Assertion of claims and defenses against assignees
Some forms of contract are known as negotiable instruments. U.C.C. 3-104. Checks and certificates of deposit are negotiable instruments. Promissory notes typically are negotiable instruments.
A negotiable instrument confers on some of its potential holders greater rights than are conferred on assignees of contracts which are not negotiable instruments. Compare the following two illustrations.
Illustration 1: A manufacturer of pens sells its pens to a chain of retail stationery stores on trade credit. In need of immediate cash, the manufacturer assigns its receivables, including its right to receive payment from the chain of retail stationery stores, to a financial institution at a discount. Using contract vocabulary, we would call the chain of retail stationery stores the obligor (or promisor), we would call the manufacturer an obligee (or promisee) in its relationship to the obligor and an assignor in its relationship to the financial institution. We would call the financial institution an assignee. Under Article 9 the receivables are collateral (whether the assignment is a sale or an assignment for purposes of security). Using Article 9 vocabulary, we would call the chain of retail stationery stores an account debtor, we would call the manufacturer the debtor, and we would call the financial institution the secured party.
Suppose some or all of the pens prove defective such that the chain of stationery stores has a defense to payment against the manufacturer. Absent a "waiver of defenses" clause in the contract between the manufacturer and the chain of stationery stores, contract law tells us that the chain of stationery stores may assert this defense to payment against the financial institution to whom the receivable has been assigned. The contract of assignment may, in turn, afford the financial institution a right to charge back such a receivable to the manufacturer or charge it against a reserve withheld from the price that the financial institution paid for the assignment.
Illustration 2: The same manufacturer of pens sells an expensive piece of its used equipment to another manufacturer for $50,000, $10,000 payable upon delivery and the balance payable, with interest, over 5 years. The buyer executes a promissory note for that balance in favor of the manufacturer. To raise immediate cash, the manufacturer assigns the note to a financial institution (called negotiating the note), by indorsing and delivering the note to the financial institution (in the same way you would indorse and deliver a check made payable to your order to the bank in which you hold a checking account). Using the vocabulary of negotiable instruments, we would call the buyer a maker of the note, the manufacturer a payee of the note in its relationship with the buyer and the indorser of the note in its relationship with the financial institution, and we would call the financial institution a holder of the note. Under Article 9 the promissory note is collateral. As an aside, note that Article 9 excludes from coverage the assignment of a promissory note (or other receivables) in some other types of cases. See U.C.C. 9-109(d). Using Article 9 vocabulary we would call the manufacturer of pens a debtor and the financial institution a secured party, but we would not call the maker of the promissory note an account debtor.
Suppose the equipment sold proves defective such that the buyer may assert a defense to payment against the manufacturer. Under defined circumstances (including that the financial institution had no reason to know of the defect in the equipment), the financial institution would be called a holder in due course of the note and would take free of the defense, i.e. could insist upon payment of the note from the buyer notwithstanding the defense. Of course the buyer could pursue remedies against the manufacturer, but those remedies may prove illusory if the manufacturer is in financial difficulty, has filed bankruptcy, or has gone out of business.
The same principles would apply to the use of a promissory note in a real estate transaction. Suppose a buyer of real property executes a promissory note in favor of a lender. The lender negotiates the note to a third party. If the third party qualifies as a holder in due course of the note it will take free of any defense to payment that the buyer of the real property may have against the seller.
To confer the advantages of negotiability, the promissory note must assume a specific form. U.C.C. 3-104 - 3-113. The maker of the note must promise to pay a fixed sum of money, the promise must be unconditional, the note must be payable either to "bearer" or to the order of an identified person or entity, the note must be payable on demand or at a definite time, and, with a few exceptions, the note may not state any promise by the maker other than the promise to pay. Terms which we describe in our Commentary. Common terms in consensual payment obligations do not render a note non-negotiable. For example, a note is payable at a definite time notwithstanding a provision calling for acceleration (U.C.C. 3-108(b)); a note calling for payment of attorney's fees if collection activity is required is permitted because the promise to pay a fixed some of money may be accompanied by a promise to pay "other charges" (U.C.C. 3-104(a)).
In a wide variety of circumstances, state common law, state legislation, or federal regulation either prohibit the use of a promissory note or deny holder in due course status, and its attendant advantages, to the holders of notes made by individuals who have acquired goods or services, on credit, for personal, family, or household purposes. See, e.g., F.T.C. Holder-in-Due Course Regulations, 16 C.F.R. 433. By doing so, the right of the consumer purchaser to assert defenses against the assignee - - the baseline contract rule - - is preserved.