instrument without having obtained that lien through a judicial proceeding such as a bankruptcy sale. The third way to take for value is to have obtained the negotiable instrument as a payment for a preexisting debt such that the negotiable instrument is worth the same value as the debt. 
The fourth way to take for value is to obtain the negotiable instrument in exchange for another negotiable instrument of equal value, but likely of a different nature. The fifth and final way to take for value would be to obtain the negotiable instrument in exchange for an irrevocable obligation to a third party. To find out more about each of these five ways of taking for value and thereby attaining holder in due course status, follow the link.

Taking in Good Faith
Another requirement for being considered a holder in due course under commercial law is that the holder must have taken the negotiable instrument in good faith. This is one of the more important requirements for being considered a holder in due course, not in the sense of legality, but in the sense of the intent of HDC doctrine. 
The entire point of HDC doctrine is to protect those parties that had absolutely nothing to do with any wrongdoing surrounding a given negotiable instrument from attempts to seek restitution, as those parties have clearly done nothing that would require them to make reparations to an injured party. Taking in good faith is the requirement of the HDC doctrine that codifies this element, as it requires the holder to have obtained the negotiable instrument while having no part in illegitimate actions and while under the belief that the transaction as a whole was legitimate. 
A party cannot have taken the negotiable instrument in good faith if that party has strong reason to suspect that the negotiable instrument has somehow been made inauthentic or manipulated illegitimately. For instance, if the would-be holder perceives that the instrument has a seemingly forged signature, then that would-be holder has a duty not to go through with the transaction. If the party does go through with the transaction, then the party would have lost any “good faith” status, as would be judged in a court.
Similarly, if the negotiable instrument is clearly obtained under questionable circumstances, such as a deal made in a back alley in which a $700 promissory note is exchanged for $50, then there is good reason to believe that the negotiable instrument was not taken in good faith. 
If, however, there was nothing to have clued the holder in to any fraudulent elements of the transaction and that holder treats the transaction properly under commercial law, then that holder will have taken the negotiable instrument in good faith. For more information about taking in good faith and some of the problems surrounding this practice, click the link.


Taking Without Notice
A further requirement for gaining status as a holder in due course is that the current holder must have taken the negotiable instrument without notice as to any of the myriad forms of wrongdoing or warning that might have clued that holder in to the fact that the negotiable instrument was not fully supported or was inauthentic. For example, if the holder received a notice to the effect that the negotiable instrument bore a forged signature and yet went through with the transaction anyway, the holder would have forfeited all possible holder in due course status, as he or she would have taken the negotiable instrument with notice. 
Such notice need not take as overly blatant of a form as this, however. Instead, such notice could take the form simply of a notice that another party to the negotiable instrument has attempted to mount a defense against paying for the negotiable instrument. If the party has been successfully notified of any of these things in a timely manner that would allow that party to take action and back out of the transaction, or at least perform a deeper investigation, then that party cannot claim holder in due course protection, as it could have remedied the situation on its own.
The problems of this particular requirement lie in that it is possible that the third parties to whom negotiable instruments are sold will never have the appropriate information given to them. To find out more about the notices that might invalidate a party’s claim to being a holder in due course, follow the link.

Being a Holder Through the HDC

Being a Holder Through the HDC

The shelter principle has its origins in common property law, where it actually ensures that those who purchase from a bona fide purchaser come to hold the rights of a bona fide purchaser themselves. Negotiable instruments law is similar to this basic contract law, and as a result, the shelter principle was transferred so as to keep negotiable instruments in line with the rest of the law.
The shelter principle ensures that a transferee is afforded the same rights to a negotiable instrument as the transferor to generally assist in the flow of the contracts and to prevent them from being caught up in litigation, as such litigation might lead them to be unusable or unsellable. The problems of the shelter principle in terms of negotiable instruments are not insignificant, however, as the shelter principle would seem to nullify the very point of holder in due course status being regulated and somewhat difficult to obtain.
If the shelter principle allows for parties that would otherwise have no way to obtain holder in due course status to gain the benefits and protections of that status, then it would undermine the efficacy of those restrictions, or so it would seem. But the shelter principle exists primarily to prevent the lack of HDC status among potential purchasers from negatively affecting the trade in negotiable instruments . For more information about the shelter principle and what exactly it entails, follow the link.


Limitations
Because the shelter principle does hold within it the potential for undermining the safeties built into holder in due course under the Uniform Commercial Code, there are certain limitations attached to the Code. Specifically, the shelter principle will not protect those who had already interacted with a given negotiable instrument without having holder in due course status.
What this means is that if a given individual or party had held a negotiable instrument without having holder in due course status, then that individual or party can never improve its status through implementation of the shelter principle. It will only ever have the rights afforded to it in its initial interactions with the negotiable instrument.
This would ensure that a party which had originally participated in some fraudulent practice regarding the instrument, or had otherwise acted in such a way as to prevent it from having holder in due course status, would not then later be able to gain the protection of holder in due course status by manipulating the shelter principle.
This limitation, however, is not perfect at preventing any such deceptive or manipulative practices. Find out more about the limitations of the shelter principle and their flaws by clicking the link.