Shelter Principle and Negotiable Instruments - Explained
How Does the Shelter Principle Affect Holders of a Negotiable Instrument?
Written by Jason Gordon
Updated at April 6th, 2023
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What is the Shelter Rule?
Status as a holder in due course (HDC) may strengthen the rights of a holder to receive payment on a negotiable instrument. When a holder may not qualify as a HDC, the shelter rule is a separate principle that may protect her rights. Pursuant to the shelter rule, the transferee of a negotiable instrument receives all of the rights of the transferor of the instrument, unless the transfer is carried out by fraud or illegal means. This is important in situations where the transferor is a holder in due course, but the transferee is not.
Example: A HDC may gift the negotiable instrument to the transferee. In this case, the transferee did not provide value for the instrument and does not qualify as a holder in due course. The shelter rule will allow the transferee to receive all of the rights of the transferor (a holder in due course) and receive the heightened protection. This rule makes the paper more marketable for the holder in due course.
The shelter rule provides liquidity to a HDC who, after accepting an instrument, learns of a defense against its enforcement. The HDC could validly transfer the instrument to another holder who has notice of the underlying defense. The new holder would have the same rights as the HDC. It is important to note that, if a holder in due course learns that there is a valid defense against enforcement or that the underlying obligation has been discharged, she must disclose that information to the transferee who provides value for the instrument. If not, the transfer by the HDC to the new holder could be deemed fraudulent. This would destroy the shelter principle protections.
Note: An exception to the shelter rule is that it does not apply if the holder in due course transfers the instrument back to a prior holder who was aware of its non-enforceable status and proceeded to transfer it to a holder in due course.
Next Article: Limit Holder in Due Course Status Back to: COMMERCIAL PAPER
Discussion Question
How do you feel about the shelter rule? Are you convinced by the objectives of the rule? Are there any arguments against allowing the transfer of HDC rights to a non-HDC?
Practice Question
Tommy is a holder in due course of a promissory note. He learns that there is a dispute between the issuer and original holder regarding the underlying contract and one party has been discharged. He does not have the time and resources to seek payment of the instrument if it is contested. He sells the instrument to Olivia, who is confident that she can enforce the instrument. What are Olivias rights with regard to enforcing the instrument?
Related Topics
- Commercial Paper (Intro)
- What is Commercial Paper?
- Negotiable Instrument
- What are the common types of commercial paper?
- Promissory Note
- Cashier's Check
- Convenience Check
- Certified Check
- Substitute Check
- Bill of Exchange
- Bank Draft Definition
- Sight Draft Definition
- Bankers Acceptance
- Who is a Holder of a negotiable instrument?
- Commercial Paper Funding Program
- What is Negotiability and why is it important?
- What is required for commercial paper to be negotiable?
- Sum Certain (Contracts)
- Inflation Adjustment Clause
- When does commercial paper contain an Unconditional promise to pay?
- Backup Line of Credit
- What is Payable on Demand or Payable on Time?
- What is Order Paper and Bearer Paper?
- Bearer Form
- How is a payee identified on the negotiable instrument?
- What rules does the court apply in determining negotiability?
- How is commercial paper negotiated to a holder?
- What is Transfer of a negotiable instrument?
- What is Indorsement of a negotiable instrument?
- What are the various types of indorsement?
- Bank Endorsement
- Blank Endorsement
- Accommodation Endorsement
- How does a holder receive payment on a negotiable instrument?
- Who is potentially liable on (or obligated to pay) a negotiable instrument?
- When is an individual liable for a representative signing a negotiable instrument?
- What rules apply if a holder loses a negotiable instrument?
- When is payment of a negotiable instrument overdue?
- What effect does a negotiable instrument have on the underlying obligation?
- What is a holder in due course?
- What are the requirements for a holder to become a holder in due course?
- Receive an instrument for value?
- Receive an instrument in good faith?
- Receive an instrument without notice of a valid defense?
- How does discharge of the Underlying Obligation affect a holder in due course?
- What is the Shelter Rule?
- Can you limit a transferee from becoming a holder in due course?
- Personal Defenses?
- Real Defenses?
- What is a Claim in Recoupment?
- What are the rights of a holder in due course if the instrument involves a consumer transaction?
- What happens if a negotiable instrument is Forged?
- What happens if a negotiable instrument is Stolen?
- Guaranty or Guarantee
- Letter of Guarantee
- Personal Guarantee
-
What is the role of a Guarantor or Surety of a negotiable instrument?
-
Surety
- Cosign
- Accommodation Paper Definition
- Secondary Liability
- Avalize Definition
- What is an Accord & Satisfaction?
- What is primary and secondary liability on an instrument?
- What is Drawer or Maker Liability for a negotiable instrument?
- What is Transferor Warranty of a negotiable instrument?
- What is Indorser Warranty of a negotiable instrument?
- What is Presentment Warranty of a negotiable instrument?
- What is a warrantors liability for a dishonored note or draft?
- What is the time limitation for warranty of a negotiable instrument?
- When are the warranties of a negotiable instrument discharged?
