Legal Definitions - close-connectedness doctrine

The close-connectedness doctrine is a legal principle that some courts use to prevent a party who buys a financial promise (like a loan agreement or a promissory note) from receiving special legal protections, if that buyer is too closely linked to the original seller of the promise.

Normally, someone who acquires a negotiable instrument (a document promising payment) in good faith, for value, and without knowing about any problems with the original deal, is granted "holder-in-due-course" (HDC) status. This status offers significant protection, often shielding the buyer from legal defenses that the person who made the promise might have had against the original seller.

However, the close-connectedness doctrine states that if the buyer of the financial promise (the assignee) has such a tight relationship with the original seller (the assignor) that they are essentially part of the same business operation, or share significant knowledge about the original transaction, then the buyer should not be treated as an innocent third party. In such cases, courts may deny HDC status, allowing the person who made the promise to raise against the buyer any defenses they would have had against the original seller.

Here are some examples to illustrate this doctrine:

• Example 1: Car Dealership and Captive Finance Company

  Imagine a customer buys a new car from "Speedy Motors" and signs a loan agreement (a negotiable note) to finance the purchase. Speedy Motors immediately sells this loan agreement to "Speedy Finance," a company that is wholly owned by Speedy Motors and exclusively finances vehicles sold by its parent company. If the car turns out to have a serious, undisclosed defect that makes it unsafe, the customer might want to stop making payments. If Speedy Finance sues the customer for non-payment, the customer could argue that Speedy Finance should be denied holder-in-due-course status because of its close connection to Speedy Motors. A court applying the close-connectedness doctrine might agree, allowing the customer to raise the defense of the car's defect against Speedy Finance, just as they would have against Speedy Motors.

• Example 2: Home Improvement Contractor and Preferred Lender

  A homeowner hires "Build-It-Right Construction" for a major renovation project and signs a promissory note to pay for the work over time. Build-It-Right Construction then sells this note to "Easy Loans Inc.," a financing company that Build-It-Right frequently recommends to its customers and from which it receives a referral fee for every loan. Furthermore, Easy Loans Inc. provides Build-It-Right with pre-printed loan applications bearing both companies' logos. If Build-It-Right performs extremely shoddy work, leaving the homeowner with significant structural problems, the homeowner might refuse to pay. When Easy Loans Inc. attempts to collect, the homeowner could invoke the close-connectedness doctrine. A court might find that the close relationship between Build-It-Right and Easy Loans Inc. (e.g., shared forms, referral fees, exclusive arrangements) means Easy Loans Inc. is not an innocent third party and should be denied holder-in-due-course status, allowing the homeowner to use the "shoddy work" defense against Easy Loans Inc.

• Example 3: Appliance Store and In-House Credit Department

  A customer purchases a new refrigerator from "Mega Appliances" on credit, signing a retail installment contract (a type of negotiable note). The contract is immediately assigned to "Mega Credit Solutions," which is not a separate legal entity but rather a division within Mega Appliances, sharing the same physical address, management, and customer service staff. If the refrigerator is delivered damaged and Mega Appliances refuses to replace it or offer a refund, the customer might stop making payments. When Mega Credit Solutions attempts to collect, the customer could argue that Mega Credit Solutions is merely an extension of Mega Appliances. Under the close-connectedness doctrine, a court would likely deny Mega Credit Solutions holder-in-due-course status, allowing the customer to assert the defense of the damaged appliance against the credit department, just as they would against the sales department of Mega Appliances.