UCC: possession is not an indication of ownership of the note. Recording of collateral assignments is not required under Revised Article 9. Enforcement of the debt without the note is allowable under Article 3. Equitable arguments are available to prevent a borrower from benefiting from the industry’s inability to keep track of its documents.
by John C. Murray and Dena Cruz
Â© 2003. All rights reserved.
Effective July 1, 2001, the rules regarding interests in promissory notes under the Uniform Commercial Code (“UCC”) dramatically changed. This was done in an attempt to accommodate asset securitization; the asset-based commercial-paper market currently holds $708 billion in assets (up from $517 billion in 1999), and is by far the most rapidly growing segment of the U.S. credit markets.
Former Article 9 of the Uniform Commercial Code classified a promissory note as an instrument, and the sale of an instrument was outside the scope of Article 9. In 2001, revised Article 9 (“Revised Article 9”) of the UCC was enacted into law in every state. Revised Article 9 expressly includes the sale of promissory notes within its scope. See UCC sec. 9-109(a)(3). However, there are some limitations:
1. Sales of promissory notes as part of the business from which they arose;
2. Assignments of promissory notes for collection only; and
3. Assignments of promissory notes to an assignee in satisfaction of indebtedness
These exclusions typically do not effect securitization transactions.
Sec. 109(b) of Revised Article 9 provides (as did Former Article 9) that “[t]he application of this article to a security interest in a secured obligation is not affected by the fact that the obligation is itself secured by a transaction or interest to which this article does not apply.” However, Comment 7 to this section makes clear the views of the drafters that a recorded assignment of a mortgage has no bearing on whether a security interest in the mortgage is created or perfected and that any cases to the contrary are overruled. According to Comment 7, “an attempt to obtain or perfect a security interest in a secured obligation by complying with non-Article 9 law, as by an assignment of record of a real-property mortgage, would be ineffective . . . [O]ne cannot obtain a 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.”
A buyer of an interest in a promissory note should enjoy automatic perfection under Revised Article 9, but should also file a UCC-1 Financing Statement in case the seller/originator’s bankruptcy trustee subsequently alleges that the transaction was really a loan and not a sale. Methods of perfection can create problems for the escrow holder and the borrower/debtor. The method of perfection of a security interest in a promissory note depends on whether the transaction involves a “sale” of that type of property or a “loan” secured by that type of property. To perfect an interest in the note, the buyer/lender should, if the interest is a:
a. “Loan secured by interest in promissory note”: Perfect by possession or filing. See UCC secs. 9-312(a) and 9-313(a). Since possession of the note is not always practical, in many instances filing of a UCC-1 may be only way to perfect. A bona fide purchaser in possession will prime perfection by filing!
b. “True Sale” of an interest in a promissory note: Be aware that neither filing nor possession is necessary or effective to perfect the security interest. Perfection is automatic upon attachment if the “security interest” results from the sale of the promissory note. See UCC sec. 9-309(4). Once perfected, the security interest takes priority over the interest of a subsequent lien creditor and the originator/debtor’s bankruptcy trustee. See UCC sec. 9-317(a)(2); 11 USC sec. 544(a)(1).
In addition, to accommodate the practice of warehouse lending, Revised Article 9 provides that a secured party does not relinquish possession of the mortgage if a mortgage warehouse lender delivers the original note to prospective purchasers. It need only instruct the third party that it is to hold for the benefit of the secured party, and to re-deliver the collateral to the secured party. See UCC sec. 9-313(h), cmt. 9.
Because perfection can be done without filing, and possession of the instrument is not determinative of ownership, and because UCC sec. 9-203(g) states that the mortgage follows the note, the original maker of the note and an escrow holder cannot rely on the public records to determine who owns the note and who can sign a reconveyance or release of the mortgage. Revised Article 9 does not protect the original maker, nor provide advice on how to determine whom to pay. Revised Article 9 simply states that the “issues are determined by real-property law”. The Comments to UCC Sec. 9-109 of Revised Article 9 also state that any attempt to obtain or perfect a security interest in a mortgage by complying with non-Article 9 law (such as recording a collateral assignment of the beneficial interest) would be ineffective. Purchasers of interests in promissory notes and the underlying debtors must rely on representations and the financial stability of originators/sellers to determine who really
owns the interest. See UCC sec. 9-308, cmt. 6.
Some commentators, viewing this phenomenon from the maker/account debtor’s perspective, refer to this set of facts as an “invisible lender scenario” because the debtor under the mortgage-secured note will not be able to ascertain what has occurred through examination of the public records (including who has the right to execute a reconveyance or release of the mortgage).
If the maker of the note cannot determine whom to pay, and recording of a collateral assignment of the beneficial interest is ineffective and not indicative of ownership, failure to rely on the public records by the escrow holder should not be the basis of a breach of fiduciary duty cause of action. Reliance on the public records would be foolhardy and may even be actionable negligence.
As noted above, an absolute assignment of a promissory note carries with it the securing mortgage without the requirement of physical delivery of either the note or mortgage. Attachment of a security interest in a promissory note (which automatically includes the attachment of a security interest in the securing mortgage) requires either a security agreement authenticated by the debtor or possession of the collateral by the secured party pursuant to an agreement. See UCC secs. 9-309(4) and 9-203. Under the “principal/incident” view of the note/mortgage relationship, UCC secs. 9-203(g) and 9-308(e) provide that attachment of a security interest in a promissory note is also attachment of a security interest in a securing mortgage, and the perfection of a security interest in a promissory note is also perfection of a security interest in a securing mortgage.
It should be noted that Revised Article 9 ostensibly makes it easier for a secured party with a security interest in a promissory note to foreclose a mortgage securing the note. After the debtor/mortgagee’s default, the secured party may exercise the debtor/mortgagee’s rights with respect to any property that secures the debtor/mortgagee’s obligations. See U.C.C. sec. 9-607(a)(3).
The secured party does not have to foreclose on the promissory note in order to foreclose on the mortgage. Of course, the secured party cannot foreclose or exercise the debtor/mortgagee’s foreclosure or other remedies unless the debtor/mortgagee is entitled to do so under the mortgage. This raises the possibility that the debtor/mortgagee may not be in default under its obligation to the secured party, but the obligor/mortgagor is in default under its note to the debtor/mortgagee. If the debtor/mortgagee is not in default, the secured party cannot foreclose on the mortgage. (The agreement between the debtor/mortgagee and the secured party should address this situation).
Title insurers may have some concerns with respect to these particular revisions to Article 9. For the secured party to have insurable title following a foreclosure, the secured party will need to have a good chain of title to the mortgage. (In some states, a secured party cannot foreclose unless it has a recorded chain of title). This is why the secured party will usually require that an assignment of the mortgage from the debtor/mortgagee to the secured party be properly recorded in the applicable land records at the time of the grant of the security interest in the note to the secured party. If this has not occurred, the debtor/mortgagee may subsequently be unwilling to cooperate in the secured party’s request for an assignment to assist the secured party (especially if the debtor/mortgagee is in default under the security agreement or other loan documents).
Sec. 9-607(b) of Revised Article 9 provides a way for the secured party to document its interest in the mortgage in the land records without the debtor/mortgagee’s involvement. Under this section, the secured party is authorized to file in the land records a copy of the security agreement and a sworn affidavit, which states that a default has occurred and that the secured party is entitled to foreclose non-judicially. However, some problems exist with respect to this procedure: (1) a conflict may arise with state laws that require an acknowledgment or other conditions to recording a document in the land records (which provisions are usually not found in a security agreement); (2) Neither revised Article 9 nor the Official Comments provide that a memorandum of the security agreement (as opposed to the entire agreement) is sufficient for recording, and there is uncertainty as to whether other loan documents referenced in the security agreement must also be recorded (most
debtor/mortgagees would not want the entire document(s) recorded); (3) a filed security agreement will only (as noted above) establish a chain of title if the debtor named in the security agreement is in fact the mortgagee in the mortgage and the secured party named in the security agreement is the secured party that proposes to foreclose. If there have been further assignments of the note, these further assignments also would have to be documented. See UCC Sec. 9-619 (explaining the transfer statement). As one commentator recently stated, “Title insurance companies presumably will develop underwriting guidelines for determining when a foreclosure by a secured party that has established its chain of title by filing its security agreement is enforceable”; (4) this procedure does not appear to be available in those states that do not permit nonjudicial foreclosure proceedings. See W. Rodney Clement and Baxter Dunaway, “Revised Article 9 and Real Property,” 36 REAL PROP. PROB. &
TR. J. 511 (Fall 2001).
Sec. 9-109(d)(11) of Revised Article 9 continues to exclude from its coverage “the creation or transfer of an interest in or lien on real property,” with certain limited exceptions. This language, but for the exceptions (which don’t affect this analysis), is identical to Former Article 9. However, this language is not entirely accurate because, as noted above, Revised Article 9 does provide for transfers of mortgages (which clearly are “liens on real property”).
If there was intent to transfer a promissory note when an assignment of mortgage was executed, the plaintiff/ lender should prevail. See UCC sec. 3-110(a) (“The person to whom an instrument is initially payable is determined by the intent of the person, whether or not authorized, signing as, or in the name or behalf of, the issuer of the instrument”). Revised Article 9 and Article 3 of the UCC (Negotiable Instruments) allow enforcement when the note has been lost, before or after the transfer to an assignee, or is simply unavailable. See UCC sec. 3-301(iii) (stating that a “Person entitled to enforce” an instrument” includes “a person not in possession of the instrument who is entitled to enforce the instrument pursuant to Section 3-309 or 3-418(d). A person may be a person entitled to enforce the instrument even though the person is not the owner of the instrument or is in wrongful possession of the instrument”). Section 3-109(a) provides that a person not in possession of an
instrument is nonetheless entitled to enforce it if the instrument was destroyed, lost, or is in the wrongful possession of an unknown person. However, under Sec. 3-309(b) the person seeking enforcement, if not the holder of the note, must prove the terms of the instrument and the person’s right to enforcement, and also must provide “adequate protection” (by “any reasonable means”) to the debtor/borrower to prevent the debtor/borrower from paying the same debt twice. If there was no intent to transfer, and the assignee of the mortgage was simply a “servicer”/ agent for the holder of the note (which is common in connection with securitized loan transactions), general agency law may still protect the lender. See also UCC sec. 3-110(c)(2)(ii) (providing that if an instrument is payable to “a person described as agent or similar representative of a named or identified person, the instrument is payable to the represented person, the representative, or a successor of the representative”).
In a recent decision by the South Carolina Court of Appeals, Swindler v. Swindler, 2003 S.C. App. LEXIS 104 (July 7, 2003), the court dealt with an issue involving the interplay between Article 3 and Article 9. While acknowledging that the UCC excludes from its application the creation or transfer of an interest in or lien on real estate, the court held that Article 3 clearly applies to negotiable instruments and that the negotiability of a note is not altered by the execution of a related real estate mortgage. The court noted that Article 3 does not distinguish an unsecured note from a note secured by a real estate mortgage and that Article 9 does not exclude a note secured by a real estate mortgage from the application of Article 3. According to the court, “nothing in Article 9 provides a limitation on the applicability of Article 3 to notes secured by mortgages on real estate.” Id. at *10. The court stated further that, “Article 9 controls over Article 3 only where some conflict
between the applicable provisions of Article 3 and Article 9 exists. Here, no conflict exists because Article 9 does not address the underlying indebtedness of a security interest.” Id. at *11.
To summarize, under the UCC possession is not an indication of ownership of the note. Recording of collateral assignments is not required under Revised Article 9. Enforcement of the debt without the note is allowable under Article 3. Equitable arguments are available to prevent a borrower from benefiting from the industry’s inability to keep track of its documents.
Filed under: CDO, CORRUPTION, Eviction, foreclosure, GTC | Honor, MODIFICATION, Mortgage, securities fraud, Servicer | Tagged: borrower, disclosure, foreclosure defense, foreclosure offense, fraud, Lender Liability, Mortgage, securitization |