Two Layers of Protection: What Lenders Need to Know about Florida's Holder in Due Course Doctrine and Its Federal Counterpart
August 8, 2014
The author discusses the holder in due course doctrine under Florida law, and its federal counterpart.
Since 2007, there have been 494 bank failures in the United States, including 70 banks in Florida alone.1 Even though the economy appears to be in recovery, 24 of those banks failed in just the year 2013—four of those in Florida.2
Often as a result of these failures, the Federal Deposit Insurance Corporation (“FDIC”) is appointed as the receiver for the failed bank3 and is tasked with closing the bank, liquidating its remaining assets, and distributing the proceeds to its depositors and other creditors.4 The overarching goal of the FDIC in these situations is to handle the disposition of the failed bank in the least costly manner available.5 Although that resolution can take several different forms, including the outright payment of insured deposits to customers of the bank by the FDIC, the most common resolution is the purchase and assumption transaction.6 Through this process the FDIC facilitates the sale of some or all of the assets of the failed bank (including its loan portfolios) to one or more other banks or investors.
Although many loans in these portfolios will still be performing loans, several will likely have become non-performing, in which case the purchaser is left to bring a lawsuit to recover under the promissory note and foreclose the mortgage or other security instrument to obtain the loan’s collateral. Frequently in these cases, the borrower will raise defenses or counter-claims alleging that certain “bad acts” of thefailed bank now prevent the purchaser from obtaining the relief sought (e.g., that the failed bank breached the loan documents, did not honor an orally agreed-to modification, or otherwise treated the borrower inequitably). As an assignee typically “stands in the shoes” of his assignor,7 without the holder in due course doctrine and its federal counterpart, these allegations may defeat the purchaser’s action or make it much more difficult and costly to pursue, especially given that the purchaser took no part in the these “bad acts,” and that the people who did take part (the management and employees of the failed bank) may be difficult to reach and may have little incentive to cooperate with the purchaser.
THE HOLDER IN DUE COURSE DOCTRINE
However, most of these difficulties are eliminated by the powerful effect of the holder in due course doctrine as it can clear the way for the purchaser to recover, even if there may have been prior “bad acts” of the failed bank, as the purchaser will acquire the loan free and clear of most defenses—the so-called “personal defenses”— that the borrower could have asserted against the failed bank.8 The holder in due course doctrine, when applicable, enables the purchaser to avoid liability for many of these “personal defenses” which may have been valid defenses to an action brought by the failed bank, but do not impede the ability of a holder in due course to enforce the borrower’s obligation to repay the loan.9 Generally speaking, these defenses are all defenses that would be available in a breach of contract action10 except for the “real defenses,” all of which involve either the original execution of the promissory note or its subsequent discharge in bankruptcy.11 These defenses cannot be avoided, even by a holder in due course. Fortunately, any “bad acts” of the failed bank which may have occurred during the course of the loan will hardly ever form the basis for a “real defense,” and thus can likely be avoided by a holder in due course.
THE RULE IN FLORIDA
In Florida, the holder in due course doctrine is now codified in statute,12 although it first began to develop in the English common-law as early as the late 1600s andearly 1700s and was codified in that country by the Bills of Exchange Act in 1882.13 The doctrine first became codified in the United States in the early 1900s as states adopted the Uniform Negotiable Instruments Law, which was later supplanted by the Uniform Commercial Code, which governs today.14
In order to be a holder in due course under current Florida law, a purchaser of a negotiable instrument must generally satisfy three conditions. Specifically, the purchaser must have: (i) acquired an instrument that does not bear any apparent evidence of forgery, alteration, or any other reason to call its authenticity into question;15 (ii) paid value for the instrument;16 and (iii) acquired the instrument in good faith, without notice that it is overdue, dishonored, contains an unauthorized or altered signature, and without notice of any claim to the instrument.17 If these three conditions are met, the purchaser will generally qualify as a holder in due course and take the instrument free all “personal defenses” that the borrower could have asserted against the prior lender.
However, in the failed bank scenario, it is often not just the bank that is in trouble; many of its borrowers are in trouble as well. Thus, when evaluating a loan that has passed through a failed bank, a purchaser may find that the loan is non-performing or “overdue” (i.e., a principal payment has been missed, the loan balance has been accelerated, or the loan has matured).18 In this case, the purchaser cannot satisfy the third prong of the Florida holder in due course test (having taken without notice that the instrument is overdue), and thus could potentially be subject to personal defenses stemming from the failed bank’s conduct, which the purchaser may not know about or even have a reasonable probability of discovering. Consequently, without additional protection, unlike the purchaser of a performing loan (which loans are frequently purchased and sold by banks and investors on the secondary market, facilitated by the holder in due course doctrine), the failed bank buyer would not be able to evaluate the loan based upon the face of the documents without having to dig into the minutia of the loan history and the failed bank’s relationship with the borrower, thus greatly diminishing the marketability of these loans.
Fortunately for these purchasers, courts have developed a counterpart to the state law holder in due course doctrine that applies when the FDIC takes over a failedbank, even if it only holds the failed bank’s assets for a brief duration, as often the case when the FDIC is appointed as receiver for the failed bank and nearly instantaneously enters into one or more purchase and assumption transactions. This federal counterpart to the holder in due course doctrine “bars the maker of a promissory note from asserting personal defenses against the Federal Deposit Insurance Corporation in connection with purchase and assumption transactions involving troubled financial institutions.”19
Significantly, this doctrine allows the FDIC to “enjoy the rights of a holder in due course even without meeting the technical requirements of state laws” and is designed to provide the same protections to federal holders in due course that “they would be entitled to had they satisfied state law requirements.”20 Therefore, even if the loan is non-performing, and therefore the FDIC (or any other purchaser on the secondary market) would not qualify as a holder in due course under Florida’s statute, the FDIC is still entitled to the protections of a holder in due course as a matter of federal law. Significantly for the subsequent purchaser of the loan from the FDIC, once the FDIC has established itself as a holder in due course, the purchaser of that instrument from the FDIC succeeds to that status, thus obtaining for itself the same protections afforded the FDIC, even if it would not qualify as a holder in due course in its own right. This is commonly known as the shelter doctrine, since the purchaser is “sheltered” from the borrower’s personal defenses by the FDIC’s status as holder in due course.21 As a result, the purchaser, by virtue of its acquisition of the loan from the FDIC, obtains the benefit of the FDIC’s federal holder in due course status,22 even when the transfer has occurred following a default under the loan documents.23 This is critical, as it enables the purchaser from the FDIC to obtain holder in due course status irrespective of whether the loan it purchases was in default prior to the bank failure or only went into default following the FDIC’s acquisition. In the first instance (where the default occurred pre-failure), while the FDIC cannot become a holder in due course under Florida’s statute (because the loan was “overdue” at thetime of its acquisition) it is nonetheless entitled to those same rights under the federal holder in due course doctrine, and upon its sale of the loan, the purchaser will succeed to those rights under the shelter doctrine. In the second instance (where the default occurred post-failure, but pre-sale), while the FDIC may have qualified as a holder in due course under both the Florida statute and the federal holder in due course doctrine, ordinarily the purchaser would not qualify as a holder in due course as the loan would have been “overdue” at the time of its acquisition from the FDIC. However, as the purchaser is entitled to succeed to the FDIC’s rights as a holder in due course under the shelter doctrine, it receives essentially the same rights it would have in the first scenario, including the ability to avoid the borrower’s “personal defenses” against the failed bank, even though the loan is now in default (although in this scenario, any defenses the borrower might have against the FDIC as receiver would still be preserved).
Such a result may seem inequitable to the borrower, as the borrower’s, potentially substantial, defenses may be avoided in their entirety simply because the bank, whose very actions or omissions may have gave rise to those very defenses, has failed. However, someone must bear the losses that arise from a failed bank, and, as a matter of policy, this burden falls to the borrowers of the failed bank, sparing the failed bank’s creditors and depositors,24 by allowing the FDIC to maximize the value of these loans in the secondary market as purchasers will not have to discount their purchase based upon the litigation difficulties they may otherwise anticipate if they were not entitled to the protections of a holder in due course. Accordingly, these additional proceeds received by the FDIC can be used pay the claims of the creditors and depositors of the failed bank who may otherwise face losses. As such, having such protections in place “facilitates the uninterrupted operation of the nation’s banking system” as it allows the FDIC “to complete purchase and assumption transactions quickly, based on the face value of a failed institution’s negotiable instruments, without the need to scrutinize the instruments for personal defenses.”25 Additionally, it facilitates the secondary market in the same manner that the state law holder in due course doctrine ordinarily does, since purchasers from the FDIC succeed to its status and enjoy the same protections as if they were holders in due course under state law.
Because of these the two layers of protection afforded by the state and federal holder in due course doctrines, a purchaser of distressed (and likely “overdue”) loan portfolios from the FDIC may have significant insulation from potential “personal defenses” arising from the failed bank’s “bad acts” to which it may otherwise have been subject as the failed bank’s successor. By being aware of both the state and federal holder in due course doctrines, a purchaser of distressed loans, even if not directly purchasing from the FDIC, can more accurately evaluate potential acquisitions and enhance its recovery through more expedient litigation or more favorable workouts.
1 FDIC Historical Statistics on Banking—Failures and Assistance Transactions, available at http://www.fdic.gov/bank/individual/failed/ (last viewed April 2, 2014).
2 FDIC Historical Statistics on Banking—Failures and Assistance Transactions, available at http://www.fdic.gov/bank/individual/failed/ (last viewed April 2, 2014).
3 Pursuant to 12 U.S.C. 1819 and 12 U.S.C. 1821(c), the FDIC has the capacity to be appointed receiver “for any insured depository institution.”
4 The Federal Deposit Insurance Corporation Resolutions Handbook, Chapter 1, available at http://www.fdic.gov/bank/historical/reshandbook/ (last viewed April 2, 2014) [the Handbook].
5 This “least-cost resolution” was expressly mandated by the Federal Deposit Insurance Corporation Improvement Act of 1991, Pub. L. No. 102-242.
6 The Federal Deposit Insurance Corporation Resolutions Handbook, Chapter 3, available at http://www.fdic.gov/bank/historical/reshandbook/ (last viewed April 2, 2014). 7 See, e.g., Cont’l Cas. Co. v. Ryan Inc. Eastern, 974 So. 2d 368, 382 (Fla. 2008). 8 Additionally, note that the common law D’Oench doctrine and its statutory counterpart 12 U.S.C. 1823(e), may also provide a similar effect in many cases, but their application will not always fully overlap with the scope of the holder in due course doctrine. 9 See, e.g., First Nat’l Entertainment Corp. v. Brumlik, 531 So. 2d 403, 404 (Fla. 5th DCA 1988) (“Failure of consideration [for example] is a personal defense which cannot be asserted by the maker of a negotiable instrument against a holder in due course. However, where, as here, the litigation is between the original parties to a negotiable instrument, the defendant maker can assert any personal defenses. . . .”). 10 Section 673.3051(1)(b), Florida Statutes.
11 The real defenses available in Florida are: (1) minority; (2) extreme duress; (3) incapacity; (4) illegality; (5) fraud in the execution; and (6) discharge in insolvency proceedings. Section 673.3051, Florida Statutes.
12 Section 673.3021, Florida Statues. 13 For a more detailed history of the birth of the holder in due course doctrine, see Edward L. Rubin, Learning from Lord Mansfield: Toward a Transferability Law for Modern Commercial Practice, 31 Idaho L. Rev. 755 (1995) and Mark B. Greenlee & Thomas J. Fitzpatrick IV, Reconsidering the Application of the Holder in Due Course to Home Mortgage Notes, 41 No. 3 UCC L. J. Art. 2 (2009).
14 Edward L. Rubin, Learning from Lord Mansfield: Toward a Transferability Law for Modern Commercial Practice, 31 Idaho L. Rev. 755 (1995) and Mark B. Greenlee & Thomas J. Fitzpatrick IV, Reconsidering the Application of the Holder in Due Course to Home Mortgage Notes, 41 No. 3 UCC L. J. Art. 2 (2009).
15 Section 673.3021(1)(a), Florida Statutes.
16 Section 673.3021(1)(b)(1), Florida Statutes.
17 Sections 673.3021(1)(b)(2)–(6), Florida Statutes.
18 Section 673.3041, Florida Statutes 19 Lassiter v. Resolution Trust Corporation, 610 So.2d 531, 537 (Fla. 5th DCA 1992).
20 Lassiter v. Resolution Trust Corporation, 610 So.2d 531, 537, 537–38 (Fla. 5th DCA 1992) (emphasis in original); see also Campbell Leasing, Inc. v. FDIC, 901 F.2d 1244, 1249 (5th Cir. 1990)(“In addition, the FDIC and subsequent note holders enjoy holder in due course status whether or not they satisfy the technical requirements of state law.”).
21 See Section 673.2031(2), Florida Statutes (“Transfer of an instrument, whether or not the transfer is a negotiation, vests in the transferee any right of the transferor to enforce the instrument, including any right as a holder in due course . . .”).
22 See, e.g., Wiers v. White, 196 So. 206, 209 (Fla. 1940)(“It is well established that, ‘A holder who derives his title though a holder in due course and who is not himself a party to any fraud or illegality affecting the instrument has all the rights of the former holder.’”).
23 City of New Port Richey v. Fidelity & Deposit Co. of Maryland, 105 F.2d 348, 351 (5th Cir. 1939)(“it acquired the rights of any former holder in due course, for such rights are transmitted and not destroyed by a transfer after notice [of default] to a third party.”); see also Cromwell v. County of Sac, 96 U.S. 51, 59 (U.S. 1877)(“The rule has been too long settled to be questioned now, that, whenever negotiable paper has passed into the hands of a party unaffected by previous infirmities, its character as an available security is established, and its holder can transfer it to others with the like immunity.”). 24 See, e.g., Sunbelt Sav., FSB v. Montross, 923 F.2d 353, 355 (5th Cir. 1991) (noting that the federal holder in due course doctrine “also prevents makers from using personal defenses to gain priority over the failed bank’s creditors’ and depositors’ rights to the note proceeds” which would otherwise be available to pay their claims.).
25 Lassiter, 610 So.2d at 537.