016 ch07 transfer by the...

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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)

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G. Participations

1. Rights of the Participants After Default 2. Lead Lender Misconduct 3. Lead Lender Bankruptcy

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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. 1186 (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

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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.


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. § 3–301 (“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. § 9–109(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. § 9–102(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

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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 9–313 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. § 9–203(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. § 3–301, 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. § 3–201. These actions will constitute the person who takes the note a “holder,” entitling him or her to enforce the note.


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. § 3–309, 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 The person providing the affidavit must have been in possession of the note (and the PETE) at the time the note was lost;

o 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. § 3–309(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. § 3–201(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

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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 3268307 (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


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. § 18–50–103(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

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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. § 9–109, 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. § 9–322(a)(1) (“Conflicting perfected security interests . . . rank according to priority in time of filing or perfection.”); U.C.C. § 9–322(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. § 9–317(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. § 9–308(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:


The assignee may perfect by taking possession of the original note. This is the safest method. U.C.C. § 9–313(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 party-assignee. 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. § 9–312(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. § 9–330(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

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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. § 9–610(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. § 9–610(b). Bank must give appropriate pre-sale notice to Mortgagee and others entitled to such notice, as outlined in U.C.C. §§ 9–611 to 9–614. Note carefully that this is not a foreclosure of the underlying mortgage, and it is not necessary to conduct an auction-type 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. § 9–607(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. § 9–620. [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. § 9–619 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).


a. Negotiability

Negotiability requirements are governed by U.C.C. § 3–104(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. 1601 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. § 3–104(a)(3), certain specific references to the mortgage in the note are permitted and will not impair its negotiability:

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-on-sale 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.

Example 1: 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.”

Example 2: A $25,000 promissory note payable to Safety Savings and Loan Association is secured by a first mortgage on

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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. § 3–104(1)(b).

Example 3: 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. § 3–112(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 non-negotiable 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. § 3–106((b)(ii).


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. § 3–201.

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. § 3–204(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. § 3–302, 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. § 3–302(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

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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 409–410 (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 424–425 (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).


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”.

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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. § 3–305(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


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. § 3–305(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. § 3–306 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. § 3–306 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, § 3–306 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. § 3–306 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

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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 well-known 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. § 433.1–.2. 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. § 433.1(d).


The FTC Rule applies only to natural persons who purchase goods or services for personal, family or household use in amounts of $25,000 or less. Real estate mortgages are affected by the rule only if they secure payment for such goods or services. Thus, for example, the FTC Rule applies to a $15,000 note and mortgage given to a home improvement contractor as a result of the latter having built an addition to the maker-mortgagor’s house. By contrast, the FTC Rule does not apply to real estate mortgages arising from sales of interests in real estate, whether the mortgagee is the vendor or a third party. Consequently, the typical purchase money real estate mortgage, whatever its lien priority status, is unaffected by the FTC Rule.

3) Predatory Lending Under HOEPA

Congress enacted the Home Ownership and Equity Protection Act of 1994 (“HOEPA”) to provide protections for consumers entering into highly disadvantageous (often termed “predatory”) home mortgage loans. HOEPA originally did not apply to purchase-money mortgages or home equity loans, but the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010 expanded HOEPA to encompass such loans if secured by the borrower’s principal dwelling. Loans are covered by HOEPA if they meet any of the following criteria:

The annual percentage rate (APR) exceeds the applicable average prime rate by more than 6.5 percentage points (for most first-lien mortgages) or by more than 8.5 percentage points (for first-lien mortgages under $50,000 on manufactured homes or for junior lien mortgages);

The transaction’s points and fees exceed 5% of the total transaction amount or, for loans below $20,000, the lesser of 8% of the total transaction amount or $1,000 (with the dollar figures adjusted annually for inflation); or

The credit transaction documents permit the creditor to charge or collect prepayment fees more than 36 months after the transaction closing, or permit such fees (in the aggregate) to exceed more than 2% of the amount prepaid.

If a loan is covered by HOEPA, and if the loan is assigned, the HDC doctrine will not apply (i.e., the assignee will take the loan subject to personal defenses) unless the assignee can demonstrate that a reasonable person could not have determined that the loan in question was covered by HOEPA. 15 U.S.C.A. § 1641(d)(1).

5. Payment to Assignor as a Defense

After the original mortgagee assigns the note and mortgage, to whom should the maker-mortgagor make payments? Obviously, if the assignee notifies the mortgagor of the assignment, and the mortgagor nevertheless makes payments to the original mortgagee, the mortgagor cannot raise those payments as a

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defense to an action by assignee to collect the debt or to foreclose the mortgage. The following material, however, focuses on the situation where no notice of the assignment is given and the mortgagor innocently continues to make mortgage payments to the original mortgagee. All references below are to the 1990 version of UCC Article 3. See generally Nelson, Whitman, Burkhart & Freyermuth, Real Estate Finance Law § 5.33 (6th ed.2015).

a. Negotiable Notes

U.C.C. § 3–602 provides that a negotiable note is paid, and the payor is discharged, “to the extent that payment is made . . . to a person entitled to enforce the instrument” (the “PETE,” as discussed above). The PETE includes a holder to whom the note has been negotiated, U.C.C. § 3–301, and any person to whom the note is delivered for the purpose of giving the right of enforcement, even if that person is not a holder, U.C.C. § 3–203(a), (b). For example, a transfer by delivery of the note without an indorsement will not constitute the transferee a holder, but the transferee is still a PETE if the delivery was made for the purpose of transferring the right to enforce the note.

Why is payment to the actual possessor of the note necessary to discharge it?

[A negotiable] instrument is a reified right to payment. The right is represented by the instrument itself. The right to payment is transferred by delivery of possession of the instrument “by a person other than its issuer for the purpose of giving to the person receiving delivery the right to enforce the instrument.” [U.C.C. § 3–203 Comment 1.]

These UCC sections are widely understood to vest the power to discharge the obligation exclusively in the PETE, even though the Code does not expressly so state. Hence, if the original payee has delivered possession of a negotiable note to another person for the purpose of transferring the right of enforcement, payment to the original payee is not recognized as discharging the obligation. The payment does not “count” against the assignee. This is true whether or not the assignee is a HDC and is true even if the payor has received no notice of the assignment.

Example: Mortgagor made 40 monthly installment payments of $450 each to Mortgagee on a mortgage whose balance was $45,000 after the 40th payment was made. After the latter payment, Mortgagee assigned the note and mortgage to Assignee, who took possession of the note but did not notify Mortgagor of the transfer. Mortgagor thereafter made ten more monthly installment payments to Mortgagee. Assignee then declared the mortgage in default, accelerated the debt and commenced foreclosure. Mortgagor defended on the ground that acceleration and foreclosure were improper because no default existed. Result: Foreclosure is permissible. The ten


monthly payments made to Mortgagee after the assignment cannot be credited to the amount of principal and interest due and owing on the debt. Black v. Adrian, 80 S.W.3d 909 (Mo.Ct.App.2002); Groover v. Peters, 202 S.E.2d 413 (Ga.1973).

This result has been widely criticized in the context of notes secured by mortgages. It is obviously unrealistic for a mortgagor to demand to see the note itself before making each installment payment to the original mortgagee. Yet in principle, the UCC would require precisely that sort of vigilance by mortgagors. See Whitman, Reforming the Law: The Payment Rule as a Paradigm, 1998 B.Y.U. L. Rev. 1169 (1998). In 2002, the Permanent Editorial Board for the UCC proposed changes to U.C.C. § 3–602 to overturn this result and make payment to the original mortgagee binding until notice of the assignment is provided to the mortgagor. As yet, however, these changes have been enacted in only twelve states.

Fortunately, in practice mortgagors are rarely harmed by this rule. This is because today most institutional purchasers of mortgages on the secondary market designate the original mortgagee as agent to service (collect payments on) the loan. Payment to the mortgagee under such circumstances constitutes valid payment to the assignee. If the secondary market assignee wishes to assign the servicing to some other agent, or to assume direct servicing of the loan, it will routinely notify the mortgagor of that fact, and federal law requires such notice. Hence, the real risks to mortgagors from the “reified right to payment” theory usually arise in the context of non-professional mortgagees and assignees.

b. Nonnegotiable Notes

If the note is nonnegotiable, the provisions of UCC Article 3 do not apply. There is, however, some case authority for the same result, at least in the context of a final payoff of the note. See Assets Realization Co. v. Clark, 98 N.E. 457 (N.Y.1912); Johnstone v. Mills, 22 B.R. 753 (Bankr.W.D.Wash.1982). However, the better rule is that the assignee of a nonnegotiable note takes subject to all payments made to the assignor before the mortgagor received notice of the assignment. Taylor v. Roeder, 360 S.E.2d 191 (Va.1987); Restatement (Third) of Property: Mortgages § 5.5 (1997).

Example: Same facts as in the previous example, except that the note is nonnegotiable. Result: Foreclosure is impermissible. Payment to Mortgagee after the assignment constituted valid payment of the mortgage debt because no notice of the assignment was given to Mortgagor. Thus no grounds for acceleration and foreclosure exist. In re Kennedy Mortgage Co., 17 B.R. 957 (Bankr.D.N.J.1982) (dictum); contra, but finding the payment effective on an estoppel theory, Rodgers v. Seattle-First Nat’l Bank, 697 P.2d 1009 (Wash.Ct.App.1985).

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A few cases and statutes provide that the recording of a mortgage assignment constitutes constructive notice of it to the mortgagor. See, e.g., EMC Mortg. Corp. v. Chaudhri, 946 A.2d 578 (N.J.App.Div.2008). This is a minority view and represents a completely unrealistic approach. Few, if any, mortgagors routinely search the public records prior to making their mortgage payments, and the burden of doing so would be immense. As a practical matter, statutes and cases taking this approach remove the protection that maker-mortgagors of nonnegotiable notes would otherwise expect and have.

F. Impact of Recording Acts

1. Need for Recording of Mortgage Assignment

As between the parties to the assignment of a mortgage note, it is irrelevant whether the assignee records an assignment of the mortgage. As explained earlier, no assignment of the mortgage is even necessary, because the mortgage follows the note automatically. Thus, even if the assignee does not record an assignment of the mortgage, the assignment is effective as against the assignor or holders of other interests in the mortgaged real estate. See, e.g., In re Cook, 457 F.2d 561 (6th Cir. 2006); In re Knigge, 479 B.R. 500 (8th Cir. B.A.P. 2012); Aurora Loan Services, LLC v. Taylor, 25 N.Y.3d 355 (2015).

Example: Mortgagor grants Mortgagee a mortgage on Blackacre. Later, Mortgagee assigns the mortgage note to Assignee. Mortgagee prepares and delivers to Assignee an assignment of the mortgage, but Assignee does not record it. Later, Mortgagor files a bankruptcy petition, and the bankruptcy trustee brings an action to invalidate the mortgage lien based on Assignee’s failure to record an assignment of the mortgage. Result: The trustee’s action will fail. Although bankruptcy gives the trustee the status of a bona fide purchaser of Blackacre, 11 U.S.C.A. § 544(a)(3), this status does not permit the trustee to claim title to Blackacre free of the mortgage, which Mortgagee duly recorded. Assignee’s priority as against the trustee is not affected by Assignee’s failure to record the assignment. See, e.g., In re Patton, 314 B.R. 826 (Bankr.D.Kan.2004).

There are roughly ten states in which the assignee cannot foreclose using nonjudicial foreclosure unless the assignee can demonstrate a recorded chain of assignments from the original mortgagee. It is not obvious what important policy is served by this requirement, as the existence of a recorded mortgage assignment is no proof that the foreclosing party is a person entitled to enforce the note (PETE). Nevertheless, in these states, while the assignee need not record an assignment of the mortgage for the assignment to be effective, recording would be required as a prerequisite to nonjudicial foreclosure. See Nelson, Whitman, Burkhart & Freyermuth, Real Estate Finance Law § 5.34, at 457 (6th ed. 2015).


2. Effect of Recording the Mortgage Assignment and Payment on the Mortgage Debt

As noted above, it makes little sense to suggest that the recording of a mortgage assignment gives constructive notice of the assignment to a mortgagor who is continuing to make payments to the original mortgagee because the mortgagor has not received notice of the assignment. Suppose, however, the mortgagor sells the real estate to a grantee after the mortgage assignment has been recorded. Here, it makes excellent sense to hold that the recordation of the assignment provides constructive notice of the assignment to the grantee, and the weight of authority so holds. The reason is that the grantee is expected to search the public records anyway to determine whether the mortgagor’s title is satisfactory. Hence, holding the grantee to notice of the recorded assignment imposes no additional burden on grantee at all, and thus grantee could not satisfy the remaining debt by payment to the original mortgagee. Consequently, recording an assignment of the mortgage saves the assignee of a nonnegotiable note the trouble of giving actual notice to someone who may subsequently buy the land.

Example 1: Rogers borrows money from Eaton and gives Eaton a nonnegotiable note secured by a mortgage. Eaton assigns the note and mortgage to Able, who records the assignment but does not notify Rogers that he now holds the note and mortgage. Result: If Rogers now pays Eaton the balance due on the loan, the better view considers the mortgage to be satisfied. The recordation of the assignment has no effect on Rogers.

Example 2: Same facts as Example 1, but now assume that Rogers sells the real estate to Grant, and Grant purports to pay off the loan to Eaton. Grant’s payment will not be effective to discharge the mortgage as against Able. Because Grant had reason to search the records at the time he bought the land, he should have discovered that Eaton had assigned the mortgage to Able. See In re Kennedy Mortgage Co., 17 B.R. 957, 965 n. 5 (Bankr.D.N.J.1982).

Note that if the note is negotiable, the above rule is superfluous because (as noted above) present UCC Article 3 provides that a payment to anyone other than the possessor of a negotiable note (or the authorized agent of the possessor) is ineffective.

3. Wrongful Satisfaction of the Mortgage by the Original Mortgagee

While the assignment of a mortgage note would be legally effective even if the assignee does not record an assignment of the mortgage, there are good reasons why the assignee may choose to record such an assignment. One reason is to protect against the consequences of a fraudulent release of the mortgage by the original mortgagee. If the assignee fails to record an assignment of the mortgage before the original mortgagee records a release of the mortgage, and the mortgagor later conveys the land to a grantee who is a bona fide purchaser for

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value, the grantee will take the land free and clear of the mortgage even if the assignee never received payment of the mortgage debt.

Example: Rogers borrows money from Eaton and gives Eaton a note secured by a recorded mortgage. Eaton indorses the note and assigns the mortgage to Able, who does not record the assignment. Later, Rogers and Eaton collude; Eaton (who has no legal right to do so) releases the mortgage on the public record, and Rogers sells the land, purportedly free and clear of the mortgage, to Grant, a good faith purchaser for value. Rogers and Eaton split their ill-gotten gains and disappear. Result: Grant takes the land free of the mortgage lien under the recording act. In re Beaulac, 298 B.R. 31 (Bankr. D. Mass. 2003); Brenner v. Neu, 170 N.E.2d 897 (Ill. Ct. App. 1960).

This result follows even if the note is negotiable and the assignee is a HDC. This situation presents a conflict between the UCC and the law of negotiability on the one hand and the real estate recording system on the other. The result reflects ultimate victory for the innocent land buyer who relies on the public records. See Nelson, Whitman, Burkhart & Freyermuth, Real Estate Finance Law § 5.34, at 446–447 (6th ed.2015). If the note in question is nonnegotiable, it is all the more clear that the BFP grantee of the land will prevail, as there is then no competing UCC policy to weigh against the recording act argument made by the grantee.

4. Recording as a Means of Gaining Notice of Litigation

There is another important reason that recording an assignment is useful to the assignee: it will ensure that the assignee will receive notice of any litigation that might affect the real estate or the validity of the mortgage. Such litigation might include a housing, building, or zoning code enforcement proceeding; an eminent domain action; or a suit to force cleanup of hazardous waste on the land. Litigation might also raise a question about the expected priority of the mortgage. Obviously, it is in the best interest of the assignee to learn about (and potentially to participate in) such litigation. If the party filing the action cannot find the mortgage assignment by means of a title examination, because it has not been recorded, then notice or service of process will go only to the original mortgagee (who may or may not inform the assignee of the litigation).

5. Wrongful Satisfaction by a Trustee Under a Deed of Trust

A trustee under a deed of trust has two alternative functions. One is to reconvey the land to the mortgagor if the mortgagor pays off the mortgage debt. The other is to foreclose if there is a default in payment of that debt. When the original beneficiary (mortgagee) assigns the note, the trustee normally is not replaced. Consequently, potential subsequent grantees are entitled to assume that the trustee is acting in accordance with the noteholder’s instructions when reconveying the land to the mortgagor.


Example: Blackacre (which was worth $50,000 free and clear of liens) was owned by Rogers, subject to a deed of trust that was security for Rogers’s $25,000 indebtedness to Eaton. Eaton then sold the note that represented that indebtedness to Able, who promptly recorded the assignment. Rogers and Trump, the trustee under the deed of trust, then carried out the following scheme without Able’s knowledge. Trump recorded a release of the deed of trust. Rogers then conveyed Blackacre to Grant, who paid $50,000 in cash to Rogers (who in turn paid part of it to Trump as compensation for Trump’s disloyal service to Eaton). Grant was at all times unaware of the scheming of Rogers and Trump. Able, after discovering what had happened, sought a judicial declaration that her note was still secured by a deed of trust on Blackacre. Result: Grant owns Blackacre free and clear of the deed of trust. Grant is entitled to rely on the release by Trump, notwithstanding Grant’s notice of the assignment.

6. Mortgage Electronic Registration System (MERS)

With the expansion of securitization, it has become common for mortgage loans to be assigned multiple times on the secondary market. For secondary market investors who take seriously the implicit obligation to record mortgage assignments (to gain the benefits discussed above), the increased number of transfers has created a substantial administrative and record-keeping burden. If each transfer was accompanied by a written assignment of the mortgage, and the recording of each assignment, a chain of transfers could result in nontrivial costs for attorney fees and recording fees.

In the mid-1990s, Fannie Mae, Freddie Mac, and major lenders and trade associations founded the Mortgage Electronic Registration System (MERS) to address this problem. MERS functions to hold mortgages of record as a nominee for the person who holds the mortgage note. If a residential mortgage lender is a member of MERS, then when that lender makes a mortgage loan, it either names MERS as the original mortgagee, or it assigns the mortgage to MERS immediately after origination. When the originating mortgagee later transfers the loan on the secondary market to another member of MERS, there is no need to prepare and record an assignment of the mortgage—MERS simply continues to be the record holder of the mortgage, but now as the nominee for the assignee rather than the original mortgagee. MERS maintains a database of note holders and servicers, and a borrower can query this database to determine who holds and who services his or her mortgage loan. Under the MERS system, MERS is always the mortgage holder as shown in the local public records, and thus someone searching the public records would need to consult MERS’s own records to determine who actually holds the loan. If a suit is filed that affects a MERS mortgage or the real estate it covers, MERS (as the mortgagee of record) is served with process, and it in turn notifies the actual holder of the note.

MERS does not hold or take possession of the promissory notes (except in the case of electronic notes). Its responsibility is exclusively to hold the mortgages

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as nominee for the note holders. In most cases, no further assignment of the mortgage is ever recorded by MERS, unless the note is transferred to a non-MERS member or an assignment is made to the servicer in preparation for foreclosure.

MERS served its function relatively smoothly until the mortgage crisis began in 2007. In the ensuing years, foreclosure defense lawyers launched a tide of litigation attacking numerous aspects of the MERS system. Among the issues they raised were the following:

Is MERS a “real party in interest” or otherwise entitled to notice of suits or administrative actions that might affect the interests of mortgagees?

As a “nominee” for the mortgage holder, does MERS have authority to execute assignments or (in states using deeds of trust) to appoint substitute trustees?

Does MERS have standing to foreclose mortgages in its own name? [In 2011, MERS ceased allowing members to bring foreclosuring proceedings in the name of MERS, but prior to 2011, this practice caused remarkable controversy, with critics appropriately noting that lenders were seeking to foreclose on homeowners without taking the public relations “hit” of doing it in their own names.]

Is MERS wrongfully depriving local recorders of the revenue they would earn if mortgage assignments were still being recorded locally?

Does placing the mortgage in the name of MERS, when MERS is not the holder or beneficial owner of the note, improperly separate the note from the mortgage and thus make the mortgage unenforceable?

Are assignments by MERS valid, given the fact that they are typically executed by employees of the secondary market participants, who serve as nominal (and unpaid) officers of MERS? [There were also many attacks on the technical aspects of these assignments, often alleging them to be “robosigned.”]

Most of the attacks on MERS were flimsy in terms of legal credibility, and MERS prevailed in court most of the time. See, e.g., Culhane v. Aurora Loan Servs. of Nebraska, 708 F.3d 282 (1st Cir. 2013) (upholding assignment by MERS); Woods v. Wells Fargo Bank, N.A., 733 F.3d 349 (1st Cir. 2013) (assignment of mortgage to MERS did not “split” the note from the mortgage and thus invalidate the mortgage); Brown v. MERS, 738 F.3d 926 (8th Cir. 2013) (MERS did improperly deprive local recording offices of recording fees given that mortgagees have no legal obligation to record mortgage assignments in any event). But defending these attacks became extremely costly, and they took a real toll in terms of MERS’ public reputation, as defaulting borrowers repeatedly claimed on blog posts that “MERS is taking my house.”

Many critics assert that MERS’s records of mortgage ownership are inaccurate. It is difficult to assess the truth of this assertion, but it would not be surprising if it were true. MERS has no real leverage to require its members to report loan


transfers to MERS, and thus it is possible that transfers are not reported. One cannot treat MERS as a correct source of information about the identity of mortgage loan investors and servicers (any more one could hope to rely on the public land records for that information). For this reason, many have suggested that Congress should establish a federal registration system for ownership of mortgage notes. See Whitman, A Proposal for a National Mortgage Registry: MERS Done Right, 78 Mo.L.Rev. 1 (2013). As yet, no such federal system exists.

G. Participations

Sometimes a mortgage lender, rather than selling and assigning a note and mortgage to a single secondary market investor, will sell fractional interests in one or more mortgage loans to multiple investors. This is often referred to as the sale of “participation” interests. The originating or “lead” lender may sell fractional interests in a single large mortgage loan, or may assemble a large portfolio of loans and then sell fractional interests in the portfolio. In either situation, the fractional interests will be evidenced by participation certificates (PCs). The certificates, in turn, will refer to and be governed by a detailed participation agreement. See Nelson, Whitman, Burkhart & Freyermuth, Real Estate Finance Law § 5.35 (6th ed.2015); In re Autostyle Plastics, Inc., 1999 WL 1005647 (W.D.Mich.1999).

Participants sometimes argue (usually after the underlying loans have gone into default) that the lead lender has misled them as to the quality of the underlying loans or the qualifications of the borrowers. See, e.g., Southern Pacific Thrift & Loan Ass’n v. Savings Ass’n Mortg. Co., 82 Cal. Rptr. 2d 874 (Ct.App.1999). In general, the lead lender does not owe a fiduciary duty to the participants. Its liability for misrepresentations is governed by the general law of fraud and the terms of the participation agreement.

1. Rights of the Participants After Default

Where one or more loans go into default almost all courts today, in the absence of a contrary agreement, grant a pro-rata priority among the participants.

Example: E–1 held a mortgage loan with a $400,000 principal balance. E–1 sold a 25% participation interest in the loan to E–2 and later sold a 50% participation interest to E–3. The mortgagor defaulted in payment on the loan, the mortgaged real estate was foreclosed and the foreclosure purchaser paid $300,000. The mortgagor was judgment-proof and thus a deficiency judgment was uncollectible. Result: Unless the participation agreement contains contrary language, each participant’s share of the foreclosure proceeds is determined by multiplying the foreclosure proceeds by that party’s participation percentage. Thus, E–1’s share would be 25% of $300,000 or $75,000, E–2’s share would be the same, and E–3’s share would be 50% of $300,000 or $150,000.

A few early decisions took the position that the participants should not share the proceeds on a pro-rata basis, but that each would be assigned a priority based on the order that such participant received its participation interest. Under this approach in the above example, E–1 received its participation interest first, E–

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2 second, and E–3 last, so the $300,000 would be divided as follows: E–1 would receive its full $100,000 investment; next, E–2 would likewise receive its full $100,000 investment; E–3, being third in priority, would receive the remaining $100,000 (half of its initial investment).

As between the lead lender and the participants, under the better and majority view, absent a guarantee of payment, the participants have no special priority relative to the lead lender. See Domeyer v. O’Connell, 4 N.E.2d 830 (Ill.1936). This rule is consistent with the result reached in the foregoing example. There are a few contrary cases, which follow a variety of approaches. Some hold that the lead lender is a trustee who should not be able to recover from the mortgage security at the other participants’ expense. Others take the position that delivery of the participation interests to each of the participants creates an implied agreement by the lead lender to subordinate its interest to those of the participants. These priority rules are seldom of practical importance today because the participation agreement itself almost always delineates the priorities of the parties in detail, and it is quite common for some participants to be given a higher priority than others or than the lead lender.

2. Lead Lender Misconduct

Because the original loan instruments remain in the lead lender’s hands, there are many opportunities for specific misconduct on its part. For example, the lead lender could reassign or “double-assign” some or all of the notes and mortgages. In theory, it could purport to sell an unlimited number of additional participation interests. It could pledge some or all of the loans to secure new or existing debts. Historically few precautions were taken against such potential misconduct because most institutional lenders had confidence in the integrity of their fellow lenders. In recent decades, well-publicized financial misdealings by major banking institutions have made loan participants reevaluate this lax attitude.

To avoid some of the above problems the participants can insist that the notes be marked so as to provide notice to non-participant third parties that they are subject to the existing rights of participants. While this expedient will be effective in preventing most lead lender misconduct, it will create practical complications. For example, where the portfolio contains numerous loans, it would require that every time a loan is paid off, consent to cancellation of the note would be required of each participant. Hence, this approach is more workable where the participation is in a single large loan.

An alternative method of preventing misdealing by the lead lender is to insist that the original mortgage documents be placed in the hands of an independent trustee or custodian, such as a bank or trust company with no other involvement in the transaction. A detailed set of instructions is necessary to delineate the conditions under which the trustee is to release possession of the mortgage documents. This approach is more practical when the participation is in a portfolio consisting of a large number of small loans.


3. Lead Lender Bankruptcy

If the lead lender goes into bankruptcy, its general creditors or trustee in bankruptcy may claim that the participation arrangement was not sufficient to transfer ownership of the notes to the participants and that the notes therefore remain a part of the lead lender’s bankruptcy estate. Two arguments are sometimes advanced to support this position.

a. Loan of Money by Participants to Lead Lender

According to this argument, the participation really amounts to a loan of money by the participants to the lead lender with the notes and mortgages constituting security for the loan. See In re Coronet Capital Co., 142 B.R. 78 (Bankr.S.D.N.Y.1992). To be insulated from the “strong-arm” powers of the trustee in bankruptcy, it is essential that these security interests in the underlying mortgage loans be perfected under UCC Article 9. However, such perfection can be accomplished only by the filing of a UCC financing statement or by transfer of physical possession of the mortgage notes to the participants or their representative. In re Churchill Mortg. Inv. Corp., 233 B.R. 61 (Bankr.S.D.N.Y.1999). If these steps are not taken, the participants remain vulnerable to attack by the lead lender’s trustee in bankruptcy.

To help avoid this argument, the participation agreement should make it absolutely clear that the transaction is intended to be a sale, not a collateral security arrangement. It is also helpful to transfer possession of the underlying mortgage documents to an independent custodian who represents the participants, as discussed above. With proper precautions, the participation will survive an attack in bankruptcy. See In re Okura & Co. (America), Inc., 249 B.R. 596 (Bankr.S.D.N.Y.2000).

b. Assignment of Mortgage Loan Proceeds

Under this argument, the participants do not receive property interests in the notes themselves but rather only assignments of the loan proceeds. Only the lead lender, as assignor, so this theory goes, has the right to enforce the mortgage notes and thus the participants have no ownership interests.

This argument plainly places form over substance. The lead lender’s capacity to enforce the underlying notes and mortgages is readily explained on the ground that the lead lender is the agent of the participants for that purpose. An equally plausible position is that the lead lender is a trustee for the participants and that therefore the former’s legal title is held for the participants as the beneficial owners of the notes. Either argument ought to be sufficient to withstand attack from the lead lender’s general creditors or claims of its trustee in bankruptcy.

c. Buttressing the Participant’s Position by Drafting

To enhance the participants’ positions, the participation agreement should include the following provisions:

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1. a statement that a transfer of ownership is intended;

2. a disavowal of the idea that the transaction was intended to effect a loan to the lead lender;

3. the lead lender should specifically be designated as either an agent or trustee for the participants and its powers should be spelled out by using agency or trust language; and

4. the interest yield to the participants and the term of the participation should be tied to the yield and terms on the mortgage or mortgages in the portfolio rather than computed on some independent basis. See Nelson, Whitman, Burkhart & Freyermuth, Real Estate Finance Law § 5.35 (6th ed.2015); Came Realty LLC v. DeMaio, 746 N.Y.S.2d 555 (Sup.Ct.2002).

Review Questions

1. T or F The secondary mortgage market refers to lenders who deal in second or junior mortgages.

2. T or F A promissory note secured by a real estate mortgage is non-negotiable if it includes any reference to the mortgage.

3. T or F Able, a dishonest lawyer, persuaded Murray, his client, who had a fourth grade education and virtually no legal or commercial sophistication, to execute a $10,000 negotiable promissory note payable to the order of Able and a mortgage on Blackacre to secure it. Able told Murray that the documents gave Able a power of attorney to deal with personal injury litigation that Able had commenced on Murray’s behalf. Able then sold the note and mortgage to Henrietta, a holder in due course. Murray has a valid defense to any action by Henrietta to collect the note or to foreclose the mortgage.

4. Why would a transferee of a promissory note and mortgage use an estoppel certificate?

5. T or F “Close connectedness” is a judicial doctrine aimed at expanding holder in due course protection to greater number of holders of promissory notes.

6. T or F Murray obtained a mortgage loan from Bank, executing a negotiable promissory note and a mortgage on his office building. Bank later assigned the note to Investor, who qualifies as a holder in due course. Murray, who was not notified of the transfer, continued to make monthly payments to Bank, but Bank did not forward these payments to Investor. The payments made to Bank following the assignment must be credited on the mortgage debt.

7. Suppose the promissory note referred to in last question was non-negotiable. Would your answer be different? Explain.


8. T or F Bank holds possession of a promissory note executed by Mary and secured by a mortgage on Blackacre. Bank assigned the note and mortgage to Assignee, who promptly recorded the assignment. Mary then conveyed Blackacre to Gary, a “subject to” grantee who continued to make mortgage payments to Bank. Assignee does not have to credit against the mortgage debt any payments made by Gary to Bank after Assignee recorded the assignment of the mortgage.

9. T or F Bank holds possession of a negotiable promissory note executed by Mark and secured by a mortgage on Blackacre. Bank assigned the note to Assignee, who is a holder in due course but who did not immediately record an assignment of the mortgage. Bank later mistakenly satisfied the mortgage of record and Mark thereafter sold and conveyed Blackacre to Griffin, who paid full value for Blackacre, had no knowledge of the unrecorded assignment, and immediately recorded his deed. Subsequently, Assignee recorded the assignment of the mortgage. Griffin now owns Blackacre subject to the mortgage.

10. T or F A valid pledge of a promissory note and mortgage to secure a loan to the holder is governed by Article 9 of the UCC.

11. T or F Four lenders, Bank One, Bank Two, Bank Three, and Bank Four, in chronological order, each took a 25% participation interest in a mortgage on Blackacre. The mortgage later went into default at a time when the outstanding balance due was $1,000,000. The mortgage was foreclosed and the sale yielded $500,000. Mortgagor was judgment-proof, so no deficiency judgment was sought against him. The participation agreement was silent on the priority of the parties’ claims to foreclosure proceeds. Thus, Bank One and Bank Two should each receive $250,000 and Bank Three and Bank Four should take nothing.

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