When Small Clerical Errors Explode Into Big Problems

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Two recent big stories may mean greater interest for the types of classes that we here on the Commercial Law blog teach. First came the spectacular UCC-3 filing error involving bank creditors of the law firm Heller Ehrman ("Oh, did I say 'termination,' I meant 'continuation!'") and the very serious consequences that this "clerical" error caused when the debtor went into bankruptcy. Now we have more press on an older and more serious problem. The New York Times this weekend reported on the lax assignment protocol followed (or rather, not followed) in the transfer of hundreds and thousands of mortgage notes into securitization pools. When the rare but brave judge (often in bankruptcy court) asks the foreclosing bank for proof of its ownership of a transferred/negotiated note, this proof is often unavailable--very good news for defaulting homeowner-debtors (as consumer advocates around the country are now informing their colleagues at CLE meetings), very bad news for banks. Perhaps lawyers-to-be will become more interested in following the nitty-gritty details of these transactions in the future to avoid spectacular losses. This interest will lead them right into our waiting hands!

Nitty-gritty details--that's what we commercial law profs are all about!

Toxic Debt Holders in Due Course

I had the opportunity to hear Christopher Peterson (Utah) speak last week at Loyola (New Orleans) on Predatory Structured Finance. His talk on the causes of the subprime crisis encompassed one issue that was hotly contested in the last few years: the potential exposure of assignees of mortgages to defenses and claims of debtors arising out of the origination of the mortgages. It is at a basic point a classic holder in due course question. Kurt Eggert has discussed at length the defense-stripping effect of the hdc doctrine in the context of predatory lending. In a related vein, efforts by states to place liability on secondary market assignees of mortgage notes for violations of state predatory lending statutes were met with, charitably, strong resistance, as this Business Week article on the political struggles between the states and the federal government pre-crisis recounts.

In the end, the issue of assignee liability boils down to a bread and butter holder in due course/doctrine of bona fide purchase question. HDC status for secondary market assignees promotes liquidity to be sure. And, liquidity of subprime loans, that we certainly got. On the other hand, stripping of hdc status forces assignees/secondary market purchasers to exert more care over the practices of the origination market. As government turns to the reform stage of the crisis, one of the more interesting commercial paper questions will be whether to continue to insulate the secondary market from abuses at the origination level through application of principles of good faith purchase, or whether to move in the other direction, for example by extending the FTC HDC regulations to encompass all or a larger portion of mortgage loans.

Renewed Interest in "Commercial Paper"!

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Finally, the sexy topic of commercial paper has made it onto the front page of the Wall Street Journal! No more hemming and hawing when our students ask for examples of commercial paper--here it is.

Ordinary people no longer use promissory notes as a payment/value device, endorsing notes from payee to payee (as used to be the case in the U.S. and elsewhere). Indeed, I doubt that most ordinary people ever put an endorsement on a check other than the restrictive "for deposit only." The whole notion of commercial paper and negotiation thus seems so artificial to our students, and I've had a hard time convincing myself that teaching the odd intricacies of this system is worth the effort (setting aside the bar examiners' idiotic continuation of testing on this anachronistic material).

Now, the main modern use of the term "commercial paper" has been thrust onto the public stage. Rather than taking short-term loans at the Prime Rate (5.0% or more currently) from a bank, large companies borrow from investors, like money market funds, by issuing promissory notes in exchange for loans, usually payable in 9 months or less, at rates much closer to the Fed's 2.0% target lending rate (thought rates have been elevated, in the 3.0% range, for nearly a month). While the investing market was awash in liquidity, this was a cheaper way to fund operations, leverage results, and have every last penny of a company's capital working at all times. When Reserve Primary Fund " broke the buck" on September 16 by admitting that losses on investments in Lehman Brothers (probably largely in its commerical paper) caused the value of its assets to fall below $1 for every $1 invested in the money market fund, public confidence in the stability and safety of money market funds was rattled, and other money market funds faced something close to a run on the bank as investors yanked money out. The commercial paper market dried up, as the primary investors in the market hoarded cash instead of investing in short-term loans to business, no matter how stable the borrower, because loans of longer than overnight would jeopardize the funds' ability to make funds available to investors who sought withdrawals--besides, who knew which company would be the next to make an ugly announcement about its financial stability and default on its short-term commercial paper loans. Again, in rides the Fed on its white horse, offering to buy commercial paper directly from companies and supply liquidity to this crucial corner of the market. What unprecedented move will we see next from the U.S. Treasury?!

Back to the classroom, though, I wonder if this "commercial paper" (1) actually satisfies the conditions for negotiability in Article 3, (2) actually changes hands more than once, from maker to payee, and (3) whether anyone in the system really cares, as these short-term loans are likely never subject to any payment dispute for which the maker-liability and holder-in-due-course rules would be relevant (they're enforceable payment contracts one way or another, one would think). Anyone have any direct knowledge on any of these points? My bet is that this paper (like the notes associated with home mortgage loans) is generally festooned with caveats and other requirements that violate the "extraneous undertaking" restriction in Article 3, removing the entire affair from the realm of negotiable instruments law. This makes me wonder whether we're really on a fool's errand in continuing to harp on these rules in Payment Systems, Commercial Paper, or whatever else the course might be called elsewhere.

Anyway, the fact that something called commercial paper has grabbed the headlines today makes me feel pretty cool in any event. Thanks, Ben and Hank!