Setting the UCC Record Straight on Mortgage Notes

The press is full of articles concerning residential real estate foreclosures. Sometimes questions arise in these judicial and non-judicial proceedings concerning ownership and enforcement of the notes and related mortgages. Uniform Commercial Code Articles 3 and 9 (and related definitions in Article 1) address some of the issues that have come up in these proceedings. The litigants and the courts considering these matters sometimes do not recognize the applicability of the UCC or may have difficulty applying the rules of the UCC. See, e.g., U.S. Bank v. Ibanez, 458 Mass. 637, 941 N.E.2d 40 (2011).

The Permanent Editorial Board for the Uniform Commercial Code has just issued a report (Report) to explain the application of UCC provisions that govern selected aspects of these matters and how those provisions apply to common fact patterns in this area. The PEB Report addresses how the UCC governs the following matters:

• Who is the person entitled to enforce a mortgage note?
• How is the transfer of a property interest (ownership or a security interest to secure an obligation) in a mortgage note accomplished?
• What effect does the transfer of a mortgage note have on the related mortgage?
• How can a person enforce a mortgage note by foreclosing non-judicially if the person does not have a recordable assignment of the mortgage?

Procedure

The PEB prepared and issued a draft Report for public comment in March 2011. The PEB received comments and prepared revisions to the Report. The final Report was issued in mid-November. It is available on the webpages of the two sponsors of the UCC, the American Law Institute (www.ali.org) and the Uniform Law Commission (www.uniformlaws.org).

During the course of the comment period, at least two courts cited the draft Report when considering issues addressed by the Report. See In re Jackson, 451 B.R. 24 (Bankr. E.D. Calif. 2011) and In re Veal, 449 B.R. 542 (9th Cir. BAP 2011). In each case the court held for the homeowner, concluding that the person seeking to enforce the particular mortgage note had not satisfied the relevant requirements of the UCC, as explained in the (draft) PEB Report.

What the Report Does Not Cover

The Report limits its discussion to selected UCC issues:

• The Report states several times that the UCC governs the issues that it governs, but does not address issues of real property law.
• The Report sometimes refers to the UCC’s use of other law in connection with the application of the UCC’s rules, for example agency law. In those circumstances, the Report notes the applicability of the other law (such as agency law) but does not discuss the content of the other law. In particular, where the UCC requires “possession” of a note to create certain rights, the Report observes that both Article 3 and Article 9 (with an assist from UCC § 1-103(b)) recognize that possession of the note can occur through an agent.
• The Report’s discussion of Article 3 recognizes that Article 3 applies only to “negotiable instruments” as that term is defined in Article 3; the Report observes that if a mortgage note is not a “negotiable instrument,” the Report’s discussion of Article 3 issues does not apply to that mortgage note.
• The Report’s discussion of Article 9 issues notes that Article 9 applies to all instruments, i.e., both negotiable and non-negotiable notes.
• The Report does not address all issues that might arise under the UCC in this context, such as the possible status of a holder of a mortgage note as a holder in due course of the mortgage note and the effect that that status might have on possible defenses that the maker might be able to assert.

Who is Entitled to Enforce a Mortgage Note?

Article 3 employs the concept of a “person entitled to enforce” a note to determine the person to whom the maker of the note owes its payment obligation. UCC § 3-301. That person might or might not be the owner of the note (UCC § 3-203, Comment 1), but payment to that person discharges the maker’s obligation under the note. UCC §§ 3-412 and 3-602.

A person is the person entitled to enforce the note if any of the following is true:

1. The person is the “holder” of the note,
2. The person is in possession of the note, which was “transferred” to that person, but the person is not a “holder” of the note, and
3. The note has been lost or destroyed (or is unavailable for other reasons) and the person who had been in possession was a person entitled to enforce the note

These alternatives for becoming the person entitled to enforce the mortgage note are satisfied (or not) as follows:

• The first alternative is satisfied only if the person (or its agent) has possession of the mortgage note and the mortgage note is payable or endorsed to that person or endorsed in blank.
• The second approach also requires that the person (or its agent) has possession of the mortgage note. If the mortgage note is not payable to the person in possession or to bearer, then the person is not a “holder.” However, if the mortgage note was “delivered” to the person in possession “for the purpose of giving” that person the right to enforce the instrument, the second alternative applies.
• The third alternative requires proof of the elements noted above, along with the terms of the mortgage note.

Transfer of Ownership

Unlike Article 3, Article 9 applies to interests in both negotiable and non-negotiable instruments. UCC § 9-102(a)(47). Article 9 applies to both a security interest in a mortgage note to secure an obligation and to the rights of a buyer of a mortgage note. UCC § 9-109(a)(1) and (3). Article 9 thus determines the requirements for an “effective” transfer of rights in those two situations. UCC § 9-203.

The requirements for an effective transfer of ownership (in the case of a sale) or a security interest to secure an obligation (in the case of a loan secured by the mortgage note) are straightforward:

1. Value must be given–this is typically satisfied by the payment of the purchase price in the case of a sale of a mortgage note and the promise to make a loan or the advance of the loan amount in the case of a security interest to secure an obligation. UCC § 1-204.
2. The seller or person creating the security interest to secure an obligation must have “rights” in the mortgage note–this too is usually easy to satisfy.
3. Generally, the seller or person creating a security interest to secure an obligation must “authenticate” a security agreement describing the mortgage note. UCC § 9-203(b)(3)(A). Whether the agreement covers the sale of the mortgage note or a security interest to secure an obligation, the agreement sufficiently describes the mortgage note if the agreement “reasonably identifies” the mortgage note. UCC § 9-108(a). For example, a description of mortgage notes by “category” or “type” is sufficient. UCC § 9-108(b)(2) and (3). (An oral (or other unauthenticated) security agreement is also possible in some circumstances. UCC § 9-203(b)(3)(B)).

If these requirements are satisfied, the buyer or lender with a security interest in a mortgage note to secure an obligation obtains a property interest in the note as owner or holder of the security interest to secure an obligation.

The Mortgage Follows the Note

The law in the United States has long followed the Mary’s Little Lamb rule–wherever the mortgage note goes the related mortgage is sure to follow. Restatement (Third) of Property (Mortgages) § 5.4. UCC § 9-203(g) codifies this rule for both sales of a mortgage note and a security interest in a mortgage note to secure an obligation. Further, perfection of a security interest in the mortgage note (whether in favor of a buyer or a lender with a security interest to secure an obligation) also perfects the security interest in the buyer’s or lender’s security interest in the seller’s or borrower’s rights in the mortgage. References to a “mortgage” in UCC § 9-203(g) include other types of consensual rights in real property to secure an obligation, such as a deed of trust. UCC § 9-102(a)(55).

Getting the Mortgage in the Secured Party’s Name

To save effort and money for all concerned, often a buyer of a mortgage note or a lender with a security interest in the mortgage note to secure an obligation will not record an assignment of the mortgage in the real estate records. As Article 9 makes clear, recording an assignment is not necessary for the buyer or lender to perfect its rights in the seller’s or borrower’s rights in the mortgage.

However, if the buyer or lender wants to foreclose, it may not have and may not be able to obtain the documents necessary to record the assignment in the real estate records, which may be necessary under local real estate law. Article 9 provides a procedure for the buyer or lender to record a document in the real estate records to reflect that assignment. UCC § 9-607(b).

Conclusion

The PEB Report describes the application of selected provisions of UCC Articles 3 and 9 to several key issues that may come up in connection with mortgage notes. There may well be additional UCC issues or issues arising under other law that also must be resolved, but the Report should help both practitioners and courts understand many of the issues that the UCC addresses in this area.