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.