Reforming the Law: The Payment Rule as a Paradigm

Dale A. Whitman* I. INTRODUCTION The concept of negotiability of promissory notes is solidly entrenched in American commercial law. It derives from the English common law notion that a negotiable instrument is a reification of the obligation it describes; the instrument is regarded as a tangible form of the obligation.1 This notion has multiple ramifications, but three stand out. The first is the holder in due course doctrine which asserts that, when a negotiable instrument is transferred by the correct process (negotiation, which requires delivery of the paper)2 to someone with the right qualities (good faith, lack of notice, and payment of value),3 the maker of the instrument may not raise against the holder most of the common defenses to payment that would have been assertable against the original payee.4 This doctrine is firmly (if complexly) established by Article 3 of the Uniform Commercial Code (UCC).5 Negotiability has traditionally been regarded as a great aid to commerce, since it relieves the secondary market purchaser of the instrument of the need to investigate its enforceability by contacting the maker.6 Thus, reification of the debt in the paper has been thought to serve a useful commercial purpose.7 A second ramification of the "reified obligation" principle involves competing transfers of the instrument. In general, the right to payment under the instrument may be gained only by acquiring possession of the paper document. Even if some other form of transfer (e.g., a separate written document of assignment) might be enforceable for some purposes, it is clear that as between competing assignees, the one who has acquired the document itself will prevail. This principle is embodied in Article 3 for holders in due course,8 but is also widely followed for instruments that are not technically negotiable or that are not held in due course as defined in Article 3.9 The third result of viewing a negotiable instrument as a "reified obligation" is the subject of this article. I refer to it here simply as the "payment rule." In substance, this rule holds that once an instrument has been delivered to an assignee, one who makes payment on the debt represented by the instrument to anyone other than the possessor of the instrument does so at his or her peril. The payment is not binding on the possessor unless actually forwarded to him or her. This is so despite the fact that the payor may not know of the transfer, having never been notified of it by either the original payee or the transferee. This view seems required by Article 3 for notes that fit its definition of negotiability,10 but is commonly adopted with respect to nonnegotiable notes as well.11 The first of these three results of "reification" of the obligation, the holder in due course rule, is under strong attack12 on the grounds that it is irrelevant, unnecessary, and out of touch with modern commercial practice. Little has been said about the second rule, which treats transfer of the paper as the best or only way to transfer the obligation. My purpose in this article is to address and attack the third rule, which in effect requires the payor of a note to make no payments without first demanding to see the note itself, in order to confirm that the payee still holds it.13 I propose to deal with the rule principally in the context of mortgage law, since that is where it nearly always causes trouble in practice. The payment rule arises in the following scenario. Mortgagor borrows money from Mortgagee, giving a promissory note secured by a mortgage. The note calls for regular monthly payments of principal and interest, which Mortgagor pays in a timely manner. Subsequently, Mortgagee transfers the note to Assignee, delivering possession of it and perhaps executing and recording an assignment of the mortgage as well. Assignee does not make Mortgagee an agent for purposes of collection of the debt. No one gives Mortgagor notice of the assignment, and Mortgagor continues to make regular payments to Mortgagee. …