Weast v. Arnold

RODOWSKY, Judge. This is a suit against the makers of promissory notes which the payee pledged as collateral for a loan. The delinquent balance on that loan has been paid by the pledgor’s surety who thereby acquired the notes and who now sues on them. Contrary to the trial court’s conclusion we shall hold that the plaintiff enjoys holder in due course status, as transferee of the lender’s rights in the notes, but only to the extent of the lender’s security interest in the notes.

The excess of the plaintiff’s claim is subject to a breach of contract defense on which the defending makers proved entitlement to no more than nominal damages as a setoff. On September 26, 1972 George E. Weast, Jr. (George), then the husband of the plaintiff, Ruth W. Weast (Ruth), borrowed $140,000 from State National Bank of Maryland (SNB). Ruth had “co-signed for [her] husband” in connection with this indebtedness. Although the documents evidencing this loan are not in evidence, the premise on which the parties presented the instant case was that, as between Ruth and George, George was the principal obligor and Ruth was an accommodation party.

We shall call this obligation and its later modifications the “Weast debt.” By November of 1973 the Weast debt was in default and an agreement was reached with SNB modifying the terms. As ⁵⁴⁴ part of this modification the notes on which the instant suit is based were made part of SNB’s security. The notes came about in the following manner. On November 23, 1973 George sold to Francis A. Arnold (Francis), one of the defendants, and to Randall Printing Company, Inc., a District of Columbia corporation (Randall Co.), common stock in Randall Co. Consideration moving to George in this transaction included three promissory notes in the combined original principal amount of $100,000, consisting of respective face amounts of $41,364, $38,636 and $20,000.

Francis and his wife, Josephine Arnold (Josephine), the other defendant herein, signed each of the notes as makers. Randall Co. also signed the $38,636 note as a maker. We shall call these three notes the “Arnold notes.” Francis and Randall Co. each pledged the Randall Co. stock respectively purchased by them as security and cross-security for the payment, inter alia, of the Arnold notes. Subsequently Randall Co. failed so that neither it nor its stock are involved in the case before us.

As part of the restructuring of the Weast debt to SNB, George on November 27, 1973 executed a security agreement in favor of SNB and indorsed the Arnold notes to the order of SNB. The security agreement recited that “as collateral security for the payment of any and all indebtedness” of George the Arnold notes and the pledges of Randall Co. stock had been “deposited with” and “pledged” to SNB. SNB was “also given a lien upon the title or interest of [George] in all property and securities now in ... the custody or possession of the Bank____” The Arnolds were notified to make payments on their notes to SNB. Further to secure SNB, George and Ruth placed a second deed of trust on their residence in favor of SNB.

George petitioned for voluntary bankruptcy on July 1, 1975 in the District of Maryland. He listed SNB as a secured creditor and stated the principal balance due SNB, without accumulated interest, to be $104,235.12. His petition referred to the second lien on the residence and the ⁵⁴⁵ Arnold notes as SNB’s security. On April 5, 1977 George received a discharge in bankruptcy.

The trustee of George’s bankruptcy estate reported there to be no assets and the bankruptcy judge, also on April 5, 1977, approved that report and ordered the estate closed. Payments to SNB on the Arnold notes ceased in the summer of 1976. At the times of the defaults on those notes the principal balances due totaled $67,844.22. SNB never sued on the Arnold notes.

About December 23, 1975 George and Ruth entered into a voluntary separation, support and property settlement agreement under which George was required to assign to Ruth all of George’s interest in the Arnold notes. The Weasts were divorced June 10, 1976. By a writing dated June 3, 1976 George assigned “all rights and interests” in the Arnold notes to Ruth. This assignment was made after George had been adjudicated a bankrupt but before his discharge and the closing of his bankruptcy estate.

The Arnold notes were then in the possession of SNB and were not, and never have been, indorsed by George to Ruth. The record in this case leaves us uninformed as to whether there were any credits against the Weast debt, once payment on the Arnold notes ceased, until 1979. In order to avoid foreclosure of the deed of trust held by SNB on the residence, Ruth, on June 5, 1979, agreed with SNB to sell the property and, from the proceeds, to pay all principal and accrued interest on the Weast debt. Ruth also agreed to the release of $10,000 to SNB from the principal of an escrow account, together with the interest earned thereon, all of which was applied to the Weast debt, including counsel fees to SNB’s attorneys.

The total paid by Ruth in 1979 in order to satisfy the Weast debt to SNB appears to have been approximately $58,400. One aspect of the settlement between Ruth and SNB was that SNB on July 13, 1979 indorsed to the order of Ruth each of the Arnold notes. At the same time Ruth assigned to SNB “all or such part of her interest in any proceeds ⁵⁴⁶ collected thereon to the extent of the then unpaid balance of her obligations” to SNB, pursuant to the settlement agreement. Ruth brought the present action on December 21, 1979 against Arnold and Josephine.

Ruth’s position at trial was that she acquired her interest in the Arnold notes by indorsement from SNB to her. She measured her claim by the total unpaid principal balance of the Arnold notes, together with 8% per annum interest thereon, as specified in the notes. Computed to February 1, 1982, the day of trial, the claim totaled $97,615.21. The Arnolds’ principal contention was that Ruth was subject to a defense based on breach by George of the agreement for sale of Randall Co. stock which gave rise to the Arnold notes.

The agreement provided that George, the original pledgee, would release part of the stock from pledge as increments of the stock purchase price were paid. One of these payment levels had been reached in 1974 but SNB, George’s pledgee, would not release any of the stock. Ruth’s reply was that this defense was not available against her because she enjoyed the rights of a holder in due course. Ruth based that status on her being a transferee of SNB which, she said, had acquired the Arnold notes in that capacity.

Another issue raised by the Arnolds was that Ruth had acquired from SNB no more than SNB’s security interest in the notes. The trial court, in a written opinion, first considered Ruth’s possible entitlement to the notes as assignee of George in June of 1976. It concluded that the assignment from George to Ruth was invalid because he was then in bankruptcy. We express no views on that holding because it is not before us.

Ruth has not challenged that holding in her brief, presumably because she does not desire to trace her interest via assignment from George and thereby, arguably, be subject to defenses, if any, arising out of the alleged breach of the terms of the stock sale transaction between George and Francis. In this Court Ruth stands exclusively on her position that she acquired the same ⁵⁴⁷ rights as SNB had, and that they are those of a holder in due course. The trial court next reasoned that Ruth had become the owner of the Arnold notes by what amounted to a sale to Ruth by SNB of the collateral following default on the Weast debt. George’s bankruptcy was pointed to as the event of default.

In concluding that SNB had transferred to Ruth full title to the Arnold notes, the court relied on Md.Code (1975), § 9-504(4) of the Commercial Law Article (CL). However, in the view of the circuit court, Ruth was not a holder in due course of the Arnold notes inasmuch as they were in default at the time she acquired them from SNB. Then, because Ruth was an assignee and had not presented any rebuttal to testimony suggesting that the failure of Randall Co. was attributable to the breach of the pledge agreement, it was held that there was “no choice other than to enter judgment in favor of the defendants,” Francis and Josephine. Certiorari was issued on our own motion prior to consideration of Ruth’s appeal by the Court of Special Appeals.

We shall reverse and remand. (1) SNB was a holder in due course. Under the test of § 3-302(1) it took the Arnold notes for value, in good faith and without notice that any instrument was overdue or had been dishonored, or that any person asserted a defense against or claim to the instrument. 1 See 5 R. Anderson, Uniform Commercial Code §§ 3-302:13 to 3-302:34 (3d ed. 1984); J. White and R. Summers, Uniform Commercial Code §§ 14-1 to 14-10 (2d ed. 1980). A holder takes an instrument for value “[t]o the extent that ... he acquires a security interest in ... the instrument otherwise than by legal process,” or “[w]hen he takes the instrument ... as security for an antecedent claim against any person wheth ⁵⁴⁸ er or not the claim is due.” Sec. 3-303(a) and (b).

See Anderson, supra, §§ 3-303:12-17, § 3-201:14, and § 3-302:35; 2 Bender’s Uniform Commercial Code Service, F. Hart and W. Willier, Commercial Paper Under the Uniform Commercial Code §§ 11.03[3]-[4] (1972, 1984 Supp.); An-not., 97 A.L.R.3d 1114 , at § 11 (1980, 1983 Supp.). There is no evidence that SNB took the Arnold notes other than in good faith. The notes were then only four days old. Express evidence that no default or dispute existed at that time- is uncontradicted.

Rights as a holder in due course can be acquired by a lender who takes as security notes of third parties payable to the borrower. See Third National Bank v. Hardi-Gardens Supply of Illinois, Inc., 380 F.Supp. 930 (M.D.Tenn.1974); In re United East Coast Corp., 6 U.C.C.R.S. 449 (E.D.N.Y.1969); Hollemon v. Murray, 666 P.2d 1107 (Colo.App.1982); Finance Co. v. Wilson, 115 Ga.App. 280 , 154 S.E.2d 459 (1967); Schranz v. I.L. Grossman, Inc., 90 Ill.App.3d 507 , 45 Ill.Dec. 654 , 412 N.E.2d 1378 (1980); Budget Financial Corp. v. Bernstein, 42 A.D.2d 893 , 347 N.Y.S.2d 593 (mem. 1973), aff'd, 35 N.Y.2d 761 , 320 N.E.2d 864 , 362 N.Y.S.2d 147 (1974); Wood v. Willman, 423 P.2d 82 (Wyo.1967). However, SNB’s acquisition of the Arnold notes as a holder in due course does not per se give SNB full title to and ownership of the notes. CL § 3-302(4) provides that “[a] purchaser of a limited interest can be a holder in due course only to the extent of the interest purchased.” Hart & Willier, supra, § 12.02[3] at 12-14-15, explain the concept more fully.

Being a holder of is not synonymous with having title to an instrument. “Title” in an ownership sense consists of a number of different kinds of interests____ Article 3 honors this distinction by providing: (1) A transferee can be a transferee of a “security interest,” something less than ownership. (2) A lien on or security in a negotiable instrument to secure an antecedent debt constitutes “value.” ⁵⁴⁹ (3) “Value” is measured by what is actually given for an instrument as opposed to what is promised, or by the extent of the lien or security interest of the holder. (4) A holder may have a limited interest and be a holder in due course only to the extent of that interest. (5) A holder in due course has rights “to the extent he is a holder in due course,” implying that he may not have all rights of such a holder.

The result is that a holder or transferee may not have or succeed to all rights of a holder or may have all such rights but be entitled to limited enforcement. Article 9 provides that a security interest in any personal property, including negotiable instruments, may be created by a security agreement signed by the debtor. However, such an interest can be protected against the interest of third persons who may acquire conflicting interests only by the secured party’s taking physical possession of the instruments. Thus, only when a secured party in fact takes possession can he be a holder under Article 3 and be protected under Article 9.

While the secured party must give value to create a security interest, what he is acquiring is governed by Article 9. He is not a buyer of the instrument as such. Article 9 governs the sale of accounts, contract rights, and chattel paper, but not negotiable instruments alone. Article 3 governs their sale. [Emphasis in original; footnotes omitted.] Because SNB acquired only a security interest in the Arnold notes, its rights as a holder in due course extended only to that security interest.

The result is recognized in Comment 4 to § 3-302. A purchaser of a limited interest — as a pledgee in a security transaction — may become a holder in due course, but he may enforce the instrument over defenses only to the extent of his interest, and defenses good against the pledgor remain available insofar as the pledgor retains an equity in the instrument. This is merely a special application of the general rule (Section 1-201) that a purchaser ⁵⁵⁰ of a limited interest acquires rights only to the extent of the interest purchased. See Third National Bank v. Hardi-Gardens Supply; In re United East Coast Corp.; Hollemon v. Murray; Finance Co. v. Wilson; Schranz v. I.L. Grossman, Inc.; Wood v. Willman, all supra.

See also Rozen v. North Carolina National Bank, 588 F.2d 83 (4th Cir.1978). The next question is whether Ruth acquired SNB’s holder in due course status as Ruth contends she did. (2) In deciding that Ruth was not a holder in due course the trial court applied § 3-302(1) to Ruth as of the time SNB indorsed the notes to Ruth. However Ruth’s argument that she achieved holder in due course status rests on the “shelter” provision of § 3-201.

That section reads in relevant part: (1) Transfer of an instrument vests in the transferee such rights as the transferor has therein, except that a transferee who has himself been a party to any fraud or illegality affecting the instrument or who as a prior holder had notice of a defense or claim against it cannot improve his position by taking from a later holder in due course. (2) A transfer of a security interest in an instrument vests the foregoing rights in the transferee to the extent of the interest transferred. Ruth is not a prior holder of the Arnold notes. Nor has it been suggested that she was party to any fraud or illegality affecting those instruments.

Thus, under § 3-201(1) SNB, as a holder in due course, transferred its rights as such a holder to Ruth. This result is explained in Official Comment 3 to § 3-201: A holder in due course may transfer his rights as such. The “shelter” provision of the last sentence of the original Section 58 is merely one illustration of the rule that anyone may transfer what he has. Its policy is to assure ⁵⁵¹ the holder in due course a free market for the paper, and that policy is continued in this section.

The comment is followed by illustrations of which example (a) is particularly pertinent here. A induces M by fraud to make an instrument payable to A, A negotiates it to B, who takes as a holder in due course. After the instrument is overdue B gives it to C, who has notice of the fraud. C succeeds to B’s rights as a holder in due course, cutting off the defense.

In the instant case, even though the Arnold notes were overdue, and even if Ruth knew when SNB indorsed to her that the Arnolds asserted a breach of contract defense, Ruth nevertheless succeeded to SNB’s status as a holder in due course. As to the “shelter” provision of § 58 of the Uniform Negotiable Instruments Law, see United States Fidelity & Guaranty Co. v. Wells, 246 Ark. 255, 258 , 437 S.W.2d 797, 798-99 (1969) (“It is immaterial that the transferee of a note from a holder in due course took it after maturity ... or without payment of value ... or with notice of existing equities, infirmities or defenses____”) (citations omitted); Tesdahl v. Hiebert, 148 Mont. 241 , 419 P.2d 298 (1966). For a case applying § 3-201(1) of the U.C.C. to cut off defenses of the maker of a note acquired by an insolvent bank as a holder in due course and subsequently assigned by it to the F.D.I.C., see F.D.I.C. v. Russo, 89 A.D.2d 575 , 452 N.Y.S.2d 231 , (mem.), aff'd, 58 N.Y.2d 929 , 447 N.E.2d 81 , 460 N.Y.S.2d 532 (1982). See generally Canyonville Bible Academy v. Lobemaster, 108 Ill.App.2d 318 , 247 N.E.2d 623 (1969); Perry v. Schlaikjer, 5 Mass.App. 866 , 367 N.E.2d 863 (1977); Cantrell v. Cafourek, 513 S.W.2d 690 (Mo.App.1974); Estrada v. River Oaks Bank & Trust Co., 550 S.W.2d 719 (Tex.Civ.App.1977, writ ref'd n.r.e.); First & Citizens National Bank v. F.D.I.C., 210 Va. 434 , 171 S.E.2d 856 (1970); Anderson, supra, § 3-201:4 and § 3-201:22; Hart & Willier, supra, § 12.02; Annot., 23 A.L.R.3d 932 , 946-47 (1969). ⁵⁵² Here SNB’s status as a holder in due course extended only to its security interest.

Accordingly, as SNB’s transferee, Ruth’s holder in due course status extends only to the security interest. The result is explicit in § 3-201, dealing with the rights of transferees of instruments, which provides in subsection (2) that “[a] transfer of a security interest in an instrument vests [such rights as the transfer- or has therein] in the transferee to the extent of the interest transferred.” See Official Comment 5 to § 3-201; Vinson v. McCarty, 413 So.2d 1026 (Miss.1982); Miller v. Merchants Bank, 138 Vt. 235 , 415 A.2d 196 (1980); Western National Bank v. Harrison, 577 P.2d 635 (Wyo.1978); Anderson, supra, § 3-201:4; Hart & Willier, supra, § 3:11 at 3-35. (3) The foregoing conclusion necessarily means we do not agree with the circuit court’s analysis of Ruth’s acquisition of the notes. Basically that court said that the following steps had occurred: 1.

The security agreement between George and SNB relative to the Arnold notes provided that George’s bankruptcy could be a default. 2. George defaulted by petitioning for bankruptcy. 3. SNB took possession of the collateral under § 9-503(1). 2 4. SNB sold the Arnold notes pursuant to § 9-504(4), dealing with the disposition of collateral by a secured party after default. 3 ⁵⁵³ The fact of the matter is that SNB did not take possession of the collateral as a consequence of default.

SNB had been in possession of the Arnold notes, which were indorsed by George to the order of SNB. Nor did default on the Weast debt, whether by George’s bankruptcy or by failure to pay, result in a sale of the Arnold notes. SNB simply ignored its security interest in the Arnold notes and pressed Ruth based on her obligation for the Weast debt. When Ruth paid SNB in 1979 she discharged her obligation to SNB on the Weast debt.

Even though Ruth was obligated to SNB, as between her and George, George was the principal debtor and Ruth was simply an accommodation party. The relation between George, Ruth and SNB was one of suretyship, as defined in Restatement of Security § 82 (1941), reading: Suretyship is the relation which exists where one person has undertaken an obligation and another person is also under an obligation or other duty to the obligee, who is entitled to but one performance, and as between the two who are bound, one rather than the other should perform. It is well-settled that a surety who pays the debt for the principal obligor becomes subrogated to the rights of the creditor, including rights in the security. We said in Finance Co. v. United States Fidelity & Guaranty Co., 277 Md. 177, 182 , 353 A.2d 249, 252 (1976) that “(subrogation is a long-standing equitable doctrine in Maryland whereby one who is secondarily liable for a debt, and has paid it, stands in the place of the creditor ... and is entitled to the benefit of all the securities and remedies which could have been resorted to for the payment of the debt.” See ⁵⁵⁴ Blair v. Baker, 196 Md. 242 , 76 A.2d 129 (1950); Embrey v. Embrey, 163 Md. 162 , 161 A. 153 (1932); Wallace v. Jones, 110 Md. 143 , 72 A. 769 (1909); Orem v. Wrightson, 51 Md. 34 (1879); Freaner v. Yingling, 37 Md. 491 (1873); Lawson v. Snyder, 1 Md. 71 (1851); Mullen, The Equitable Doctrine of Subrogation, 3 Md.L.Rev. 201, 218-20 (1939).

For recent cases applying the principle, see LeRoy v. Marquette National Bank, 277 N.W.2d 351 (Minn.1979); Murray v. Payne, 437 So.2d 47 (Miss.1983); O’Hara v. First National Bank, 613 S.W.2d 306 (Tex.Civ.App.1980). And see generally 1 Bender’s Uniform Commercial Code Service, P. Coogan, W. Hogan, D. Vagts & J. McDonnell, Secured Transactions under the Uniform Commercial Code § 5A.06 (1983); D. Dobbs, Handbook on the Law of Remedies at 250-52 (1973); 2A Hart & Willier, supra, § 13:29; L. Simpson, Handbook of the Law of Suretyship at 215-20 (1950); A. Stearns, The Law of Suretyship § 11.4 (Elder 5th ed. 1951); 10 S. Williston, A Treatise on the Law of Contracts § 1273 (Jaeger 3d ed. 1967). A good statement of the rule is found in Reimann v. Hybertsen, 275 Or. 235 , 550 P.2d 436 , modified, 276 Or. 95 , 553 P.2d 1064 (1976). There an accommodation co-maker paid the debt evidenced by notes.

The principal obligor had secured the notes by mortgages. Having satisfied the principal debt the accommodation party sued