Held Up in Due Course: Codification and the Victory of Form Over Intent in Negotiable Instrument Law

• Publication year: 2000

35 Creighton L. Rev. 363. HELD UP IN DUE COURSE: CODIFICATION AND THE VICTORY OF FORM OVER INTENT IN NEGOTIABLE INSTRUMENT LAW

Creighton Law Review

Vol. 35

KURT EGGERT(fn*)

I. INTRODUCTION

The holder in due course doctrine is part of the little-known, often-ignored backwater that is negotiable instruments law and, simultaneously, is at the heart of today's great crisis of the American financial system, predatory lending. On the one hand, even the authors of the standard treatise on the Uniform Commercial Code open their chapter on the holder in due course doctrine with this question: Given the declining significance of the holder in due course doctrine, why study it?(fn1) Grant Gilmore has called negotiable instruments law "so dreary a subject," one "which has disappeared from the curricula of most forward-looking law schools."(fn2) On the other hand, in years of Congressional hearings designed to understand and halt a "national scandal,"(fn3) - predatory lending and the resulting foreclosures that are devastating poorer communities throughout the country - advocatesfor residential borrowers are calling for an end to the holder in due course doctrine. These advocates decry the doctrine's pernicious effect on defenseless homeowners, as it encourages fraud and sharp practices by unscrupulous lenders, aids them in their attempt to plunder the equity in borrowers' homes, and leaves its victims, most often the elderly, minorities, and the financially unsophisticated, defenseless and threatened with foreclosure when the initial lenders almost immediately negotiate the loans to a third party.(fn4) A recent analysis of lending practices estimated that predatory lending costs U.S. borrowers $9.1 billion annually; an estimate that expressly and intentionally excludes perhaps the greatest damage caused, residential foreclosures.(fn5) Worse yet, the problem of mortgage fraud and unscrupulous lending appears to be growing.(fn6)

This article is the first of a two part series on the holder in due course doctrine and is part of an effort to understand this odd juxtaposition, to understand how the holder in due course doctrine, once so important to the economic development of England and the United States, has become part of a system of assigning risk of fraud and misrepresentation that encourages those very deceptive practices by lenders. All the while, the holder in due course doctrine is almost completely unknown to the general public and especially to the victims of the deceit and high cost loans that it encourages.

This analysis is divided into two parts, published as separate but related articles. This first article undertakes a reinterpretation of the history of the development of the holder in due course doctrine and shows how negotiable instruments law changed from a crucial and reasonably efficient means of transferring and transporting capital into an inefficient, unnecessary, and even dangerous tool used by thefinancial industry against consumers. I argue that negotiability and its primary effects were once understood by the people who created negotiable instruments and that they by and large intended to create those instruments and be bound by those effects. Because of this knowledge and intent by the instruments' makers, the law of negotiable instruments developed and worked fairly efficiently given the primitive financial systems available. As the knowledge of negotiable instruments declined and as those instruments came to be created by many who have no idea of the nature or legal effects of negotiability, this efficiency has diminished alarmingly. Negotiable instrument law and the financial industry have come to assign the risk of fraud, theft and deception in such a way as to increase and encourage deceptive practices.

Part II of this first article is a discussion of the competing theories regarding the development of negotiable instruments law. The traditional theory is that negotiable instruments law represents one of the greatest developments of commercial law and sees the codification of the common law of negotiable instruments as a necessary method of preserving the great advances made by such notable English judges as Lord Mansfield in developing that law. A newer school of thought is that the codification movement did preserve the common law of negotiable instruments, but did so at a price, as it prevented judges from improving that law when faced with new situations. A third school doubts whether negotiability and, specifically, the holder in due course rule has any current effect or perhaps was ever the central element of negotiable instruments law.

Part III of this article lays out the definition and basic elements of a negotiable instrument and Part IV describes and defines the holder in due course doctrine, which has long been considered the defining element of negotiable instruments law. The central purpose of the holder in due course doctrine, which protects a bona fide assignee from most claims and defenses that the maker of a note had against the original beneficiary of the note, had been to increase the transferability and liquidity of negotiable instruments. In this way, the doctrine effectively turned negotiable instruments into a replacement for currency by relieving the buyers of those instruments of most of their concern regarding any claims or defenses the makers might have had.

In Part V, I argue that, during the initial development of negotiable instruments law during the 17th and 18th centuries, changes in the law governing those instruments followed and roughly tracked changes in the usage of the instruments and in the intent of the makers of those instruments. As a result of an appreciation for the role of intent in the creation of negotiable instruments, that law workedfairly efficiently, especially given the relatively primitive framework of the financial, communication, and transportation systems of the time. Part VI describes the decline of the use of negotiable instruments after the classical period, as the wide use of negotiable instruments ended and common understanding of their legal implications disappeared.

During the codification of the law of negotiable instruments, at the end of the nineteenth century, there was a sea change in the relationship between intent, formal requirements, and the creation of negotiable instruments, a change that is the topic of Part VII. Negotiability was no longer conceived of as the product of the intent of the maker of the instrument. Formal requirements were no longer considered necessary merely as evidence from which the intent to create a negotiable instrument could be inferred. Instead, negotiability came to be seen solely as a question of the form of the instrument itself, completely independent of the intent, or lack thereof, of the maker. The victory of form over intent in the codification of negotiable instruments law is a cause of the widespread and profound misuse of negotiable instruments that has occurred since codification, as consumers and homeowners create negotiable instruments secured by their purchases, homes, or other property, with little or no understanding that they are doing so, or of the legal effects of negotiability.

The holder in due course doctrine was widely used during the twentieth century to victimize purchasers of home improvements and consumer goods on credit, who found to their dismay that even though the goods or services they had purchased either were faulty or were never even delivered or provided, they were still fully liable on their credit purchase contracts because those contracts had been assigned to third parties. The third parties typically claimed ignorance of the underlying fraud, even when they dealt hand-in-glove through many years and many transactions with the unscrupulous home improvers or sellers. Action by a federal regulatory agency finally ended the use of the holder in due course doctrine in these forms of consumer contracts during the 1970s.

The holder in due course doctrine has again come to be broadly effective against unwitting makers of negotiable instruments, now against consumers not of goods or services but of credit itself. My second of these two articles on the holder in due course doctrine, Held Up in Due Course: Securitization, Predatory Lending and the Holder In Due Course Doctrine,(fn7) to be published in April 2002, will discuss how the holder in due course doctrine has again become part of the victimi-zation of the makers of negotiable instruments. In this follow-up article, I discuss the interaction of the holder in due course doctrine and assignment of risk issues with two significant trends in modern residential lending that have combined to create a fertile environment for predatory lending: the growing securitization of residential mortgages and the troubling rise of the subprime mortgage industry.

Securitizers, who transform the relatively non-liquid notes secured by real property into very liquid securities, seek to avoid all risk of loss for themselves and their investors, both through contractual arrangements with originators of loans and through the use of negotiable instruments, with the protection of the holder in due course doctrine. In this way, investors in securitized mortgages are protected even while buying predatory loans, whether the originator of the loan goes bankrupt or not. The subprime...