Transfer by the Mortgagee

Transcription

1 Chapter IVII Transfer by the Mortgagee ANALYSIS A. Nature of the Mortgagee s Interest 1. The Twofold Nature of the Mortgagee s Interest 2. Primary Importance of the Obligation 3. Enforcement of the Obligation, Ownership of the Obligation, and Governing Law B. Transferring Ownership C. Transferring Entitlement to Enforce (or PETE Status) 1. Negotiable Notes 2. Nonnegotiable Notes 3. Can an Assignee Other than a PETE Foreclose Nonjudicially? D. Assignment of the Note and Mortgage for Security Purposes 1. The Application of UCC Article 9 to Transfers of Mortgage Notes as Security 2. How Is Perfection Accomplished? 3. Which Method of Perfection Should Be Used? 4. How Does a Security Assignee Realize on the Security? E. Rights and Obligations of the Assignee Relative to the Mortgagor 1. Qualifying as a Holder in Due Course (HDC) 2. The Rights of an Assignee Who Is a HDC 3. Non-HDC Status 4. Limitations on the Holder in Due Course Doctrine 5. Payment to Assignor as a Defense F. Impact of Recording Acts 1. Need for Recording of Mortgage Assignment 2. Effect of Recording the Mortgage Assignment and Payment on the Mortgage Debt 3. Wrongful Satisfaction of the Mortgage by the Original Mortgagee 4. Recording as Means of Gaining Notice of Litigation 5. Wrongful Satisfaction by a Trustee Under a Deed of Trust 6. Mortgage Electronic Registration System (MERS) 1

2 2 CHAPTER IVII G. Participations 1. Rights of the Participants After Default 2. Lead Lender Misconduct 3. Lead Lender Bankruptcy

3 TRANSFER BY THE MORTGAGEE 3 It is a common practice for mortgagees to sell some or all of their mortgage loans to other investors shortly after origination of the loans. The sale of a loan is often loosely referred to as an assignment of the mortgage. Such sales are most often made by mortgage bankers, whose business consists of originating loans for immediate sale to other institutional lenders. Other originating lenders, such as savings banks and commercial banks, may retain in their own portfolios some of the mortgage loans they originate, while selling others. The market into which these sales occur is the secondary mortgage market. Numerous entities, both private and governmental, actively participate in purchasing mortgage loans in the secondary market. Some of the agencies and their significant economic impact on the housing industry are described in Chapter XI, infra. Two of the largest, Fannie Mae and Freddie Mac, are federally-chartered corporations. This Chapter focuses on the legal rights and obligations that arise from secondary market transactions. During the period from the 1990s to the mid-2000s, it became increasingly common for pools or packages of mortgage loans to be securitized. Securitization is a process by which the mortgage loans are assigned to and held by a custodian or trustee on behalf of a special purpose entity (SPE). The SPE issues debt securities in the capital markets and sells these securities to investors, with the payments to the investors being derived from payments made by the mortgagors on the underlying mortgages. These securities may take one of several forms: The pool of mortgage loans may be divided into fractional shares, and the securities sold to investors may represent ownership interests in the mortgage notes in the pool. Such securities are often known as participation certificates or PCs. See Bankers Trust (Delaware) v. 236 Beltway Invst., 865 F.Supp (E.D.Va.1994). The pool of mortgage loans may be pledged as collateral for a set of debt securities that are sold to investors with the understanding that each investor will receive a fractional share of the payments of principal and interest made by the mortgagors on the underlying mortgage loans. These are usually termed pass-through securities, because the mortgage payments are passed through directly to the securities investors. These securities differ from the PCs mentioned above because here the mortgage loans serve as collateral for the securities, while in the PC arrangement the securities are actual shares of ownership in the mortgage loans. The Government National Mortgage Association (GNMA) guarantees payment on pass-through securities of this type, collateralized by FHA and VA residential mortgage loans. See U.S. v. Logan, 250 F.3d 350 (6th Cir.2001). The pool of mortgage loans may be pledged as collateral for a set of securities that do not individually represent fractional shares of the payments of principal and interest (although in the aggregate, the payouts on the securities must, of course, mirror the payments being made on the mortgage loans). The securities may be issued in as many as ten to twenty different classes or tranches, each of which has different characteristics in terms of interest rate, timing of payment of principal and/or interest, and priority of payment relative to the other securities issued out of the same pool. Each tranche may appeal to somewhat

4 4 CHAPTER IVII different investors. If the mortgages employed to make up a pool of this type are large loans on commercial property, the securities are often termed commercial mortgage-backed securities or simply CMBS. See Recupito v. Prudential Securities, Inc., 112 F.Supp.2d 449 (D.Md.2000). But securitization can involve the pledging of large pools of residential loans for this purpose as well, and these securities are termed residential mortgage-backed securities or RMBS. No matter which form of mortgage securitization is involved, all securitizations require that the mortgages be assigned to a trustee or custodian to be held for the benefit and protection of the securities investors. Hence, the problems involving the transfer of notes and the assignment of mortgages are equally applicable to securitizations as to the traditional sale of mortgages on the secondary mortgage market. A. Nature of the Mortgagee s Interest 1. The Twofold Nature of the Mortgagee s Interest A real estate mortgagee owns two interests: the personal obligation owed by the mortgagor (usually evidenced by a promissory note) and the interest in the real estate that is the security for that obligation (usually evidenced by a mortgage or deed of trust). 2. Primary Importance of the Obligation When there is a transfer of the mortgagee s interest, the primary object of the transfer is the personal obligation, usually represented by a promissory note. The mortgage security is an important but subsidiary aspect of the transaction. The security follows the obligation unless the parties express a contrary intent (which is rare indeed). Whoever is the transferee of the note automatically obtains the benefit of the mortgage on the land. See Restatement (Third) of Property (Mortgages) 5.4(a); Horvath v. Bank of New York, N.A., 641 F.3d 617 (4th Cir. 2011). 3. Enforcement of the Obligation, Ownership of the Obligation, and Governing Law When considering the transfer of a promissory note, recognize that there are two distinct sets of rights that can be transferred: the right to enforce the note, and ownership (or title ) to the note. These two sets of rights are distinct from one another, and a great deal of confusion and nonsense has been created by muddling the two concepts. Entitlement to enforce a note means that one can sue on it or (if applicable foreclosure requirements are met) foreclose the mortgage that secures it. The maker of the note (the mortgagor) is the party most concerned with the identity of the person entitled to enforce the note (or the PETE ). The concept is designed to protect the maker against having to pay twice or defend against multiple claims on the note. If the maker pays the PETE in full, the maker is discharged and the mortgage that secures the note is extinguished.

5 TRANSFER BY THE MORTGAGEE 5 By contrast, the owner of the note is the person ultimately entitled to its economic value. Thus, the owner of the note is the person who can claim the payments, including regular installment payments, a voluntary payoff, and the proceeds of a short sale or a foreclosure. PETE status and ownership of the note are not necessarily synonymous. A person need not be the owner of a note to be the PETE, and one can be the owner of a note without being the PETE. See Permanent Editorial Board for the Uniform Commercial Code, Application of the Uniform Commercial Code to Selected Issues Relating to Mortgage Notes (Nov. 14, 2011) ( PEB Report ); U.C.C ( A person may be a person entitled to enforce the instrument even though the person is not the owner of the instrument.... ). This is so because, PETE status and ownership are governed by two separate legal regimes that establish different criteria. Transfers of ownership of notes (either outright sale transfers or transfers of security interests) are governed by UCC Article 9. U.C.C (a)(3) (Article 9 applies to a sale of... promissory notes ), regardless of whether the notes are negotiable instruments or nonnegotiable instruments. By contrast, PETE status and the transfer of PETE status is governed by UCC Article 3 if the note is negotiable, but by the common law of contracts if the note is nonnegotiable. (All references to UCC Article 3 in these materials are to Revised Article 3 (1990)). In the mortgage context, one obvious application of the distinction between ownership and PETE status is that the servicer of a mortgage in a securitized mortgage pool might well be the PETE (assuming it meets the requirements of applicable law), but the trustee of the securitization trust (as the owner of the note) would be entitled to have the proceeds of the enforcement action remitted to it. For example, suppose that Fannie Mae purchased a mortgage loan and placed it into a securitization pool, but that ABC Bank is servicing the loan for Fannie Mae. If the mortgagor goes into default and foreclosure is necessary, Fannie Mae can deliver the note to ABC Bank (the servicer) so that the servicer can foreclose, and that foreclosure may even occur in the name of the servicer. Yet the proceeds of the foreclosure sale obviously flow, under the servicing agreement, back to Fannie Mae. In other words, Fannie Mae remains the owner of the note while its servicer, ABC Bank, is the PETE. See, e.g., Giles v. Wells Fargo Bank, N.A., 519 Fed.Appx. 576 (11th Cir. 2013); In re Veal, 450 B.R. 897 (9th Cir. B.A.P. 2011). B. Transferring Ownership As noted above, UCC Article 9 governs transfers of ownership of promissory notes (including those secured by real estate mortgages). A note an instrument in the lexicon of Article 9. See U.C.C (a)(47) ( instrument is a negotiable instrument or any other writing that evidences a right to the payment of a monetary obligation... and is of a type that in ordinary course of business is transferred by delivery with any necessary endorsement or assignment ). Thus, Article 9 governs the transfer of ownership interests in both negotiable and nonnegotiable notes. Unfortunately for our purposes, Article 9 is written in the terminology of creation of security interests in collateral. The Code then (rather obliquely) defines security

6 6 CHAPTER IVII interest to include transfers of ownership; under 1 201(b)(35), security interest includes an interest of a buyer of... a promissory note. This peculiarity makes Article 9 s wording confusing and difficult to follow as applied to outright sales of notes. To avoid this problem, we have rewritten 9 203(b), the section dealing with creation of security interests, as though it were solely about sales of notes. As so rewritten, 9 203(b) reads in pertinent part: [A] [sale of an interest in a promissory note] is enforceable against the [seller] and third parties with respect to the [note] only if: (1) value has been given; (2) the [seller] has rights in the [note] or the power to transfer rights in the [note] to a [buyer]; and (3) one of the following conditions is met: (A) the [seller] has authenticated a [sale]... agreement that provides a description of the [note]... ; [or] (B) the [note] is in the possession of the [buyer] under Section pursuant to the [seller s] agreement. Thus, assuming the seller has rights in the note (or is an agent of someone who has such rights), and assuming the buyer gives value, ownership can be transferred in either of two ways: (1) by a signed, written agreement (or its electronic equivalent), such as a contract of sale or a written assignment, or (2) by delivering possession of the note to the buyer, provided that there is some agreement (though not necessarily written or signed) indicating that ownership is to be transferred. A sale of ownership rights in the note automatically transfers the corresponding ownership rights the real estate mortgage securing that note. See U.C.C (g). This means that whoever is entitled to the economic benefits of the note is entitled to the economic benefits of the mortgage as well. C. Transferring Entitlement to Enforce (or PETE Status) Under UCC Article 3, a note may either be negotiable or nonnegotiable. Article 3 says nothing at all about nonnegotiable notes; thus, their enforcement is left to the common law of contracts. There is little modern case law concerning their transfer, perhaps because courts tend to assume (often without analysis) that the notes before them are negotiable. 1. Negotiable Notes If a note is negotiable, then under U.C.C , there are only three permissible ways in which one can acquire PETE status: Becoming a holder. This will occur if the note has been delivered to and is in the possession of the person enforcing it, with an appropriate endorsement. The endorsement may be in blank, which makes the note a bearer note, or it may be a special endorsement that specifically identifies the person to whom the note is delivered. U.C.C These actions will constitute the person who takes the note a holder, entitling him or her to enforce the note.

7 TRANSFER BY THE MORTGAGEE 7 Becoming a nonholder who has the rights of a holder. This will occur if the note has been delivered to and is in the possession of the person seeking to enforce it, but without a proper endorsement. Absent a proper endorsement, the person taking delivery of the note cannot be a holder, but can still get the right of enforcement if he or she can prove that the delivery occurred for the purpose of transferring the right to enforce the note. See, e.g., U.S. Bank, N.A. v. Squadron VCD, LLC, 504 Fed.Appx. 30 (2d Cir. 2012). Providing a lost note affidavit. Under U.C.C , a person who is not a holder (or a nonholder who has the rights of a holder) may still enforce it if they can provide a lost note affidavit. The requirements for the affidavit are quite strict: o o The person providing the affidavit must have been in possession of the note (and the PETE) at the time the note was lost; The loss of possession must not have been the result of a transfer by the person or a lawful seizure of the note; and o The note must have been destroyed, its whereabouts not discoverable, or it must be in the wrongful possession of an unknown person or one who cannot be found or served. Before accepting such an affidavit, a court might well demand evidence as to efforts made to locate the note. In addition, the court can require the enforcing party to provide assurance (typically in the form of a bond or indemnity) against the possibility that the borrower will have to pay twice. The 2002 amendments to Article 3 allow a person to enforce a note by providing a lost note affidavit if he or she has directly or indirectly acquired ownership of the instrument from a person who was entitled to enforce the instrument when loss of possession occurred. U.C.C (a)(1)(B) (2002). However, because the 2002 amendments to Article 3 have been adopted in only twelve states, a secondary market purchaser may be unable to use the lost note procedure if it purchased a note that was lost or destroyed by its predecessor. For the transferee to become a holder or a nonholder with the rights of a holder, the note must be physically transferred into the hands of the person seeking to enforce it. The parties can use a separate document of assignment, but it cannot substitute for delivery of the note. See, e.g., Bank of New York Mellon v. Deane, 41 Misc.3d 494, 970 N.Y.S.2d 427 (2013); State St. Bank & Trust Co. v. Lord, 851 So.2d 790 (Fla.Ct.App.2003). If the delivery is accompanied by a proper endorsement of the note, the transfer is known as a negotiation, U.C.C (a), and the transferee (if otherwise qualified) may become a holder in due course, as discussed in the next section. 2. Nonnegotiable Notes By contrast, if a note is nonnegotiable, the right to enforce it can be transferred by assignment. This may occur by (1) endorsement on the note by the original

8 8 CHAPTER IVII payee-mortgagee; (2) execution by the payee-mortgagee of a separate document stating that rights under the note are transferred to the assignee; or (3) an oral statement to the assignee that a transfer is being made. See, e.g., In re Stralem, 303 A.D.2d 120, 758 N.Y.S.2d 345 (2003) (no particular words necessary to effect assignment; test is whether the assignor intended to transfer some present interest ). To assign a nonnegotiable note, it is not strictly necessary that possession of the note itself be given to the transferee, although a delivery of possession will almost certainly transfer the right to enforce the note. See, e.g., YYY Corp. v. Gazda, 761 A.2d 395 (N.H.2000). A question sometimes arises whether the right to enforce a nonnegotiable mortgage note can be transferred by an assignment of the mortgage securing the debt. If the document assigning the mortgage states that the note or debt is being transferred, an effective transfer of the note occurs. If the document assigning the mortgage is silent, courts have split as to whether the document implicitly assigns the note as well. Some courts treat the assignment as ineffective. See, e.g., Homecomings Financial, LLC v. Guldi, 108 A.3d 506, 969 N.Y.S.2d 470 (2013); Wells Fargo Bank, N.A. v. Heath, 280 P.3d 328 (Okla.2012). Others hold that assignment of the mortgage implicitly assigns the obligation absent proof that the parties had a contrary intent, and the Restatement takes this view. Restatement (Third) of Property: Mortgages 5.4(b) (1997); Reinagel v. Deutsche Bank Nat l Trust Co., 735 F.3d 220 (5th Cir. 2013). 3. Can an Assignee Other than a PETE Foreclose Nonjudicially? Because UCC Article 3 has been enacted in all American states and it imposes uniform rules for transferring the right to enforce a negotiable note one would expect nonjudicial foreclosures (discussed in further detail in Chapter ) to operate under the same concepts as judicial foreclosure with respect to the question of who can initiate foreclosure. For negotiable notes, a person seeking to foreclose should not be able to do so unless that person is a PETE. See Nelson, Whitman, Burkhart & Freyermuth, Real Estate Finance Law 5.28, at 387 (6th ed. 2015). Nevertheless, eight states (AL, AZ, CA, GA, ID, MN, MI, and TX) have construed their nonjudicial foreclosure statutes to disregard Article 3 s requirements, and have held that the foreclosing party need not demonstrate the right to enforce the note. Some courts have reached this result by reasoning (wrongly) that nonjudicial foreclosure is not a method of enforcing the promissory note, See, e.g., Reardean v. CitiMortgage, Inc., 2011 WL (W.D. Tex. 2011). Other courts have reasoned that the state s nonjudicial foreclosure statute provides comprehensive rules for conducting nonjudicial foreclosures that supersede Article 3. See, e.g., Debrunner v. Deutsche Bank Nat l Trust Co., 204 Cal.App.4th 433, 138 Cal.Rptr.3d 830 (2012). These decisions are poorly reasoned and fail to acknowledge the role that PETE status plays in protecting the borrower against the risk of double enforcement. See Whitman & Milner, Foreclosing on Nothing: The Curious Problem of the Deed of Trust Foreclosure Without Entitlement to

9 TRANSFER BY THE MORTGAGEE 9 Enforce the Note, 66 Ark.L.Rev. 21 (2013); Nelson, Whitman, Burkhart & Freyermuth, Real Estate Finance Law 5.28, at 389 (6th ed. 2015). Fortunately, numerous other states have recognized the correct approach that the party seeking nonjudicial foreclosure must be a PETE and must provide some evidence of that fact, typically in the form of an affidavit. See, e.g., Ark. Code Ann (2) (notice initiating foreclosure must include a true copy of the note with all required indorsements, the name of the holder, and the physical location of the original note). D. Assignment of the Note and Mortgage for Security Purposes Mortgagees often obtain loans by pledging their notes and mortgages as collateral for the loans. In essence, what results might be termed a mortgage on a note and mortgage. Sometimes an individual mortgagee may borrow money by pledging a single note and mortgage as security. More commonly, a mortgage banker will obtain short-term commercial financing from a bank (often called a warehouse line of credit or warehouse loan) by delivering a package of notes and mortgages to the bank as collateral. When the mortgage banker finds permanent purchasers for those notes and mortgages on the secondary market, it will often pay off the warehouse loan, take back possession of the notes and mortgages from the warehouse lender, and deliver them to the permanent purchasers. Consistent with the rules discussed above (and for additional reasons discussed below), a prudent warehouse lender would have the notes properly indorsed and would take possession of the notes. [Where the notes are negotiable, this would place the warehouse lender in the position of a PETE should the mortgage banker default on the warehouse loan.] Often, however, the package of loans is delivered to the warehouse lender with no formal assignment or endorsements. Sometimes, no physical delivery at all takes place, and the mortgage banker simply designates itself as custodian for the warehouse lender. As discussed below, this is a particularly risky procedure. 1. The Application of UCC Article 9 to Transfers of Mortgage Notes as Security As discussed above, a transfer of a promissory note will automatically assign the mortgage that secures the note; no separate assignment is necessary (although it may well be desirable for the reasons in Section of this Chapter). This is equally true of a transfer as security as it is of an outright transfer by sale of the note. When a mortgage note is assigned as security, however, the assignee must also take care to accomplish perfection of the assignee s security interest. Perfection of security interests in promissory notes ( instruments ) is governed by UCC Article 9. As the drafters of Revised Article 9 stated: The security interest in the promissory note is covered by this Article even though the note is secured by a real-property mortgage. Also [the creditor s] security interest in the note gives [the creditor] an attached security interest in the mortgage lien that secures the note.... One cannot obtain a

10 10 CHAPTER IVII security interest in a lien, such as a mortgage on real property, that is not also coupled with an equally effective security interest in the secured obligation. [U.C.C , Comment 7.] Perfection under Article 9 is critically important in two distinct contexts: Assume that the original mortgagee, having transferred the note as security to an assignee, later experiences financial distress and gives another security interest in the same note to another creditor. [This is termed double-pledging the note, and it occurs more frequently than it should.] Which security interest would have priority? In other words, which assignee would be entitled to collect the payments made on the note? The original assignee has priority over the later assignee only if its security interest in the note is perfected and was perfected before the later assignee perfected its interest. See U.C.C (a)(1) ( Conflicting perfected security interests... rank according to priority in time of filing or perfection. ); U.C.C (a)(2) ( A perfected security interest... has priority over a conflicting unperfected security interest.... ). Assume that the original mortgagee, having transferred the note as security to an assignee, becomes insolvent and files bankruptcy. A trustee in bankruptcy has the strong-arm power, under 544(a) of the Bankruptcy Code, which gives the trustee that status of a judgment lien creditor of the bankrupt as of the date of bankruptcy. Acting under this power, the trustee might claim the note as against the first assignee. See U.C.C (a)(2)(A) (security interest is subordinate to judgment lien that arose before security interest was perfected). If the assignee had not taken steps to perfect its security interest before the bankruptcy petition, the trustee can avoid (invalidate) the assignee s unperfected security interest under 544(a). This would permit the bankruptcy trustee to collect the payments on the note and use those payments for expenses of bankruptcy and payment of unsecured creditors. If the assignee properly perfects its security interest in the note, Revised Article 9 makes it clear that the assignee is also perfected as to the mortgage. See U.C.C (g) ( Perfection of a security interest in a right to payment or performance also perfects a security interest in a lien on personal or real property securing the right, notwithstanding other law to the contrary. ). Thus, if the assignee has properly perfected its interest in the note, the assignee does not have to record a mortgage assignment in the real property records to perfect as to the real estate collateral. 2. How Is Perfection Accomplished? UCC Article 9 characterizes a promissory note (whether it is negotiable or not) as an instrument, and it provides two distinct methods of perfecting security interests in instruments:

11 TRANSFER BY THE MORTGAGEE 11 The assignee may perfect by taking possession of the original note. This is the safest method. U.C.C (a). Incidentally (but very importantly), taking possession really does require the physical moving of the note. The courts are very disinclined to accept anything less than a manual transfer of possession to the secured partyassignee. For example, it is most unwise for the assignee to leave the note in the hands of the mortgagee-assignor as the assignee s trustee, nominee, agent, or the like. See, e.g., Prime Financial Servs. LLC v. Vinton, 761 N.W.2d 694 (Mich.Ct.App.2008) ( A debtor cannot qualify as the agent for a secured party for purposes of taking possession of collateral because the continued possession by the debtor establishes the opportunity for fraud. ); In re Executive Growth Investments, Inc., 40 B.R. 417 (Bankr.C.D.Cal.1984). The assignee may perfect by filing a financing statement (a UCC 1 form), typically with the Secretary of State s office. U.C.C (a). 3. Which Method of Perfection Should Be Used? Financings secured by mortgage notes and other consumer notes are often for short periods of time and involve large numbers of notes. Transferring physical possession of the notes to the creditor and back again can be burdensome, and notes can become lost or mislaid. Filing a financing statement is obviously much easier, because a single filing can cover a large number of notes, can be accomplished electronically in most states, and costs only a small fee. For this reason, Article 9 permits the assignee of a mortgage note to perfect its interest by filing a financing statement. Nevertheless, perfection by filing is second-rate perfection, because it can be trumped if the debtor later gives actual possession of the notes to a different creditor who gave value and did not know about the first assignment. See U.C.C (d) ( [A] purchaser of an instrument has priority over a security interest in the instrument perfected by a method other than possession if the purchaser gives value and takes possession of the instrument in good faith and without knowledge that the purchase violates the rights of the secured party. ). Filing a financing statement is sufficient to protect the assignee against a subsequent trustee in bankruptcy of the assignor-mortgagee. However, it quite clearly cannot protect the assignee in the double-pledging case, if a second assignee gets possession of the note and does not know about the first assignment. The fact that the first assignee filed a financing statement is simply irrelevant; the filing imparts no constructive notice to the second assignee, who (because he or she is taking possession of an instrument ) need not do a UCC search for prior conflicting interests in the note. 4. How Does a Security Assignee Realize on the Security? Assume that Bank has taken and perfected a security interest in a note and mortgage as collateral for a debt owed by Mortgagee. Now assume that Mortgagee defaults on that debt. How does Bank realize (or in mortgage

12 12 CHAPTER IVII parlance, foreclose) on the note and mortgage? Article 9 offers three basic methods: Bank can place the mortgage loan on the secondary mortgage market and sell it to another investor. This is known as disposition of the collateral; U.C.C (a). Such a sale can be a private sale (not an auction) as long as the sale is commercially reasonable in all respects. U.C.C (b). Bank must give appropriate pre-sale notice to Mortgagee and others entitled to such notice, as outlined in U.C.C to Note carefully that this is not a foreclosure of the underlying mortgage, and it is not necessary to conduct an auctiontype sale, as is typically used for mortgage foreclosures. Bank can step into Mortgagee s shoes and notify Mortgagor to make all further payments to Bank. Bank can then enforce the obligations of Mortgagor by all means that would have been available to Mortgagee, including a foreclosure of the mortgage or a suit on the note. This is known as collection of the underlying obligation. U.C.C (a). Bank can accept (and assume ownership) of the underlying note and mortgage in full or partial satisfaction of Mortgagee s debt. This is known as acceptance. See U.C.C [As a practical matter, it differs little from the collection method discussed above.] Whichever method Bank uses, it is very convenient for Bank to be able to memorialize its actions in the public real estate records. For example, if Bank uses the collection remedy and subsequently finds it necessary to foreclose the underlying mortgage, in many states it will be necessary for Bank to be able to establish a chain of ownership of the mortgage by recorded documents. To accomplish this, U.C.C allows Bank to record a transfer statement reciting that Mortgagee defaulted to Bank, that Bank exercised its post-default remedies with respect to the underlying note and mortgage, and that a transferee (which may be the creditor, or in the case of a disposition, a third party) has acquired the rights of Mortgagee in the note and mortgage. Thus, the transfer statement can fill the gap in the chain of title to the mortgage. E. Rights and Obligations of the Assignee Relative to the Mortgagor 1. Qualifying as a Holder in Due Course (HDC) Holder in Due Course (HDC) status confers significant benefits on an assignee of a note and mortgage, and is highly sought after. The assignee can achieve HDC status only by satisfying two requirements: (1) the promissory note itself must be a negotiable instrument and (2) the process by which the note is transferred must be a proper negotiation. See Nelson, Whitman, Burkhart & Freyermuth, Real Estate Finance Law 5.29 (6th ed.2015).

13 TRANSFER BY THE MORTGAGEE 13 a. Negotiability Negotiability requirements are governed by U.C.C (a) and are fairly complex. The basic requirements for negotiability include the following. The note must contain the maker s unconditional promise to pay a fixed amount of money (with or without interest) on demand or at a definite time It must be payable to order or bearer. It may not state any other undertaking or instruction to do any act in addition to the payment of money (with certain exceptions mentioned below). Because of the prohibition on including other undertakings, it is risky to include in the note a clause generally incorporating the terms of the mortgage by reference. See Resolution Trust Corp. v Partners, Ltd., 796 F.Supp. 238 (N.D.Tex.1992). Such an incorporation clause may result in reading into the note conditions or additional promises contained in the mortgage that will destroy the note s negotiability. See, e.g., Guniganti v. Kalvakuntla, 346 S.W.3d 242 (Tex.Ct.App.2011) (note incorporating guaranty agreement by reference was nonnegotiable) However, under U.C.C (a)(3), certain specific references to the mortgage in the note are permitted and will not impair its negotiability: Example 1: Example 2: The note may include an undertaking or power to give, maintain, or protect collateral. For example, it may state that it is secured by a mortgage on real estate, and may include or incorporate mortgage provisions dealing with protection of the real estate, such as payment of taxes and insurance premiums and avoidance of waste. The note may incorporate by reference specific provisions of the mortgage dealing with prepayment and acceleration rights, because these provisions simply define the amount of money to be paid. For example, a statement in the note referring to a due-onsale clause in the mortgage is permissible. In re Knigge, 479 B.R. 500 (8th Cir. B.A.P. 2012). The note may include authority for the holder of the note to confess judgment and to dispose of the collateral, and it may include a waiver by the maker of any law intended to protect him or her. R executed a promise to build a driveway across Blackacre for E s benefit. The promise was secured by a mortgage on Blackacre. Result: the promise is not a negotiable note because it does not contain a promise to pay a fixed amount of money. A $25,000 promissory note payable to Safety Savings and Loan Association is secured by a first mortgage on

14 14 CHAPTER IVII Example 3: Blackacre. In addition to the usual terms, the note also contains a covenant by the maker (mortgagor) to purchase certain additional real estate from the mortgagee. Result: The note is not a negotiable note because the promise to purchase additional real estate is not among the promises permitted in a negotiable note under U.C.C (1)(b). First Bank extends a line of credit, up to $1 million, to Bob Borrower. Bob s note promises to repay $1 million, or so much thereof as Bob has borrowed from time to time. Result: The note is not a negotiable note because the promise is not to pay a fixed amount of money. Yin v. Society Nat l Bank, 665 N.E.2d 58 (Ind.Ct.App.1996). Example 4: Lender requires Borrower to sign a note which imposes a covenant that mortgagor shall use this real estate only as his personal residence. Result: The note is not a negotiable note because it contains an additional undertaking besides the promise to pay, and the undertaking does not relate to giving, maintaining, or protecting the collateral. See Insurance Agency Managers v. Gonzales, 578 S.W.2d 803 (Tex.Ct.App.1979)). Consider the following types of notes that are sometimes used in real estate transactions: Under the pre-1990 version of Article 3, courts held that a note that provided for an adjustable rate of interest (an ARM or adjustable rate mortgage) was non-negotiable because it did not provide for payment of a sum certain. See Northern Trust Co. v. E.T. Clancy Export Corp., 612 F.Supp. 712 (N.D.Ill.1985); Taylor v. Roeder, 360 S.E.2d 191 (Va.1987). The 1990 version of the UCC reversed this view, and ARM notes can now be negotiable (assuming they otherwise satisfy the other standards for negotiability). See U.C.C (b) ( The amount or rate of interest may be stated or described in the instrument in any manner and may require reference to information not contained in the instrument. ); In re McFadden, 471 B.R. 136 (Bankr. D. S.C. 2012). Under the pre-1990 version of Article 3, a non-recourse note (one that imposed no personal liability on the debtor, and permitted collection only out of the real estate) was considered nonnegotiable because it was not an unconditional promise to pay. However, revised Article 3 reversed this rule, providing that a note is not considered conditional because payment is limited to resort to a particular fund or source. U.C.C ((b)(ii).

15 TRANSFER BY THE MORTGAGEE 15 b. Negotiation To constitute a proper negotiation, a promissory note must be transferred by indorsement (if the note is payable to an identified person, as is almost always the case with notes secured by real estate) and delivery of possession of the original note. U.C.C The delivery must be of the original note; a photocopy will not do. One indorses a promissory note in much the same fashion as a check. An indorsement normally will consist of language similar to the following on the back of the note: Pay to the order of Fannie Mae. [Signature of payee/transferor ] If there is not enough space to write the indorsement on the note, it can be written on a separate piece of paper (called an allonge ) which is affixed to the note and made a part of it. U.C.C (a). But if the allonge is not firmly affixed, as by stapling or pasting, a court may well disregard it. See JP Morgan Chase Bank, N.A. v. Murray, 63 A.3d 1258 (Pa.Super.Ct.2013) (loose allonge did not suffice as indorsement); Adams v. Madison Realty & Dev., Inc., 853 F.2d 163 (3d Cir.1988) (placing allonge in same file folder with note did not suffice as proper indorsement). c. Taking in Due Course For the transferee to hold in due course under U.C.C , the note must not be obviously forged, altered, irregular or incomplete. The assignee must take it for value, in good faith, and without notice that it is overdue or has been dishonored it (or another note in the same series) is in default in payment it contains an unauthorized signature or has been altered someone else has a claim to it, or the maker or someone else has a defense or a claim in recoupment to it. Normally courts treat the good faith and notice requirements as much the same thing: one who has notice of a defect cannot take in good faith. The notice requirement is satisfied if the assignee has either actual knowledge or reason to know of the problem In other words, a person cannot be willfully ignorant of information of which an ordinary person would have become aware. Nelson, Whitman, Burkhart & Freyermuth, Real Estate Finance Law 5.29, at 407 (6th Cir. 2015). By contrast, constructive notice from filings in the public records will not deprive a holder of HDC status. U.C.C (b). Example 1: Payee sold a promissory note and mortgage to Assignee. Payee properly indorsed the note, but the note contained evidence of erasure and modification of the note language

16 16 CHAPTER IVII stating the due date. In fact, the note was overdue. Result: Assignee will be held to have knowledge of the note s contents, including the discrepancies described above, and cannot be a HDC. Example 2: Payee was an aluminum siding contractor who obtained a note and mortgage from Homeowner as payment for siding installation. Payee indorsed and sold the note and mortgage to Finance Company. Homeowner later refused to pay the note, claiming that Payee had defrauded Homeowner by lying about the quality of the siding. Result: If Finance Company had a long course of dealing with Payee and knew of Payee s general practice of defrauding his customers, the court may hold that Finance Company lacked good faith and is not a HDC, even though Finance Company had no specific knowledge of the fraud in this transaction. United States Fin. Co. v. Jones, 229 So.2d 495 (Ala.1969)). See generally Nelson, Whitman, Burkhart & Freyermuth, Real Estate Finance Law 5.29, at (6th ed. 2015) (discussing close-connectedness doctrine ). 2. The Rights of an Assignee Who Is a HDC a. Personal Defenses A HDC takes free of certain of the defenses against collection or foreclosure that the maker (mortgagor) of the note could have used against the original holder-mortgagee. These defenses are called personal defenses and include: failure or lack of consideration, breach of warranty, unconscionability and garden variety fraud (fraud in the inducement). Nelson, Whitman, Burkhart & Freyermuth, Real Estate Finance Law 5.31, at (6th ed. 2015). Example: Mortgagor hired Mortgagee to construct a shell house on Blackacre. To finance the construction, Mortgagor executed and delivered to Mortgagee a promissory note for $9,700 secured by a mortgage on Blackacre. Mortgagee assigned the note and mortgage to Assignee, a HDC. After making installment payments for four years, Mortgagor defaulted and Assignee filed an action to foreclose. Mortgagor defended by attempting to prove that the actual value of the shell house was greatly less than the purchase price. Result: Assignee prevails. Mortgagor s defense is inadequacy of consideration, which may not be raised against a HDC. Such a defense will be ineffective both in a suit on the note and in a mortgage foreclosure action. See Colburn v. Mid-State Homes, Inc., 266 So.2d 865 (Ala.1972).

17 TRANSFER BY THE MORTGAGEE 17 b. Real Defenses A HDC takes subject to certain defenses known as real defenses. These are described in UCC 3 305(a)(1): infancy, to the extent that it is a defense to a simple contract duress, lack of legal capacity, or illegality of the transaction which nullifies the maker s obligation fraud that induced the party to sign the instrument with neither knowledge nor reasonable opportunity to obtain knowledge of its character or its essential terms (usually called fraud in the execution or fraud in the factum ) discharge in insolvency proceedings. Example: Waterproofing, Inc. persuaded Frank, an elderly man with no close relatives, that the basement in Frank s home needed waterproofing to protect against serious structural problems. Frank was only partially sighted and showed some evidence of senility. Frank paid $2,000 in cash of the $7,000 waterproofing charge and, as maker-mortgagor, executed and delivered to Waterproofing, Inc. as mortgagee a $5,000 promissory note secured by a mortgage on his house. Frank did not know that he had mortgaged his house; rather Waterproofing, Inc. told him that he had signed an unsecured promissory note. Waterproofing, Inc. then sold the note and mortgage to Third Federal Savings and Loan, a HDC. Shortly thereafter the sole shareholder of Waterproofing, Inc. skipped town and Frank obtained no waterproofing service at all. Frank refused to make any payments on the promissory note, and Third Federal initiated a foreclosure action on the mortgage on Frank s house. Result: The foreclosure action against Frank should be dismissed. Even though Third Federal is a HDC, Frank s physical and mental infirmities, Waterproofing, Inc. s affirmative misrepresentations as to the character of the instruments, and Frank s inability to discover their true character are sufficient to give Frank a real defense, such as fraud in the execution or incapacity. 3. Non-HDC Status An assignee of the mortgagee s interest can lack HDC status for one of three reasons. First, the note itself may be non-negotiable. Second, the transfer in which the assignee obtained the note may not have sufficed as a negotiation. Third, even if the note is negotiable and was negotiated, it may have been obviously irregular or the assignee may not have taken it for value, in good faith and without notice. However, even a non-hdc is not necessarily subject to all defenses; as explained below, the non-hdc may still be free of defenses based on latent equities.

18 18 CHAPTER IVII a. The Patent-Latent Equity Distinction The term equities, as used in this context, means that someone has a claim to the real estate or the promissory note, or a defense to enforcement of the note and mortgage. If the maker-mortgagor can assert the claim or defense, it is a patent equity. If a third party is raising the claim or defense, it is commonly called a latent equity. One can think of two distinct categories of latent equities those in which the third party has a claim to the real estate, and those in which the third party has a claim to the promissory note or other secured obligation. The examples below illustrate these two types of latent equities. Example 1: Trustee held title to Blackacre subject to a trust agreement for the benefit of Beneficiary. However, the trust agreement was not recorded and from the recorded documents it appeared that Trustee held title in his personal capacity. Trustee executed a mortgage on Blackacre to Mortgagee in violation of the terms of the trust, which stated that Beneficiary s consent was required for any mortgage. Beneficiary s defense to foreclosure of the mortgage resides in a third party and is a latent equity. (See Scott, Trusts 284 (Fratcher ed. 1989)). Example 2: Mort holds a note and mortgage on Blackacre, Mort indorses the note in blank and delivers the note and the mortgage to Abe. Abe inadvertently loses the note, and Frank finds it. Frank later transfers the note to George. Subsequently, Abe discovers that George has the note and sues George for its return. The claim to ownership of the note is by a third party (Abe) and is a latent equity. b. Raising Patent Equity Against Transferee The mortgagor may raise a patent equity against an assignee to the same extent that the mortgagor could have raised it against the original mortgagee. U.C.C (a)(2) (holders who are not HDCs are subject to any defense that would be available if the person entitled to enforce the instrument were enforcing a right to payment under a simple contract ). c. Estoppel Certificates An assignee of a note and mortgagee who believes that HDC status may be lacking often quite wisely insists on obtaining an estoppel certificate from the maker-mortgagor before taking the assignment. In this document, the maker-mortgagor states that the note is valid and that it is not subject to defenses by the maker-mortgagor. Such a certificate is actually more powerful and valuable to an assignee than the HDC doctrine, because it protects the assignee against the maker-mortgagor s assertion of both real and personal defenses. However, estoppel certificates only protect the

19 TRANSFER BY THE MORTGAGEE 19 assignee against patent equities. The maker-mortgagor s certificate cannot, of course, create an estoppel as to third party claims (latent equities). d. Raising Latent Equities Against Transferee As mentioned above, U.C.C (a)(2) allows the assertion of simple contract defenses against non-hdcs. In effect, the UCC adopts state case law in this situation. In general, state law here is favorable to good faith purchasers for value; thus, the transferee of the note who pays value and has no notice of the latent equity will usually be held to take free of it, whether it is a claim of title to the land or a claim of ownership of the note. This is the better result, because the transferee of the note has no way to discover such claims. If the note is negotiable, U.C.C may govern. It provides that a person having rights of a holder in due course takes free of the claim to the instrument. Thus, if the transferee is a holder in due course, the UCC produces the same result as the common law described in the previous paragraph. Consider the two examples on the preceding page. U.C.C would have no bearing on Example 1, because it involves a claim to the land rather than the note. However, in Example 2, which involves a claim to the note, would mandate that George would prevail if George is a holder in due course. It might appear that the common law and U.C.C are duplicative in this context, but that is not quite so. The reason is that, in a sense, it is easier to be a holder in due course (a UCC concept) than a good faith purchaser for value (a common law concept). In general, constructive notice is irrelevant to HDC status; only actual knowledge counts. Thus, mere constructive notice of a claim or defense derived from the recordation of a document in the public land records will not preclude the holder of a negotiable note from establishing HDC status. The same is true of constructive notice arising from the identity of someone in possession of the real estate. By contrast, either type of constructive notice can prevent one from being a BFP. 4. Limitations on the Holder in Due Course Doctrine The HDC doctrine has been subject to special criticism when it shields assignees from defenses that relate to the quality of consumer products purchased in credit transactions. In the real estate setting, the consumer is usually someone who gives a note secured by a mortgage on his or her home to a home improvement contractor. In the past four decades courts, legislatures and regulatory bodies have imposed substantial limitations on the HDC doctrine in a wide variety of consumer lending contexts. a. The Close-Connectedness Concept Some courts hold that HDC status may be denied to an assignee of a negotiable note who is too closely connected to the original payee. Based on closeness alone, a court may impute to the assignee notice of a defense or

20 20 CHAPTER IVII lack of good faith even though there is no direct evidence to establish the knowledge otherwise required to deny HDC status to the assignee. The standards for finding a close connection are somewhat elastic. One wellknown opinion expressed them as follows: When it appears from the totality of the arrangements between [seller] and financer that the financer has had a substantial voice in setting standards for the underlying transaction, or has approved the standards established by the [seller], and has agreed to take all or a predetermined or substantial quantity of the negotiable paper which is backed by such standards, the financer should be considered a participant in the original transaction and therefore not entitled to holder in due course status. Unico v. Owen, 232 A.2d 405 (N.J.1967). b. Legislation and Other Regulation 1) The Uniform Consumer Credit Code While many state legislatures have modified the HDC protection in a variety of consumer lending contexts, the most significant state legislation limiting or modifying the HDC doctrine is contained in the Uniform Consumer Credit Code (UCCC) which, in either its 1968 or 1974 version, has been enacted in at least 12 states. This legislation is extremely complex and subject to variation in many of the adopting states. In general, it abolishes HDC status for many assignees of vendor home improvement mortgages (usually junior liens) and a limited class of first mortgages as well. If the original note and mortgage run to a third party lender (a consumer loan ) and the debtor is able to establish a close connection between the provider of goods and services and the third party lender, both the lender and subsequent assignees are subject to all claims... arising from that sale although only to the extent of the amount owing to the lender when he receives notice of the claim. See Nelson, Whitman, Burkhart & Freyermuth, Real Estate Finance Law 5.30 (6th ed.2015). 2) The Federal Trade Commission Rule Under a rule adopted by the Federal Trade Commission in 1975 (entitled Preservation of Consumer s Claims and Defenses ), it is an unfair trade practice for certain sellers of goods and services to finance a sale without including in the debt instrument specific ten-point-type bold-face language that makes the holder subject to the maker s claims and defenses. See 16 C.F.R Loans originated by third party lenders to finance sales of consumer goods and services are covered by the above requirement if a very broad close-connection test is satisfied. Close connection exists if the seller of goods or services refers consumers to the lender or is affiliated with that lender by common control, contract or business arrangement. See 16 C.F.R (d).