What if a note is missing an endorsement or there are other problems with the negotiation of the note (e.g., the allonge is not properly affixed), such that the person to whom the note was delivered and who is in possession of the note is not a holder? In that scenario, Section 3-301 of the Uniform Commercial Code (UCC) recognizes that enforcement is not limited to holders and that transferees may take shelter in the rights of the transferor. Person Entitled to Enforce (PETE) the instrument includes non-holders in possession with rights of holder.

UCC Section 3-203(b) provides the rule known as the shelter rule:

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, but the transferee cannot acquire rights of a holder in due course by a transfer, directly or indirectly, from a holder in due course if the transferee engaged in fraud or illegality affecting the instrument.

“Transfer” is defined as delivery of an instrument “by a person other than the issuer for the purpose of giving to the person receiving delivery the right to enforce the instrument.” Comment two to Section 3-203 states “transfer vests in the transferee any right of the transferor to enforce the instrument ‘including any right as a holder in due course.’ If the transferee is not a holder because the transferor did not indorse, the transferee is nevertheless a person entitled to enforce the instrument under Section 3-301 if the transferor was a holder at the time of transfer. Although the transferee is not a holder, under subsection (b) the transferee obtained the rights of the transferor as holder.”

In other words, under UCC Section 3-203(b), the buyer of the note takes “shelter” in the rights of the seller. For example, suppose the payee sells the note to a new owner, but fails to indorse the note (so no “negotiation” takes place). The new owner is not a “holder” (since there has not been an indorsement by the payee), but the new owner takes shelter in the holder status of its seller and thus is a PETE according to both Section 3-301 (defining PETE) and Section 3-203(b) (the shelter rule itself).

While the UCC recognizes the rights of a transferee in possession, the burden of proving “transfer” is on the person holding the instrument, including proving the validity of previous transfers as appropriate. According to one court, “the transferee does not enjoy the statutorily provided assumption of the right to enforce the instrument that accompanies a negotiated instrument.” The possessor of the note must prove both the fact of delivery and the purpose of the delivery to qualify as “person entitled to enforce.”

In summary, whether or not indorsements are complete, a person in possession of a note may enforce the note upon showing that the note was “transferred,” and may take shelter in the rights of the transferor, including any right as a holder in due course.