Security follows the note, but only the note can foreclose

Much has been written recently on the subject of mortgage foreclosure under the rubric “show me the note,” which suggests that a consequence of the widespread practice of, first, originating and, second, pooling and reselling mortgage obligations, is that many of these mortgages may have become unenforceable. This claim is based, in part, upon the fact that many notes have been “separated” from the mortgages or deeds of trust that secure them, and, in part, upon the fact that many notes have simply been lost.

The suggestion that this current state of confusion will ultimately redound to the benefit of borrowers is, however, overstated.

“A real property loan generally involves two documents, a promissory note and a security iStock_000010081985XSmallinstrument. The security instrument secures the promissory note. This instrument ‘entitles the lender to reach some asset of the debtor if the note is not paid. In California, the security instrument is most commonly a deed of trust (with the debtor and creditor known as trustor and beneficiary and a neutral third party known as trustee). The security instrument may also be a mortgage (with mortgagor and mortgagee, as participants). In either case, the creditor is said to have a lien on the property given as security, which is also referred to as collateral.’” Alliance Mortgage Company v. Rothwell (1995) 10 Cal.4th 1226, 1235.

When a loan is sold, the promissory note is assigned to whoever buys the note, together with the note’s security. The security follows the note automatically. (California Civil Code § 2936 (enacted 1872).)

“Similarly, this has long been the law throughout the United States: when a note secured by a mortgage is transferred, ‘transfer of the note carries with it the security, without any formal assignment or delivery, or even mention of the latter.’ Carpenter v. Longan, 83 U.S. 271, 275 (1872).” In re Vargas (2008) (PDF) 396 B.R. 511, 516, emphasis added.

Under California Civil Code section 2934, assignees of mortgages and deeds of trust can record their assignments, but there is no provision for recording assignments of promissory notes. In a simple transaction, therefore: Lender A makes a loan to Borrower B, and immediately sells and delivers the note, and records an assignment of the trust deed securing the note to Investor C, and tells Borrower B that their note has been sold. If Borrower B stops making payments to Investor C, Investor C (the note holder) instructs the trustee of its trust deed (the neutral third party) to foreclose on Borrower B.

If Investor C would then sell their note to Investor D, and Investor D to Investor E, and so forth and so on, each sale would require the recording of another assignment and the transfer of the original note to its new owner.

Simple, except a problem of keeping track of the note and security arose when the transaction described above was multiplied hundreds of thousands of times. The recording of assignments of hundreds of thousands of deeds of trust over and over again became tedious, and expensive, so a new private entity entitled “Mortgage Electronic Registration Systems, Inc.” (“MERS”) was created to enable mortgages and deeds to trust to be assigned only once (to MERS).

“MERS, Inc., is an entity whose sole purpose is to act as mortgagee of record for mortgage loans that are registered on the MERS System. This system is a national electronic registry of mortgage loans, itself owned and operated by MERS, Inc.’s parent company MERSCORP, Inc.” In re Kang Jin Hwang (2008) 396 B.R. 757, 761, emphasis added.

MERS became the “neutral third party” of choice because the promissory notes secured by the mortgages and deeds of trust assigned to MERS could be re-sold over and over again without the inconvenience of re-recording assignments of the mortgages and deeds of trust.

Simple, except someone forgot to keep track of the notes, and many notes got lost, never assigned, assigned and never transferred, or in some other way “separated” from the documents that secured them.

As recently as August 2009, the Supreme Court of the State of Kansas, in the case of Landmark National Bank v. Kesler, acknowledged “in the event that a mortgage loan somehow separates interests of the note and the deed of trust, with the deed of trust lying with some independent entity, the mortgage may become unenforceable.”

“’The practical effect of splitting the deed of trust from the promissory note is to make it impossible for the holder of the note to foreclose, unless the holder of the deed of trust is the agent of the holder of the note. [Citation omitted.] Without the agency relationship, the person holding only the note lacks the power to foreclose in the event of default. The person holding only the deed of trust will never experience default because only the holder of the note is entitled to payment of the underlying obligation. [Citation omitted.] The mortgage loan [becomes] ineffectual when the note holder [does] not also hold the deed of trust.’ Bellistri v. Ocwen Loan Servicing, LLC (PDF), 284 S.W.3d 619, 623 (Mo. App. 2009).” Landmark National Bank v. Kesler, emphasis added.

As a practical matter, the Supreme Court of Kansas may be right in the sense that the note-holder cannot foreclose until they become re-connected with the holder of the deed of trust securing their note. But, because the security always follows the note, this should not be taken to mean that the holder of a valid promissory note cannot, as a legal matter, eventually enforce their note. Their note’s enforcement will only be delayed until the history of the note is traced to the bona fide holder, and that bona fide holder determines that a breach has occurred and authorizes the neutral third party holding their security, to foreclose.

And eventually may take a very long time because, as explained above, there is no vast database of promissory notes and their holders, while there is a vast database of security instruments held by neutral third parties, MERS in particular.

MERS is left with the ability, but not the right to foreclose. Without the note, MERS is entitled to do nothing but hold the beneficiary’s security. Unfortunately, in California at least, the vast majority of foreclosures are conducted non-judicially by way of trustee sales. MERS, as a neutral third party, for example, may receive instructions from a “beneficiary” named in their vast database (who may or may not hold the original promissory note) that one of the beneficiary’s notes is in default, and initiate and complete a non-judicial foreclosure without ever having the note in hand. (Trustees are not required to take possession of the original note and deed of trust when asked to initiate a foreclosure. California Trust Co. v. Smead Inv. Co. (1935) Cal.App.2d 432, 434-435.)

On the subject of “show me the note,” a borrower being foreclosed upon non-judicially will have no opportunity to say “show me the note” to anyone who matters, unless the borrower ends up in bankruptcy court seeking a stay, or in Superior Court seeking an injunction. In either case, the borrower’s counsel or the court should ask the foreclosing party to “show them the note” to confirm that the beneficiary or its agent is, in fact, “in court” and entitled to relief from stay, or entitled to foreclose.

So “show me the note” is not the answer to every borrower’s wish, but it is a fair question to be asked of all foreclosing parties, who each should be required to enforce their bona fide legal rights in accordance with established law, not the law of convenience.  The fact that insufficient care was taken to preserve the bona fides of any mortgage transaction should not be allowed to create a windfall for either borrower or lender.  Each should be required to negotiate the terms of foreclosing or re-financing based upon their actual transaction, not upon the transaction they wish they had.

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