Charles Cox 11:18 AM
To: Charles Cox
Dale A. Whitman
Professor of Law Emeritus
University of Missouri-Columbia
A good deal has been written on DIRT recently about transferring to a securitized trust the right to foreclose. Unfortunately, a lot of the commentary has disregarded the relevance of UCC Article 3. I’m going to try to shed some light on it with this post. Those who want to know more can read the famous PEB report of Nov. 2011, officially entitled REPORT OF THE PERMANENT EDITORIAL BOARD FOR THE UNIFORM COMMERCIAL CODE: APPLICATION OF THE UNIFORM COMMERCIAL CODE TO SELECTED ISSUES RELATING TO MORTGAGE NOTES. It’s readily available on line, and really should be read by everyone with an interest in the legal aspects of the secondary mortgage market.
1. Why is the UCC Article 3 relevant?
A mortgage note may be negotiable or nonnegotiable. The definition of negotiability, found in UCC 3-104(a), is complex, and this isn’t the place to go over it in detail. Suffice to say that now about a dozen cases have held that the Fannie-Freddie uniform residential note is negotiable, and not a single case has held the contrary. Commercial mortgage notes are a very different matter. A reasonable rule of thumb (subject, of course, to an analysis of each individual document) is that commercial mortgage notes are usually nonnegotiable and residential notes on the GSE form are negotiable.
Article 3 governs only negotiable notes, but if the note in question is negotiable, Art. 3 in effect preempts the field and supersedes the common law to the extent of any conflict. For purposes of analysis of residential mortgage-backed securitization, Article 3 is the relevant body of law.
2.What is being transferred?
There are two very distinct aspects of a note that can be transferred, and one can’t write or speak intelligibly about “transferring” a note without making clear which aspect one has in mind. The two aspects are (a) the right to enforce the note (often called PETE status, where PETE means the “person entitled to enforce”); and (b) ownership, which refers to the party with the ultimate right to the economic benefits of the note — the proceeds of payment, prepayment, foreclosure, etc. Transferring PETE status is governed by Article 3 if the note is negotiable; transferring ownership is governed by Article 9 (whether the note is negotiable or not).
For purposes of mortgage foreclosure, it is PETE status that is relevant. This fact has become increasingly clear in the past few years; older cases usually betrayed no understanding of the difference between PETE status and ownership, but many recent cases have clarified it, and virtually without exception, they have held that PETE status (and not ownership per se) confers the right to foreclose. The mortgage, of course, follows the note, so that the same party (the PETE) has the right to sue on the note and foreclose the mortgage. It is common for the owner and the PETE to be the same party, but that isn’t necessarily the case. For example, a securitized trustee may deliver the note to its servicer to foreclose; the servicer thus becomes the PETE, while the trustee remains the owner.
For all purposes related the borrower, it is PETE status that counts. If the borrower pays the PETE, the note is discharged. The PETE is the party who can modify or compromise the note, agree to a short sale, take a deed in lieu, or do any other act that affects the borrower’s rights. The borrower, on the other hand, has no legitimate interest in who owns the note. That’s a matter for the secondary market parties — transferors, transferees, and servicers — to work out among themselves. The borrower need only be concerned with identifying the PETE.
3. How is PETE status transferred?
If the note is negotiable, PETE status is transferred by delivery of the original instrument to the transferee. No separate document of assignment of the note is relevant or required. Hence, it’s confusing to refer to such a transfer as an assignment, since that terms seems to suggest a separate piece of paper.
Delivery is the key. The note need not be endorsed, and no allonge is needed. The ultimate question is whether the party trying to enforce the mortgage has possession of the note or not. An endorsement is helpful, but only in an evidentiary sense; if there’s no endorsement, the party in possession of the note may be required to prove that it was delivered for the purpose of transferring the right of enforcement (while, if there is an appropriate endorsement, no such proof is required). But that sort of proof should not be very difficult to adduce. (A party with possession, but without an endorsement, is called “a nonholder with the rights of a holder.”)
There’s only one exception to the requirement of possession of the note. Under UCC 3-309, if the note has been lost or destroyed, a lost note affidavit may be substituted for possession of the note (though the party filing the affidavit may be required to post a bond, give an indemnity, or provide other security against the possibility of double-enforcement of the note). There are many unresolved questions about lost note affidavits, but in an appropriate situation, such an affidavit can provide an alternative to a missing note.
Because of the UCC’s governance of the process of transferring PETE status, discussions about the common law of assignments simply aren’t relevant or helpful in this area. On the other hand, ownership of notes can be transferred, under Article 9, either by a separate document of assignment or by delivery of the notes. Hence, it’s appropriate to talk about assignments with respect to ownership. But as I’ve indicated above, ownership is of no importance to borrowers.
For New York lawyers, it’s significant that NY has not adopted the current version of Article 3. (It’s the only state not to do so.) However, it probably makes little or no difference for purposes of the points I have made here. For an excellent exposition of NY’s version of Art. 3 in this context, reaching essentially the same results as outlined above, see Bank of New York Mellon v. Deane, 2013 WL 3480255 (N.Y.Supreme Ct., July 11, 2013). (The court does such a nice job that I won’t try to embellish it. It takes the Appellate Division to task because of a number of App.Div. opinions that seem to say that the right to enforce a negotiable note can be transferred either by delivery or by a document of assignment. But even under the old version of Article 3, this is wrong, as the Deane opinion points out very effectively.) And NY has adopted the current version of Article 9.
4. How do Articles 3 and 9 interact?
Operationally, Articles 3 and 9 are not difficult to reconcile. They simply deal with different issues. Here’s a simple, straightforward way to think about it:
Article 3 governs transfers of the right to enforce the note; the common law “mortgage follows the note” rule means that, in effect, Article 3 governs transfers of the right to enforce the mortgage as well. (Incidentally, there are a large number of recent cases — cases that do recognize the difference between ownership and the right to enforce — that agree with this statement.)
Article 9 governs transfers of ownership of the note; the common law “mortgage follows the note” rule, which is embodied in 9-203(g), means that, in effect, Article 9 governs transfers of ownership of the mortgage as well.
5. The role of mortgage assignments.
It is crucial to understand that, for purposes of having the right to foreclose, mortgage assignments are completely irrelevant. A mortgage assignment, particularly if it’s recorded, may be beneficial in other ways. For example, it may ensure that the holder of the mortgage will get notice of litigation filed that affects the property or the mortgage. It will also effectively prevent the assignor from illegally discharging or subordinating the mortgage after assigning it, thus preventing a subsequent BFP from taking free of (or gaining priority over) the mortgage. For these reasons, recording a mortgage assignment may be a good idea. But for purposes of foreclosing, a mortgage assignment is entirely unnecessary.
6. Variations in nonjudicial foreclosure states.
The material above is virtually universally followed in judicial foreclosure proceedings in every state. (Maine is arguably an exception, in the sense that its statutes can be read to require a recorded chain of mortgage assignments as a prerequisite to a nonjudicial foreclosure.)
But nonjudicial foreclosures are another matter. There is a sharp split of authority as to whether PETE status is necessary to conduct a nonjudicial foreclosure. California, Arizona, Idaho, Texas, Minnesota, Michigan, and Georgia have held that it is not, based on their interpretation of their nonjudicial foreclosure statutes. On the other hand, the courts in Nevada, Washington, Maryland, North Carolina, and Massachusetts have disagreed, reading their statutes to require PETE status (essentially possession of the note) as a requirement to foreclose. I think the former group of states are wrong, because they fail to read the UCC in pari materia with foreclosure statutes, but there they are. Most of the states in the former group would say that the foreclosing party must have a recorded chain of mortgage (or deed of trust) assignments in order to foreclose, but in some of them it simply isn’t clear what the documentary requirements to foreclose are. Frankly, the nonjudicial foreclosure statutes generally don’t handle this issue well; they were drafted at a time when secondary market sales of mortgages were rare, and their drafters didn’t think this issue through very carefully. Remember, this is exclusively an issue with nonjudicial foreclosure; even in the states where nonjudicial is the predominant mode of foreclosure, one can always qualify to foreclose judicially under the principles outlines in sections 1-4 above.
7. Transfers to securitized trustees.
By now it is clear that in many thousands of cases involving RMBS, notes were not transferred to securitized trustees within the 90-day REMIC window. Failure to do so was an obvious violation of the Pooling and Servicing Agreements, which universally required such transfers. But let’s be more specific: was it PETE status or ownership that was to be required within the 90-day window? In most cases, the PSA spelled out exactly what was to be transferred: usually possession of the notes, often combined with the original mortgages, mortgage assignments, and appropriate endorsements.
As I’ve already pointed out, failure to comply with most of these PSA requirements is irrelevant to the trust’s power to foreclose. It doesn’t matter whether the trust got endorsements or mortgage assignments. But it must get the notes in order foreclose the corresponding mortgages. Must it do so within the 90-day window? There’s no legal reason that it must, provided it gets them before it institutes foreclosure. Yes, a late delivery of the notes is doubtless a violation of the PSA, and that may make the transferor and its predecessors (the sponsor and the depositor) liable to the trust for damages. But if the trust gets the notes before instituting foreclosure, it has the right to foreclose. From the viewpoint of PETE status, the fact that the notes were transferred late is completely irrelevant.
8. The relevance of New York trust law.
Much has been made of the provision of New York Estates, Powers and Trusts Law § 7-2.4, which provides that acts of the trustee not authorized by the terms of the trust (here, the PSA, which is the only trust instrument) are void. Supposedly, this means that if the notes are not delivered within the 90-day window, acceptance of them by the trustee at a later time is unauthorized, the transfers are void, and the trustee can’t foreclose.
On its face, this argument strikes me as absurd. The “void” language of the statute was designed to protect the trust beneficiaries (here, the bond-holders) against unauthorized acts of the trustee. But in the present context, the result of the argument would be to deprive the bond-holders of the power to foreclose the mortgages that their trust has purchased and paid for — a disastrous result for the bond-holders. This has the effect turning the statute on its head, changing it from a protection for the beneficiaries to a weapon used against the beneficiaries. Isn’t it obvious that the courts will ultimately rule that the bond-holders should be deemed to have ratified the trustee’s action (even though performed late)?
I’m suggesting that recent contrary cases, like Erobobo (NY Supreme Court) and Glaski (Cal. Ct. of App.) will not survive. Their conclusion is nonsensical. The likely logic of the contrary viewpoint, which I believe will survive, is found in Calderon v. Bank of America , 2013 WL 1741951 (W.D.Tex. 2013), which adopts the “beneficiary ratification” approach.
9. The REMIC rules.
Int. Rev. Code 860G requires transfer of the loans to the trust within 90 days of the Start Date. The purpose, as everyone agrees, is to ensure that the REMIC is a “static” investment vehicle; that it won’t engage in active trading of its assets once it has gotten started. The actual language, which defines “qualified mortgage,” is that the mortgage must be “transferred to the REMIC on the startup day in exchange for regular or residual interests in the REMIC, [or] (ii) … purchased by the REMIC within the 3-month period beginning on the startup day.”
Fine, but the language leaves a fundamental question unanswered: which aspect of the mortgage notes, ownership or PETE status, must be transferred during the three-month period? (Pretty obviously, Congress had no idea of the difference when it passed the statute in 1986, but it’s still necessary to impute some intent to Congress.) The more plausible interpretation, I would suggest, is that ownership must be transferred. That view of the statute would allow the establishment of the “static pool” that Congress had in mind. Whether the REMIC got the right to enforce or foreclose the mortgages during the 90-day window would be irrelevant; it would have fixed its right to the economic benefits of the pool by getting ownership.
As I mentioned above, ownership is governed by Article 9, which allows transfers either by delivery of the notes or by a separate document of assignment. Moreover, the description of the notes in a document of assignment can be fairly general — no legal descriptions of the land covered by the mortgages would be necessary, for example. Hence, if the executed PSA included an appendix listing the loans to be transferred by the depositor, in all probability Article 9′s requirements (and hence, the REMIC rules) would be satisfied.
I’m not at all sure that this was done in all cases; during the heyday of RMBS securitization, people got very sloppy indeed. But if it was done, I think the IRS would find it to comply with the Code.
Note that we’re talking here only about satisfying the IRS. The REMIC rules are tax rules; if they are not satisfied, the REMIC becomes a taxable entity, with extremely harsh results to the bond-holders (though not as harsh as the nutty argument that the trust can’t enforce the mortgages, of course). Noncompliance with the REMIC rules has no direct relevance at all to the enforceability of the notes or mortgages.
One last observation. The argument that many REMICs violated the REMIC rules has been floating around for at least two or three years now, and yet the IRS has not shown the slightest inclination to pursue it. Why not? One reason is doubtless a desire to avoid the enormous financial impact on the bond-holders that would result from making all non-complying REMICs into tax-paying entities. Another is the fact that the Federal Reserve Board has bought more than a billion dollars (I wasn’t able to find the exact amout) of private-label RMBS. Does anyone think the IRS (which is part of the Treasury) is going to take an action that will destroy a large part of the value of an asset that the Fed has purchased? The idea is nonsensical. No one should spend much energy on the expectation that the IRS is going to start attacking REMICs; it isn’t going to happen.
10. Can we stop the nonsense?
The extent of outrageous misinformation that exists on the internet about this issue is frightening. As lawyers, we need to be more careful. In particular, let’s try harder to make it clear what we mean when we take about “transferring” or “assigning” a note or a mortgage. If we disregard the difference between transferring ownership and transferring PETE status, we run a real risk of writing gibberish.
Charles Wayne Cox
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