Merger of debt

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“What if the issuer holds its own note for a bit?”

Issuing a debt security is largely a question of herding a lot of bureaucratic, pedantic and yet strangely wilful cats.

Many things need to be done: agency appointments made, instruments set up in the clearing systems, instructions matched, hedges struck, collateral acquired, global securities authenticated, and many, many documents need to be approved and then signed by many many people.

There is something to be said for breaking the process down, perhaps parking a newly-minted instrument, for the time being, somewhere safe, while you hunt down and tie up extant loose ends. If the instrument is issued but yet out of harm’s way: in the fridge, so to speak — one can sort out remaining formalities in relative tranquillity before settling the instrument into the market when all cats are at peace and the trade is finally, irrevocably, on.

Who would the best person be to hold the instrument in such a case? You might think its own issuer. After all: what mischief can come from a fellow’s IOUs when they are safe and sound in his own pocket?

Yet his counsel may instinctively cavil against the idea.

“This, ah, is problematic. In, er, theory. So to speak. As it were.”

“Oh?”

“Well, there’s the debt. It might, um, merge.”

She will be a bit shoe-shuffly about this, the same way Anglicans are shoe-shuffly about the more mystical bits of orthodoxy they are meant to subscribe to, but in practice don’t. It is as if there is some deep magic in play here — the Bills of Exchange Act 1882, which is still on the books, has something to say — but it has become somehow stale.

The theory of “merger”

The theory is this: you cannot have a contract with yourself. If, therefore, you hold your own promissory note — however you come by it — then at the point where you become its bearer, there is no longer a debt.

Logically, this is true. This is a matter not just of the law of contract, but of common sense. Even if the Chancery Division contrived to allow it, a basic grip on reality would not. You cannot owe yourself money.

But so what?

There is the debt — the res legis, to use our own coinage — and there is the substrate: the paper it is written on, by which our learned friends recognise the debt’s existence in our messy physical realm. We like to think of debt and instrument as coterminous, but on closer inspection, they are not. They cannot be.

Being a matter of logic and not law, the proposition that, as long as you are holding your own paper, no-one owes anyone anything is a matter of basic ontology. It has no bearing on the physical universe. It does not make your own IOU spontaneously burst into flames when you touch it. The ink with which your promise to pay is inscribed will not fade upon its contact with your own pocket. It simply means that, for as long as you hold the note, there is nothing to pay to anyone.

But where does the debt go?

The continuity, or not, of debt

What happens to the debt is is a question that only arises — that only matters — if one imputes it with some kind of legally material continuity. Does an instrument represent just one debt? Must it maintain continuous existence until its final discharge? If that continuity is denied somehow, is the debt irrevocably undone?

No.

A debt is a contract between two parties; issuer and holder. It has no independent existence of them. It has no legal personality. If a holder transfers the note constituting its debt to another, the existing debt is not “transferred” with the note, as such: rather, one contract of indebtedness is extinguished and another is made. The same applies for novations. That the creation and extinction process is beyond the debtor’s influence is neither here nor there. It was the debtor’s idea: it threw open its doors to the world — one at a time, to be sure — and may not complain now if, until the time for redemption arrives, its debts serially wink and sparkle in and out of existence amongst that unknown horde.

Now there is this American doctrine of “merger” which is something like transubstantiation: that the intangible contract of indebtedness that logically precedes the issuance of a deed “merges” the obligations into the instrument’s physical form, somehow animating and giving the debt continuity independent of its holder — but that seems like a classic piece of stiltery from our American cousins, and in any case we are not clear that it necessarily changes anything.

The absence of history

The thing about a bearer instrument is that it has no history. It is what it is, on its face, and none may gainsay it. It comes with no backstory, absent trailing footprints in the sand to indicate whence it came, or by what convoluted route. We neither know nor care where it has been. We care only for where it is now.

Nor does its present holder know. How would it? There is no register of transfers. Title passes by delivery. A bona fide transferee without notice takes the instrument as it finds it, and that is without context. If a chance encounter with its maker somewhere in its history were to invalidate an instrument, any later holder would be imperilled. How would it know? If this were the deal, the bond market may never have developed.

The issuer of a bearer note may not, for the time being, know to whom it is indebted: that being so, it must carry “the” debt on its books anonymously, as against the world. As long as it does not control it, the instrument is as good as live, since anyone who comes across it may pick it up and present it for repayment. But because the issuer may as well treat the debt as continuous, that is not to say that it is.

That being the case, and mindful of the non-evaporating nature of physical bearer instruments in the possession of their issuer, an issuer who repossesses its own note may then reconstitute the debt by giving the note to someone else. This sacred paper is not besmirched, nor compromised, by its passage through the issuer’s hands. How would anyone even know it had been there?

There is another logical challenge here: there must be a point in the life of every negotiable instrument after its creation but before its issuance, where the Issuer must hold it. It has to sign it, after all. If the “evaporation” theory were to hold water, a bearer debt instrument would vanish the very moment it was created. Its first breath would be choked out of it before it had a chance to escape its surly bonds into a life of disembodied indebtedness amongst the society of random strangers.

Infrastructure to spoil a good story

In any case the intervention of the clearing systems and the endemic agencies that otherwise suffuse all goings on in the financial markets, ensure that these ontological perplexities need never see the light of day.

Firstly, the Issuers’ indebtedness is held by common depositary on behalf of clearing systems, as principal, in favour of those systems’ account holders, which will usually not include the issuer itself. There are at least two principal intermediations between Issuer qua issuer and issuer qua holder there.

Secondly, even if one disregards these principalities, perhaps on grounds that they are essentially infrastructural in nature (if that would matter), it is unusual for an issuer to ever directly hold its own debt, legally, even where it does so beneficially: Issuers tend to hold third party custodians who in turn hold through custody networks. We do not know how those who fear evaporation would regard intermediation, but surely it must be less likely that a bond would evaporate in the hands of one’s agent than in one’s own. And — allowing the bond metaphysical extension for a minute, how would it know its holder was an agent?

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• What the Bills of Exchange Act 1882 has to say about all of this.
• The ontology of debt, assets and negotiable instruments: the brass tacks of trade finance

See also

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• Debt securities
• Repackaging