Negotiating the American dream: a critical look at the role of negotiability in the foreclosure crisis.

• Author: Ice, Thomas Erskine
• Position: Cover story

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Contemporary negotiable instruments law developed hundreds of years ago, before every important institution of the modern financial world: incorporated banks, business corporations, developed capital markets, global monetary systems, electronic transfers, and even paper currency. (1) It is counterintuitive that this ancient law of negotiable instruments would have any relevance to one of the world's most sophisticated, cutting-edge tools of high finance--the pooling and securitization of mortgage loans. Yet, the courts routinely look to such law to resolve a foreclosure crisis spawned by the collapse of mortgage-backed securitization, a process which is as strained as trying to decide First Amendment issues using cases pre-dating the Constitution. It is all the more extraordinary that, just as the nation begins to awaken to "robo-signing" and other such pervasive and methodical abuses of the court systems, judges should find themselves slavishly compelled to apply a body of law shaped (and then abandoned) by the very authors of such scandals: the financial institutions.

This article explores the historical underpinnings of negotiability and whether the evidentiary shortcut that negotiability appears to offer as a means of proving a plaintiff's standing to sue can or should be applied in the context of the foreclosure cases facing the courts today. Examination of the original purposes of negotiability, as well as recent changes to the Uniform Commercial Code, leads to the conclusion that mere possession of a negotiable instrument (the promissory note) is insufficient to enforce a mortgage. The possessor or "holder" must prove ownership of the instrument--a complete chain of title from the original creditor--to invoke the equitable remedy of foreclosure.

The Private Currency of Merchants

The concept of negotiability is rooted in European mercantile customs, which, as of the 17th century, had developed a means of paying for goods, principally in international transactions, using documents called "bills of exchange." (2) Similar to a cashier's check today, the bill of exchange was an instrument representing an amount of money that the buyer had deposited with a third party. The bill instructed a fourth party, typically located near the foreign seller of the goods, to pay the seller upon presentment of the bill. Bills of exchange offered the advantage of being easier and safer to transport than precious metals or other valuables. (3)

As the use of these instruments became more common, merchants developed the practice of transferring the bills among themselves by endorsement. (4) Rather than presenting the bill to the local "fourth party" for payment, the payee would endorse the bill to another merchant as payment for goods or services. (5) Such instruments were often transferred dozens of times and served the function that currency serves today. (6)

This practice of transferring the bill to additional parties by way of "negotiation" and "endorsement" was later extended to promissory notes--two-party debt instruments. (7) As the courts came to recognize and enforce this endorsement-and-delivery method of transfer, documents that could be circulated in this manner came to be known as "negotiable" instruments. The "negotiability" of the instrument typically referred to its degree of "transferability." (8)

Holder in Due Course Doctrine

The "holder in due course" doctrine is said to be, not only the primary feature of negotiable instrument law, but "the most important principle in the whole law of bills and notes." (9) This doctrine grew out of an information vacuum typical in the age before computers and worldwide communications. In those days, the more times a particular instrument was transferred, the more attenuated the later recipients' knowledge about the original transaction became. Merchants, therefore, developed rules of negotiability to enhance the liquidity of the instruments by reducing the need for information about transactions earlier in the chain. (10) The most important of these was the "holder in due course" status, which simply disallowed most claims or defenses that might undermine the value of the instrument. (11) The holder in due course was a "good faith purchaser"--someone who paid value for the document without knowledge of any defect in either the seller's right to sell it or in the transaction that created it. (12) Because the holder in due course was a transferee that could receive greater rights than those of the transferor, the doctrine was a remarkable departure from basic common law principles that governed ordinary contracts, (13) but one necessary for the documents to function as a currency substitute.

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Over time, governments began to issue paper currency, (14) supplanting the need for the unfettered transferability of bills and notes. New technology revolutionized payment systems by creating the means for instantaneous transfers of money and information about transactions. Negotiability had become anachronistic and unnecessary. (15) Nevertheless, in 1952, the already antiquated holder in due course rules were codified into Article 3 of the Uniform Commercial Code (UCC). (16) As a result, the "law for clipper ships and their exotic cargoes from the Indies" (17) became frozen in time and, rightly or wrongly, continues to influence court decisions today. (18)

Evolving from Article 3 Negotiability to Article 9 Sales as a Means to Transfer Mortgage Loans

Article 3 has been criticized as having been drafted by a process that was "captured by bank attorneys" such that the end result was "a pro-bank statute." (19) Yet, as the technology of payment systems continued to advance, the banking industry itself became dissatisfied with Article 3 as a means of transfer, particularly with respect to mortgage loans. The necessity of physical delivery of the documentation became a nuisance that hindered, rather than expedited transfer ability. (20)

In response, the industry orchestrated a change to Article 9 of the UCC in 1998 that brought mortgage loans within its purview. (21) Specifically designed to facilitate securitization, (22) not only did the new Article 9 provide for automatic perfection of the buyer's interest upon sale, even without the transfer of possession, (23) but it officially sanctioned the practice of using third-party agents as document custodians to "possess" the instruments. (24) When the transferor and transferee used the same document custodian, the transfers of possession could take place without physically moving the documents; the custodian could simply acknowledge the change. (25) Most importantly, revised Article 9 applied regardless of whether the promissory notes were actually negotiable. (26) Article 9, therefore, now provides all the benefits of negotiability, such as transferability and liquidity, without the outdated custom of transporting the note and mortgage. (27)

Infusion of the Concept of "Holder" into Foreclosure

In the early days of the foreclosure crisis, the allegations of standing in complaints filed in Florida merely tracked the language of the foreclosure form approved by the Florida Supreme Court--that the plaintiff bank "owns and holds the note and mortgage." (28) Over time, the complaints have evolved such that the word "holder" has been substituted for the "owns and holds" language approved by the Florida Supreme Court. (29) Replacing the traditional language with the unrelated Article 3 term "holder" (30) permits the bank to argue that mere possession of a document that its attorney asserts to be an original note endorsed in blank (or specially endorsed to the plaintiff bank) conclusively establishes its standing to foreclose.

Thus, despite the shift toward Article 9 as the real-world mechanism for transferring loans, Article 3 negotiability has become the dominant legal theory argued by plaintiffs in support of their standing to bring foreclosure actions. In the courtroom, Article 3 serves as the basis for arguing an evidentiary shortcut which not only discards ownership of the loan as an element of proof, but which circumvents basic foundational evidence for the authenticity of the note itself. By claiming that promissory notes are "self-authenticating" under the UCC, (31) standing is now routinely, albeit incorrectly, (32) established on a single unsworn representation by plaintiff's counsel that the document presented is the original note.

Can a Thief Really Enforce a Note?

The key to this evidentiary shortcut, this indifference to who actually owns the loan, is the idea that, under Article 3, mere possession, even wrongful possession, of a bearer instrument confers an unassailable right of enforcement. This argument holds that the court need not inquire into the true ownership of the note because, even if the bank's possession is shown to be illegitimate, the matter does not concern the borrower (or the court), but rather, concerns only the true owner. (33)

The notion that a borrower is precluded from challenging a holder's right of enforcement is often expressed apothegmatically as: "Even a thief is entitled to enforce a bearer instrument." (34) Needless to say, the assertion that a thief can obtain or pass title to stolen property...