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Holder in Due Course Discharge of Underlying Obligation

26. How does discharge of the underlying obligation affect a holder in due course?

Negotiable instruments are generally created as consideration in a contract between two parties. That is, there is a contractual relationship (known as the underlying agreement) between the original creator (issuer) and recipient (issuee and holder) of the negotiable instrument. If the parties to the underlying agreement fail to carry out their obligations, it may affect the ability of a holder to later enforce the instrument against the payor. This is because the holder (as transferee) receives the same rights and the transferor. She also is subject to any defenses the payor may have against the issuee with regard to the underlying contract. A HDC, however, is not subject to the payor’s personal defenses to payment of the instrument.

Pursuant to the above-stated rules, discharge of either party from her obligations under the contract giving rise to the negotiable instrument may serve as a defense to the payor having to pay the instrument. Discharge of the underlying obligation does not, however, affect the payment rights of a HDC who takes the instrument without notice of the discharge. While notice of discharge of the underlying obligation does not constitute “notice of a valid defense”, it may affect the HDC’s right to seek payment against the payor if the HDC received the instrument with knowledge of the underlying discharge.

•    Discussion: Why do you think discharge of the underlying obligation is not a defense to payment of a holder in due course of the instrument? Why does this rule change when the HDC has notice of the discharge prior to receiving the instrument? Should there be a distinction? Why or why not?

•    Practice Question: Venus and William enter into a contract. Venus issues a promissory note to William in consideration for William’s obligation to perform services. William sells the promissory to Martina, who meets all of the requirements for a holder in due course. During this time, William is discharged from the contract due to a serious injury he suffered. Does this affect Martina’s right to seek payment from Venus? If Martina sells the paper to Billy Jean and notifies her of the underlying discharge, would this discharge affect her right to seek payment?

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