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Holder in Due Course Notice of Valid Defense

25. What does it mean to receive an instrument without notice of a valid defense to enforcement?

A recipient of a negotiable instrument cannot become a holder in due course if she is aware (or has “reason to know”) that there are some valid defenses that the payor may assert against payment of the instrument. Remember, status as holder in due course would insulate the holder against these defenses. Valid defenses of the payor against payment of the instrument may include:

•    Overdue – If the instrument has a stated time for payment and that time or date has passed, it is overdue.

⁃    Example: Checks are overdue 90 days after its posted date. A demand instrument is overdue the day after it is presented for payment or upon a reasonable time after it was issued. If the individual is subjectively aware that the instrument was presented for payment with no luck, that can indicate overdue status.

•    Dishonored – If the instrument has been presented for payment and is dishonored.

⁃    Example: If the note or draft has been dishonored by the maker or drawee, there is a defect. Also, checks drawn on insufficient funds, once presented, cannot be transferred to a holder in due course.

•    Default on Collateral Instrument – This generally arises when the instrument is issued as part of a series of transactions. Knowledge of an uncured default in another instrument issued as part of the same series is notice of a valid defense.

•    Instrument is Altered, Forged, or Incomplete – An unauthorized alteration, unauthorized filling in of an incomplete instrument, or a forgery of an instrument is a valid defense against payment. Notice of these defenses may be actual or constructive. That is, if the name signed on the instrument is wrong or incorrect, this could be considered constructive notice of a valid defense.

⁃    Note: Remember that an alteration or completion of an incomplete (blank) note or check that is signed by an individual makes her liable for any amount filled in.

•    Notice of Claims or Disputes – A valid defense includes when a third party has a claim to the instrument or there is a dispute between the original parties to the instrument. This places the risk on the maker or drawer responsible for creating the incomplete instrument.

⁃    Example: A party enters into two contracts where they purport to transfer the same promissory note as value. The other party’s claim to the instrument is a valid defense against payment. Also, if the instrument was created as part of a contractual agreement, a dispute between the parties to the contract may be a valid defense to the instrument.

The UCC specifically excludes a list of individuals from HDC status based upon the manner in which they became holder of the instrument. Judgment creditors, bulk instrument purchasers, and heirs inheriting the instrument, for example, do not qualify as HDCs.

•    Discussion: Why do you think the UCC prevents HDC status for individuals aware of a defense to payment? Should it matter the nature of the defense (such as a weak or partial defense)? Why or why not? Why do you think the UCC specific excludes acquirers of the paper through judgments, debtor sales, and inheritance from HDC status?

•    Practice Question: Stacy issues a promissory note to Todd. Todd and Stacy have an argument regarding the underlying agreement and Stacy threatens to not pay the instrument. Todd agrees to sell the note to Unis at 50% of the value. Unis is familiar with the UCC and believes that she will qualify as a holder in due course? What rights will Unis have if Stacy denies payment on the instrument because of her contract dispute with Todd?

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