Prior article at The Hallmark Abstract Sentinel: ‘The Foreclosure Process: What a difference a state makes!‘
THE MORTGAGE FOLLOWS THE NOTE . . . . . or Does it?
By Charles Wallshein Esq.
October, 2012, All Rights Reserved
Perhaps most frustrating for attorneys defending securitized mortgage foreclosures is not knowing the identity of the loan’s actual owner. The case caption often reveals the Plaintiff as a large commercial bank acting as the “servicer “or as a large commercial bank acting as “trustee”. Even though the caption purports to identify the plaintiff, in more cases than not, the named plaintiff cannot prove it has an interest in the loan. In most cases the entity that appears as the “lender” on the promissory note is not a party to the action. Over sixty percent of all mortgages in the country situate in securitized mortgage pools.
Standing has become the most widely and most successfully used affirmative defense in securitized mortgage foreclosure cases. Standing is the demonstration that the plaintiff is the proper party entitled to relief. The plaintiff in a foreclosure action must make a prima facie case that it has a legal interest in the underlying indebtedness (promissory note) to the security interest (mortgage). Most simply put, the plaintiff has to either own the note or be an agent of the entity that owns the note.
New York law requires that at the time the foreclosure is commenced the entity foreclosing must own the note.1 New York law also requires that the plaintiff must file its lis pendens twenty days before the entry of its judgment of foreclosure and sale.2 Another requirement is that all mortgages (and assignments of mortgages) being foreclosed must be recorded prior to title to the property being transferred by the referee post-sale.3 This means that besides the plaintiff having to own the note prior to the commencement of the case, the mortgage has to be recorded in that party’s name before the plaintiff can enter a judgment of foreclosure and before the referee can transfer title.
These rules make perfect sense. The party cutting off the fee owner’s right of redemption and all entities with subordinate interests in the property must be identified with constructive notice to the world via the recording statutes. If this were not the case then anyone could foreclose on anyone. Foreclosure defendants could not defend their rights in real property against the proper parties.
“Who owns the note?” This question is asked most often during the modification process prior to the commencement of a foreclosure. Once the foreclosure is commenced defendants can see the plaintiff in the caption and automatically assume the entity named there owns the note. Too often the named plaintiff does not, cannot and has not ever owned the promissory note. In other words, the plaintiff has no standing.
One would think that a careful examination of recorded assignments at the county clerk’s office would reveal the last mortgagee of record and presumably that
assignee would also own the note. After all, what sane or right-minded transferee of a mortgage note would risk its priority position by not diligently recording the security instrument with the county clerk? You would be surprised.
Almost without fail the mortgage is immediately recorded after its creation. The borrower borrows the money and the title insurance company, having insured the priority and validity of the new mortgagee’s position, immediately records the mortgage. It is what happens thereafter that the note owner’s identity becomes murky.
One court eloquently described the rules governing transfer of notes and mortgages as having dual purposes for dual “worlds”.4 One can be seen as protecting competing interests from each other and the other protects fee owners from unlawful attacks or liens on their title. Real property law is a set of rules that ensures that entities with interests in real property know exactly what they have and their position against superior, subordinate and competing interests. Overriding these rules is the ancient rule against any law that restrains the alienation of property. The law has always favored the marketability of title.
The recording statutes were enacted to give the world constructive notice of the existence of liens and encumbrances on title to real property. Lien perfection is the cornerstone principle enabling existing and prospective lien-holders to have notice of each other’s existence for the purposes of determining their respective priority positions. A person who advances money against real property secured by a mortgage should know whether there is a pre-existing lien on the same property. Likewise, a purchaser of real property should know whether the entity he is taking title from has good and clear title to transfer.
Millions of parcels of real property are encumbered by mortgage liens that may be unenforceable yet those liens can never be removed. The culprit is the Residential Mortgage Backed Securities transaction. The RMBS transaction requires multiple transfers of the underlying mortgage notes and a corresponding number of transfers of the security instruments. It has become apparent that these transfers were improperly executed or not executed at all. None of it made any difference and nobody would have noticed until the entities that thought they owned these loans had to foreclose to recapture their investment.
The RMBS transaction changed the incentives mortgage creditors had to, and the manner by which they perfected their interests. It is because of this that we are witnessing the total breakdown of a hundreds–of-years-old system caused by the blind acceptance of a brilliantly devised, logical and lawful transaction that was implemented poorly. It is counterintuitive to think that the multi-trillion dollar mortgage industry would systematically neglect to take steps to properly perfect their interests in real property. However, this is exactly what happened. It is called “securitization failure”.
Securitization failure is just what it sounds like. It is the failure of the note to lawfully vest in the possession of the entity claiming an interest therein. Securitization fail occurs in two ways; first, it is the unlawful transfer of notes to, and unlawful acceptance of notes by, the trust pursuant to the terms of the trust agreement. Second, it is the unlawful transfer of notes pursuant to statute.
The legal arguments are thus framed; is “securitization fail” a sound affirmative defense in mortgage foreclosure proceedings? And if it is, how does one prove it? The answers to these two questions require a basic understanding of the rules governing mortgage and mortgage note transfers in securitized mortgage transactions.
Securitization is the conversion of cash flow from a pool of loans (accounts receivable) into a security like a stock or a bond. An entity is created to collect the principal and interest payments from a pool of mortgage loans and redistribute that income to investors (certificate holders) according to the entity’s governing document. The entity is created as a common law trust under New York’s Estate Powers and Trusts law, as a government sponsored entity (Fannie Mae/Freddie Mac) or as a government guaranteed entity (Ginnie Mae). The trust sells certificates that entitle investors to receive a portion of the trust’s income.
The trust has two main objectives; first, to be insulated from creditors, especially chapter 7 trustees. Second, the trust has to qualify as a tax free pass through in accordance with the internal revenue code so the cash flow from the loans is only taxed once at the investor level and not twice as if it were regular income.5
When financial assets such as accounts receivable or other debts are securitized, parties to the transaction typically attempt to ensure that the assets are “bankruptcy remote.” This means that creditors of the party that originally extended credit cannot reach the financial assets and the assets cannot become part of the originating firm’s estate in the event of a bankruptcy.6 Instead, even with the bankruptcy of the originating firm, the securitized assets of the trust can continue to benefit of the certificate holders. Think of Lehman Bros. and Bear Stearns securitizations. The bankruptcy trustees could not invade the trusts created by Lehman and Bear to reach the assets.
Bankruptcy remoteness is typically concerned with establishing three things; first, the sale of assets is a true sale of the assets; second, the transfer of loans to the trust is not a fraudulent conveyance; and third, the assets in the trust will not be comingled with assets from other entities. In other words the trusts are “closed”.
Typically securitizations have three or four parties in between the originator of the loan and the trust. These intermediaries have no real purpose other than to serve as bona-fide purchasers of the assets. Attorneys for the industry apparently
felt that if there were three bona fide transactions in between the originator of the loan and the trust, creditors of the originator could not attack trust assets.
The loans therefore have to travel a path from originator to seller to depositor to the trust (A to B to C to D). This means that actual possession of the mortgage notes have to pass from originator to seller to depositor to the trust. Eventually the security instrument (mortgage) has to be recorded in the name of the trust to be enforceable against the borrower. A mortgage is an interest in real property a mortgage note is not. To establish race/notice priorities, mortgages and assignments of mortgages must be in writing and recorded. Notes and note transfers do not. To satisfy the statute of frauds, mortgages and assignments of mortgages have to be in writing. Note transfers do not.7
A promissory note by itself can be lawfully transferred by mere delivery. UCC Article 3 defines “a holder in due course” as one who lawfully possesses a negotiable instrument.8 A holder in due course has the presumption that it is the proper party to enforce or negotiate the instrument. UCC Article 9 governs transactions where there is a security instrument attached to the promissory note. If the provisions of Article 9 are not satisfied, a mortgage note that is transferred will not automatically transfer the security interest in the property attached thereto.
UCC §9-203(g) is the codification of the common law maxim “the mortgage follows the note”. New York and every other jurisdiction recognize that a security instrument cannot be enforced independently of ownership of the underlying indebtedness.9 In other words, a person cannot have a security interest in nothing, there has to be an underlying promise to secure against.
The most common affirmative defense in securitized mortgage foreclosures is that the failure to record the assignments of mortgage in each entity’s name in the chain of possession to the note from originator to seller to depositor to trust is fatal to the trust’s foreclosure. It is the norm for assignment of the mortgage directly from the originator, or by MERS as nominee of the originator/lender, to the plaintiff-trust (leaving out the assignment of the mortgage to the seller and from seller to depositor and depositor to trust). Meanwhile plaintiffs argue that lawful delivery of the note from originator to seller to depositor to trust is sufficient to vest standing to foreclose in the plaintiff-trust because the mortgage follows the note.
The securitization industry has relied on both the common law and the codified versions of “the mortgage follows the note” to demonstrate priority of ownership against competing interests in the mortgage AND enforceability of the mortgage in securitized mortgage foreclosures.10 The industry was only half correct.
To demonstrate that lawful delivery of the note obviates the need for every assignment of the security instrument to be in writing the securitization industry uses the “Article 9 argument”. The 2001 amendments to Article 9 include sales of promissory notes, accounts, and payment intangibles, not just classical security
interests. When a promissory note is sold under Article 9, the buyer is the “secured party.”
The terms used for the participants in the Article 9 revisions have their origins in the section’s secured transactions roots. The note-seller is the “debtor,” and the note is the “collateral.” The buyer’s ownership interest in the promissory note is a “security interest.”11
The American Securitization Forum’s12 “Article 9 argument” is as follows:
1. The sale of a promissory note is a grant of a security interest in the promissory note.13
2. A security interest is good against the parties to the transaction when it attaches, and good against the rest of the world when it is perfected.14
3. The buyer’s security interest in a purchased promissory note is perfected as soon as it attaches.15
4. The buyer’s security interest in the mortgage attaches as soon as the interest in the note attaches16
5. and is perfected as soon as the interest in the promissory note is perfected.17
6. While ”the creation and transfer of an interest in or lien on real property” is excluded from Article 9, there is an express exception to this rule.18
In other words, recorded (written) assignments of security interests (mortgage) are irrelevant as long as there is lawful transfer of the underlying promises to pay (mortgage notes).
The ASF’s position is that the UCC takes priority over state real property laws even when note transferees do not record the transfer of the associated assignment of mortgage pursuant to state recording statutes. This may be true as to competing interests in the priority of payments with regard to the mortgagee’s priority against other mortgagees. However, extending this argument to give note purchasers priority against subsequent bona fide purchasers of the real property is absurd.
The Article 9 argument seems to reason that a mortgage note endorsed in blank automatically vests the right of the §9-203(g) “note-owner” or the §3-204 “holder in due course” to elect to enforce the equitable remedy in foreclosure against the mortgagor’s property without ever recording the assignment of the security instrument in the public record.
Any practitioner who has conducted a forensic review of the collateral file associated with a securitized mortgage foreclosure has observed that a majority of note transfers in the A to B to C to D chain are indorsed in blank. As a practical matter the Article 9 argument fails because it reduces the security instrument (the mortgage) to nothing more than a personal check made out to a bearer that endorses it in blank. The party entitled to enforce the mortgage in foreclosure is either a mystery or a secret. In either case the proper party’s identity is not a matter of public record.
1 U.S. Bank v Collymore, 68 AD3d 752 (2nd Dept. 2009).
2 Real Property Law §1331
3 Real Property Law §1353
4 In re SGE Funding Corp., 278 B.R. 653 (Bankr. M.D. Ga. 2001).
5 Internal Revenue Code §860.
6 The End of Mortgage Securitization? Electronic Registration as a Threat to Bankruptcy Remoteness, John Patrick Hunt, Richard Stanton and Nancy Wallace August 10, 2011
7 New York General Obligations Law §5-703.
8 UCC §3-301, §3-302.
9 UCC §9-203((g) Lien securing right to payment. The attachment of a security interest in a right to payment or performance secured by a security interest or other lien on personal or real property is also attachment of a security interest in the security interest, mortgage, or other lien.
10 American Securitization Forum, Transfer and Assignment of Residential Mortgage Loans in the Secondary Mortgage Market [hereinafter ASF White Paper] (Nov. 16, 2010).
11 UCC §9-102(28)(B), (12)(B) & 1-201(35).
12 The American Securitization Forum is the lobbying group that represents the interests of the securitization industry.
13 UCC §9-109(a)(3)
14 UCC §9-308, comment 2.
15 UCC §9-309(4)
18 UCC 9-109(d)(11)(A) “. . . (d) Inapplicability of article. This article does not apply to: (11) the creation or transfer of an interest in or lien on real property, including a lease or rents thereunder, except to the extent that provision is made for: (A) liens on real property in Section 9-203 and 9-308;
Irrespective of the enforceability of bearer paper with attached security instruments in foreclosure, plaintiffs still bear the burden of proof that they actually took title to the mortgage notes in a lawful manner. Even if the mortgage follows the note, the alleged note owner still has the burden of proof that it is the note’s lawful owner.19
In New York a foreclosure plaintiff cannot commence a foreclosure unless it owns the mortgage note and cannot complete its foreclosure until it records the assignment of mortgage in its name. So far, there is no decision in New York that states otherwise. Sooner or later a court of review will be called upon to resolve the apparent conflict between the Real Property Law and the Uniform Commercial Code. If the dicta in MERS v. Romaine is any indication of how the Court of Appeals may still feel about secret ownership of mortgages, proponents of the Article 9 argument will have a lot to think about.
19 UCC §9-203(b)(1), (2) & (3)(A); a security interest is enforceable against the debtor and third parties with respect to the collateral only if: (1) value has been given; (2) the debtor has rights in the collateral or the power to transfer rights in the collateral to a secured party; and (3) one of the following conditions is met: (A) the debtor has authenticated a security agreement that provides a description of the collateral . . .Google+