Learning from theMortgage Crisis

By Dale A. Whitman

Inmany respects, the mortgagecrisis that began in mid-2007 andcontinues to plague us today has

been a miserable experience. Mil-lions of people have lost their homesand their jobs, and there have beenendless rounds of recrimination andfinger-pointing. But bad news canhave beneficial consequences. Onepositive result of the mortgage cri-sis is that we now know a great dealmore about mortgage law than wedid seven years ago.This might seem strange. After

all, mortgage law has been with usfor centuries, and one might havethought that all of the interestingquestions were answered long ago.Not so. As a result of the litigationspawned by the crisis, and particu-larly the aggressive (though oftenmisplaced) efforts of foreclosure

defense lawyers, we now have amuch clearer picture of numerousimportant mortgage law issues. Theauthor discusses seven of them hereand, in doing so, paints a picture ofwhat we have learned. For a moreextensive discussion of these issues,with more extensive citations, see theauthor's recent Real Property, Trustand Estate Law Journal article. DaleWhitman, What We Have Learned fromthe Mortgage Crisis about TransferringMortgage Loans, 49 Real Prop. Prob. &Tr.J. _ (2014).

rights in a note can be transferred.Articles 3 and 9 of the Uniform Com-mercial Code specify the methods oftransfer, at least when the obligationin question is a promise to pay money.Viewed from the perspective of

the Code, promissory notes (includ-ing those secured by mortgages) havetwo aspects, ownership and entitlementto enforce. It is critical to distinguishbetween them, and a great deal ofmisleading nonsense has been writ-ten because of the failure to do so.uee Article 9 deals with the way

both outright sales and securitytransfers of notes occur. It governsownership of notes, as well as securityinterests in ownership rights. UCC§9-109(a)(3)provides that "thisarticle applies to ... a sale of ...promissory notes." It plainly appliesto all mortgage notes, whether or notthey are negotiable.UCC Article 3, on the other hand,

governs not ownership but" entitle-ment to enforce" a note (often termed

Ownership of the Note andMortgage Must Be

Distinguished from theRight of Enforcement

When we speak of "selling" or "trans-ferring" a mortgage loan, what do wemean? The question is more subtlethan may first appear. The reason isthat the promissory note is the mostsignificant document in a mortgagetransaction, and two distinct sets of

Dale A. Whitman is professor of law anddean emeritus at the University of Missouri-Columbia.

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"PETEstatus," with PETEbeing anacronym for "person entitled toenforce")- the right that mortgageinvestors and their servicers need whenforeclosinga mortgage and that mort-gage borrowers need to know about. Byits terms Article3 governs only nego-tiable notes, because it applies only to"instruments" and uce §3-104(b)statesthat '''[ilnstrument' means a negotiableinstrument." If the note is not nego-tiable, the common law of contractsgoverns transfers of entitlement toenforce.What's the difference between

ownership and the right to enforce?Ownership refers to the economicbenefits of the note and mortgage-who is entitled to the proceeds of avoluntary payoff, a foreclosure sale,or a suit for a deficiency. On the otherhand, entitlement to enforce a notefocuses on the relationship betweenthe maker of the note (the mortgagor,in the case of a mortgage note) andthe person enforcing it. One who isentitled to enforce the note can sueon it or (if other applicable foreclo-sure requirements are met) foreclosethe mortgage that secures it. The bor-rower is most concerned with whois entitled to enforce the note, for theconcept is designed to protect the

c borrower against having to pay twiceor defend against multiple claims onthe note.

Although it is common for own-ership and the right to enforce toreside in the same party, it is alsoentirely possible to separate them. Inthe mortgage context, one obviousexample is that a servicer of a mort-gage might well be given the right toenforce the note (if it met the appli-cable requirements of Article 3), butthe secondary market purchaser, asowner, would be entitled to have theproceeds of the enforcement actionremitted to it. See, e.g., Bank of Amer-ica, N.A. v. Inda, 303 P.3d 696 (Kan.Ct. App. 2013) (finding that Bank ofAmerica as servicer was entitled toenforce note, although it was ownedby Freddie Mac).The distinction between owner-

ship and entitlement to enforce washighlighted in a report by the Perma-nent Editorial Board for the UniformCommercial Code, Application of theUniform Commercial Code to SelectedIssues Relating to Mortgage Notes 4(Nov. 14,2011), available at http:/ /www.uniformlaws.org/Shared/Committees_Materials/PEBUCC/PEB_Report_111411.pdf (often simplytermed the "PEB report"). Before therelease of the PEBreport, it was hardto find any judicial decisions that rec-ognized the distinction, and courtopinions often (and inaccurately)used the terms "ownership" and"right to enforce" interchangeably. It

is important not to fall into this trap.A secondary market purchaser of

a mortgage loan ordinarily wantsand expects to get both ownershipand the right of enforcement. Thatmeans that the transfer must satisfythe requirements of both UCC Article3 (if the note is negotiable) and Arti-cle 9.

The Right to EnforceNegotiable Notes Can

Be TransferredOnly by Delivery

If a note is negotiable, and hence itsright of enforcement is governed byUCC Article 3, that right can be trans-ferred only by delivery of possessionof the original note to the transferee.Because the mortgage follows thenote, delivery of the note is likewiseessential to a transfer of the rightto foreclose the mortgage. The onlyexception to the delivery requirement,found in UCC §3-309, arises if thenote has been lost, destroyed, or isin the possession of someone who isunknown or cannot be found.The exception for missing notes

is ordinarily implemented by filingof a "lost note affidavit." The caselaw, however, conflicts on whethersuch an affidavit can be filed if thenote was not lost by the present partyclaiming the right to enforce it, butinstead by a predecessor. The seminal

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•

case restricting the lost note proce-dure to use by the party that itself lostthe note is Dennis Joslin Co. v. Rob-inson Broad. Corp, 977 F. Supp. 491(D.D.C. 1997). The 2002 amendmentsto Article 3 cleared up this dispute,adopting the rule that one could filean affidavit based on the loss of thenote by one's predecessor in inter-est. Only 12 states have adopted theamendments, however, and in manyof the remaining states the resolutionof the issue remains unclear.There is also uncertainty about

how to use lost note affidavits in thecontext of a nonjudicial foreclosure.Most of the nonjudicial foreclosurestatutes make no reference to suchaffidavits; indeed, only Virginia'sstatute has a satisfactory procedurefor incorporating the affidavits intothe nonjudicial foreclosure process.See Va. Code Ann. § 55-59.1(B).If the note is nonnegotiable, the

methods of transferring the rightof enforcement are more flexible(although there is little recent caseauthority). A transfer might beaccomplished by delivery or by use ofa separate document of assignment.For a negotiable note, on the otherhand, a separate assignment will notwork; unless the note has been lost,there is no substitute for delivery.

Negotiability MattersBecause uee Article 3 governs thetransfer of the right of enforcement ofnegotiable notes, while the commonlaw governs the transfer of nonnegotia-ble notes, it can be critical to determinewhether a particular note is negotiable.Article 3's definition of negotiability isfound in uec §§3-104and 3-106.Thedefinition is subtle and complex, how-ever, and cannot always be appliedwith certainty.Space does not permit a complete

discussion of negotiability here, butone aspect that has been controver-sial is the provision of uec § 3-104(a)(3) that, to be negotiable, the notemust not contain any" other under-taking ... to do any act in additionto the payment of money." For exam-ple, the uniform Fannie Mae-FreddieMac, one-to-four-family mortgagenote contains a provision that if the

40 PROBATE &: PROPERTY. JULy/AUGUST 2014

.:!..

Although the case lawthus far concludes thatthe uniform residentialnote is negotiable, eventhat conclusion must beregarded as tentative

because the matter has notyet been determined bythe highest court ina state or by a federalcircuit court of appeals.

borrower wishes to make a prepay-ment, the borrower has to notify thelender that she or he is doing so. Onemight argue that this notificationrequirement is an "other under-taking," thus making the uniformresidential note nonnegotiable.The New Jersey Appellate Divi-

sion rejected this argument, however,in HSBC Bank USA, N.A. v. Gouda, No.A-1983-09T2, 2010 WL 5128666 (N.J.Super. App. Div. Dec. 17,2010) (notreported in A.3d). Since then, abouta dozen courts have reached thesame result, and none have found theuniform residential note to be nonne-gotiable on this or any other theory.See Kurt Eggert, Not Dead Yet: TheSurprising Survival of Negotiability, 66Ark. L. Rev. 145 (2013). Thus, at thispoint there is a clear consensus thatthe uniform residential note is nego-tiable (and hence governed by ueeArticle 3).Notes used in commercial mort-

gage loans are another matter andfrequently contain language thatmakes them nonnegotiable. Consider,for example, a commercial mortgagenote providing: "All of the terms, def-initions, conditions and covenantsof the Loan Documents are expresslymade a part of this Note by refer-ence in the same manner and withthe same effect as if set forth herein atlength." It is virtually certain that thislanguage violates the terms of uee§ 3-106(a), which disallows negotia-bility if the note states: "(ii) that thepromise ... is subject to or governed

by another record, or (iii) that rightsor obligations with respect to thepromise ... are stated in anotherrecord."The lesson to be learned is that one

cannot assume a note is negotiable.Instead, its terms must be examinedin detail and compared with Article3's definition. Although the case lawthus far concludes that the uniformresidential note is negotiable, eventhat conclusion must be regarded astentative because the matter has notyet been determined by the highestcourt in a state or by a federal circuitcourt of appeals. More litigation islikely in the future on this point.

The Right to Foreclose theMortgage Follows the Right to

Enforce the Note

It is the transfer of the promissorynote that is of critical importance. Ifthe note is properly transferred, themortgage will follow automatically.This principle has been standardAmerican common law for more than200 years; the classic (though not theearliest) case is Carpenter v. Longan, 83U.S. 271 (1872).But now that we understand the

difference between ownership andthe right to enforce the note, we mustask the question, "which of thesesets of rights does the right to fore-close the mortgage follow?" Sevenyears ago, it would have been virtu-ally impossible to find an answer inthe case law, but today it is reason-ably clear: the right to foreclose themortgage follows the right of enforce-ment, not the right of ownership.See, e.g., Edelstein v. Bank of N.Y.Mel-lon, 286 P.3d 249 (Nev. 2012); Bank ofAmerica, N.A. v. Cloutier, 61A.3d 1242(Me. 2013). Whoever has the right toenforce the note also has the right toforeclose the mortgage. This makesperfectly good sense, for foreclosureis simply one way for the holder ofthe note to enforce it.Sometimes people have been con-

fused by uee § 9-203(g), whichprovides that the transfer of "a rightto payment or performance securedby a security interest or other lienon personal or real property is alsoattachment of a security interest in

the security interest, mortgage, orother lien." This provision seemsreminiscent of the common lawprinciple that the mortgage followsthe note, discussed above. But it isemphatically not the same principle.The reason is that Article 9, and spe-cifically uee § 9-203(g), deal withownership. In essence, its message isthat whoever has the economic ben-efits (that is, ownership) of the noteis entitled to the economic benefits ofthe mortgage as well. This does notmilitate against or overlap with thecommon law principles discus edabove.The overall state of the law can

thus be summarized as follows:under the common law, whoe erhas the right to enforce the note canenforce (for e ample, foreclose) themortgage as well. Under uee_ 9-_03(g),whoever is the ownerof the note is also the owner of theproceeds of the foreclosure of themortgage and is entitled to receivethose proceeds.

Note Endorsements Are HelpfulBut Usually Not Essential

If a note is negotiable, and hencethe right to enforce it is governedby uee Article 3, that right must betransferred by delivery of posses-sion of the note, as indicated above. Ifthe note is properly endorsed (eitherin blank, making the note a "bearernote," or specially to the party receiv-ing it), then the party to whom it isdelivered becomes a holder and canenforce the note (and foreclose theassociated mortgage). The endorse-ment may be placed on the note itselfor on an attached piece of papertermed an "allonge."On the other hand, if the note is

delivered without a proper endorse-ment, the person to whom it isdelivered can still become a "non-holder with the rights of a holder,"and if so, can enforce the note andthe mortgage. See uee §3-301.Sucha party has an extra burden of proof,however, that holders do not have:proof that the note was delivered "forthe purpose of giving to the personreceiving delivery the right to enforcethe instrument." See uee §3-203(a).

Thus, a proper endorsement ishelpful to the transferee, because itsimplifies the transferee's burden ofproof. Nonetheless, such proof of thepurpose of the delivery is usuallynot impossible to adduce. It mighttake the form of a servicing contractor (in the case of a securitized loan)a pooling and servicing agreement(PSA).See t.t: Robert Co., Inc. v. Signa-ture Properties, LLe, 71A.3d 492, 503n.l (Conn. 2013). It might be pro-vided by affidavits or certificationsof the note possessor's employees.See Equity Assets II, LLC v. Samay, No.A-0872-12T2,2014WL 183915(N.J.Super. App. Div. Jan. 17,2014). Thelanguage of an accompanying mort-gage assignment might prove thepurpose of delivery of the note if itmakes specific reference to the note.See Wells Fargo Bank, N.A. v. Burek, 81A.3d 330, 332 (Me. 2013).But what-ever method is employed, provingthe purpose of a note delivery (or aseries of deliveries, if there have beenmultiple transfers) is a burden thatno foreclosing party wants to shoul-der. Moreover, if that burden is notdischarged effectively, a party withan unendorsed note cannot enforce itor foreclose its mortgage. It is muchsimpler to have a chain of validendorsements!Proper endorsement provides an

additional advantage: it is essen-tial in order to permit the holder tobe deemed a holder "in due course."Being a holder in due course can be ahelpful status in some cases, becauseit gives the holder immunity fromcertain defenses that the borrowermight wish to raise, such as fraud inthe inducement and failure of consid-eration. Overall, having the transferor

put an endorsement on the note is avery good idea indeed, although it isusually not essential to gaining theright of enforcement.

Mortgage AssignmentsAre Irrelevant to the Rightto Foreclose by Judicial

Proceeding

Because the mortgage follows thenote, no separate assignment of themortgage (recorded or unrecorded)is necessary to transfer it. In all statesexcept Maine (under Me. Rev. Stat.Ann. tit. 14, § 6321)an assignment isnot needed to confer the right of judi-cial foreclosure on the note's holder.See, e.g.,Metlife Home Loans v. Hansen,286 P.3d 1150(Kan.o.App. 2012).Nonjudicial foreclosures may be a dif-ferent story, as we will see below.Despite the irrelevance of mort-

gage assignments to judicialforeclosure, they have two other valu-able purposes. To illustrate the first,assume a mortgage is the subject ofone or more unrecorded assignments.Then a different party-for exam-ple, the holder of another mortgageon the property, whether prior orsubsequent to the one that has beenassigned-institutes litigation thatmay affect the rights of the holderof the assigned mortgage. On whomwill this plaintiff serve process? Ordi-narily, the plaintiff will look in thepublic records, will discover there theidentity of the original mortgagee ofthe assigned mortgage, and will servethat party. Unless the plaintiff hasactual knowledge of the unrecordedassignment, it has no way of know-ing the assignee's identity, and hencethe assignee will not be notified ofthe litigation. Moreover, the original

PROBATE & PROPERTY. JULy/AUGUST 2014 41

mortgagee may disregard the ser-vice of process since it no longer hasany interest in the matter, and mayfail to pass the notice along to theassignee. Nonetheless, the assigneewill almost certainly be held boundby the outcome of the case. See Pin-ney v. Merchants' Nat'l Bank, 72N.E.884 (Ohio 1904).Recording assignments has a sec-

ond important benefit. Supposea mortgage securing a negotiablenote is assigned to a new holderwho does not record the assignment.Then the original mortgagor andmortgagee engage in a bit of skull-duggery. The mortgagor inducesthe mortgagee (quite wrongfully)to execute and record the custom-ary form of discharge or satisfactionof the mortgage, even though thedebt has not been paid. Having nowostensibly cleared the title, the mort-gagor sells or mortgages the land toa bona fide purchaser who supposesthat the mortgage has been properlydischarged.This case presents a fundamental

conflict between the UCC, which pro-tects a holder of the note (and by theusual extension, the mortgage also),and the innocent land buyer who hasrelied on the public records. The casesuniformly resolve the conflict in favorof the bona fide purchaser of the land,who takes free of the mortgage. SeeAmeribanc Sav. Banks, FSB v. Resolu-tion Trust Corp., 858F.Supp. 576 (E.D.Va. 1994).There is no question that recording

assignments is costly and inconve-nient for secondary mortgage marketinvestors. Whether these benefits aresufficient to incentivize them to do sois a debatable question. The MERS©electronic mortgage registration sys-tem was developed to accomplish thesame purposes without the necessityfor recording formal assignments inthe official public records, and it hasworked relatively well.

Many Nonjudicial ForeclosureStatutes Are Weak and

InadequateAll American states, as a matter ofcommon law, permit judicial foreclo-sure of mortgages, but about 30 states

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also have statutes authorizing nonju-dicial foreclosure by means of a saleconducted by the mortgagee or by aseparate trustee. About a dozen ofthese states require a chain of assign-ments of the mortgage (in most cases,recorded) as a prerequisite to theright to foreclose nonjudicially. Theyinclude Arizona, California (thoughthe cases on the point are divided),Georgia, Idaho, Massachusetts, Mich-igan, Minnesota, Nevada, Oregon,South Dakota, and Wyoming.It is not particularly clear what

policy objectives these requirementsserve. They do borrowers little goodfor informational purposes, for noneof these states requires contemporane-ous recording of assignments, evenfor a nonjudicial foreclosure. Nothingprevents a secondary market investorfrom obtaining a chain of assign-ments but delaying recording it until(and only if) foreclosure is necessary.In fact, this is precisely the policy thatFannie Mae and Freddie Mac havefollowed for several decades, andmany other secondary market inves-tors do the same.Most of the nonjudicial foreclosure

statutes were enacted when second-ary mortgage market transfers wereuncommon, and some of them arecompletely inadequate in their treat-ment of proof of the right to enforcethe note when a transferee forecloses.This issue might have been (and insome states has been) resolved simplyby applying common law mortgageforeclosure concepts and the UniformCommercial Code as an "overlay" tothe statutes.In eight states, however, the courts

have failed to adopt these concepts,leaving nonjudicial foreclosures mud-dled and unsatisfactory. They haveheld that the foreclosing party neednot demonstrate or establish in anyway that it has the right to enforcethe obligation. See Dale A. Whitman& Drew Milner, Foreclosing on Noth-ing: The Curious Problem of the Deedof Trust Foreclosure Without Entitle-ment to Enforce the Note, 66Ark. L.Rev.21 (2013).Often these decisionsare described as rejecting the" showme the note" defense. States takingthis step include Alabama, Arizona,

California, Georgia, Idaho, Minnesota,Michigan, and Texas.A number of other nonjudicial fore-

closure jurisdictions have taken theopposite tack, holding that one must bea PETE-a person entitled to,enforcethe note under Article 3-and must pro-vide at least some evidence of the fact(usually in the form of an affidavit) inorder to foreclose. These states, whichusually have plainer statutory language,include Arkansas, Colorado, Maryland,Nevada, North Carolina, Massachusetts,Missouri, Washington, and arguablyVirginia. The Massachusetts court (toits credit) took this view despite theabsence of any reference to possessionof the note in its nonjudicial foreclo-sure statute in Eaton v. Fannie Mae, 969N.E.2d 1118(Mass. 2012).The courts that disregard the UCC

and its requirement of possession of thenote have done a real disservice to bor-rowers. Under our present legal system,the foreclosing party's possession of thenote (if it is negotiable) is the only sureindicator to the borrower that the loanis being enforced or foreclosed by thecorrect party. If no proof of possessionis required, the borrower is potentiallyexposed to a later action on the note bysomeone else-surely an unwarrantedand unfair risk.

ConclusionOur present system of mortgage trans-fers works, but it is cumbersome andweighted down with paperwork. Whatis needed is a nationwide, authorita-tive electronic records system, charteredby Congress with authority to preemptand override state law. Such a systemcould be designed so that it would besimple and straightforward for sec-ondary market participants to use, andwould be transparent to borrowers sothat all borrowers could identify theholders of their mortgages by a quickinquiry on the Internet. It could elimi-nate, for purposes of foreclosure, thedistinction between negotiable andnonnegotiable notes. It could make thepresence or absence of recorded mort-gage assignments, and the issue of lostnotes, completely irrelevant. No suchsystem exists at present, but there ishope that one may be introduced in thenot-too-distant future .•