UCC Article 3 and Mortgage Backed Securities
Borrowing money to buy a home used to be straightforward. Nowadays, the promise to pay back the borrowed money (Note) is transferred into securities, known as mortgage-backed securities (MBS), and pieces of this MBS are sold in the form of certificates to investors all over the world. The Deed of Trust, which secures the promise to pay with the home, also known as a mortgage, lives in a virtual world somewhere between your home and the investors in the security holding your Note.
UNIFORM COMMERCIAL CODE
The transfer of the Note into securities is governed by the Uniform Commercial Code (“UCC”)[1]. The UCC is a set of laws adopted by most states to maintain uniformity in commercial transactions. The sale and transfer of promissory notes are commercial transactions governed by the UCC. UCC Article 3 and Article 9 are the substantive provision applying to the transfer of promissory notes and their status once inside a MBS. [2] C.R.S. 38-38-101 et seq. are the procedural laws governing foreclosure under Allen v. Bailey, 91 Colo. 260, 14 P.2d 1087 (Colo. 1932). Article 9 governs if there is conflict with Article 3.[3]
Article 3 applies to “negotiable” instruments. Article 9 applies to “security interests”. Promissory notes can be both “negotiable instrument” and “security interests”. While there is some discussion whether Notes are negotiable and therefore the applicability of Article 3[4], Article 9 specifically identifies the “sale of a promissory note” (Note) as a commercial transaction covered by Article 9.[5]
ARTICLE 3
Article 3 lays out the requirements that allow Notes to travel from one owner to another. [6] Think of checks you write as “instruments” showing your promise to pay a sum of money. Article 3 uses the terms “transfer” or “negotiation” to define the type of travel. The minimum requirement for transferring a Note is an indorsement.[7] An indorsement can be made out “to order” of a specific person or “to bearer”.[8] For example a check made out to a specific person is “to order” and a check made out in blank can be cashed by anyone who has possession.
With limited exceptions, possession of the Note with an indorsement is required to enforce the Note and it does not matter if coming into possession is “wrongful”. A person in possession of the Note with an indorsement is considered a “holder” of the Note with the right to enforce the Note.[9]
The reason for focusing on possession of a Note to enforce it, regardless of how one comes into possession, is the premium placed on keeping commercial activity moving. Commercial activity moves when the one obligated to pay a sum of money knows who to pay. Possession is the best way to identify who to pay. And, to complete the symmetry, the only way to discharge a debt is to pay the one who has the power to enforce it[10] or simply the one in possession.
ARTICLE 9
Prior to 2001 Article 9 applied only to personal property. In 2001 Article 9 was changed to apply to the sale of promissory notes.[11] Under Article 9, the Note takes on a legal significance different from a “negotiable instrument” under Article 3. The Note becomes security for its underlying obligation to pay a certain sum of money. The Note does not lose its identity as a promise to pay because it is transferred into a MBS. [12] A Note, once lodged in a MBS, is both a promise to pay and a security interest for the promise to pay.
The concept that a Note becomes the security for itself is a strange concept when compared to the original structure of a home loan in which the home secures the promise to pay with a deed of trust or mortgage.
The concept is less strange when one understands that the reason for allowing Notes to lodge in mortgage backed securities is to provide more money in order that more homes can be bought.
Article 3 and Article 9 are similar in their requirements that a promissory note signed by a homeowner to purchase a home and sold into the stream of commerce must be in possession of the person or entity enforcing the Note after a default.
A person or entity comes into possession of a “promissory note”[13] through a sale and is a considered “secured party” [14] with a right to “enforce” the note if three requirements are met:
1) Value is given,( which means any consideration that would support a simple contract) ;
2) Debtor has rights in the collateral or power to transfer the collateral; and
3) Collateral is in possession of the Debtor pursuant to debtor’s security agreement.[15]
A person or entity in possession[16] of a promissory note has the right to enforce the Note by any judicial procedure, including “foreclosure”.[17] Article 9 helps with foreclosure by specifically providing that the deed of trust follows the note,[18] a concept reaffirmed by the Colorado Supreme Court in Columbus Investment v. Lewis, 48 P.3d 1222 (Colo. 2002).[19]
If one were to challenge the standing of a trustee of a MBS to bring a foreclosure on a Note within a MBS, a challenge might focus on whether “value” was given or whether the MBS ever obtained possession of the Note.
As “value”[20] is defined as any consideration to support a simple contract, the consideration of transferring a Note into a MBS would not be hard to find. The MBS buys the Note at a discount and assumes the right and obligation to collect the monthly mortgage payments and disperse these monthly payments minus administrative and other deductions to investors in the MBS. Either the money or the assumption of responsibility for holding the Note constitute consideration to satisfy the requirement of “value”.
POSSESSION
Possession of a security interest would necessarily follow the Pooling and Service Agreement of the MBS as mandated by securities regulations and explored in an earlier post, titled PSA Defense.
A difference between Article 9 and Article 3 is whether the Trustee of a MBS must prove its right to enforce the Note by filing an affidavit in the public land records pursuant to UCC 4-9-607.[21] Colorado’s non-judicial foreclosure statute provides for the filing of this affidavit with the Public Trustee at the same time as it is filed with County Clerk and Recorder. [22] It is not clear if any foreclosures comply with this requirement. A reason for not complying with this voluntary recording is the penalty provisions of C.R.S. § 38-35-109(3) for filing a knowingly false document. [23]
Another difference between Article 9 and Article 3 is that there appears to be no corollary requirement for an indorsement.[24] Indorsements insure the person or entity enforcing the Note has rightful possession of the Note. If the Note is not covered by Article 3 because it is not negotiable, the only way to insure that the Note is in possession of the person or entity entitled to enforce the Note is that the person or entity has actual possession of the Note.
But does possession alone show that the one in possession is entitled to enforce the Note through a foreclosure? UCC § 4-9-203 states that possession is “pursuant to a security agreement”. A “security agreement” is defined as “an agreement that creates a security interest.”[25] A security interest is defined as an interest of a buyer of “a promissory note in a transaction that is subject to article 9 of this title.”[26] Comment 4 to UCC § 4-9-203 states that: “In the unlikely event that possession is obtained without the debtor's agreement, possession would not suffice as a substitute for an authenticated security agreement.” Therefore the only agreement that qualifies as a debtor security agreement would be the Note itself.
Promissory notes contain language similar to: “I understand that he Lender may transfer this Note. The Lender or anyone who takes this Note by transfer and who is entitled to receive payments under this Note is called the “Note Holder”. “Transfer” is defined in C.R.S. § 4-3-203 (a): “An instrument is transferred when it is delivered by a person other than its issuer for the purpose of giving to the person receiving delivery the right to enforce the instrument.”
According to the above traverse of the UCC, it appears that no indorsement is necessary to show that the person or entity trying to foreclose is entitled to foreclose under Article 3 but is necessary for Article 9. All the more reason to insist on production of the original note in a foreclosure.
[1] “UCC” in this Blog refers to Colorado statutes adopting the UCC at C.R.S. §4-1-101 et seq.
[2] UCC 4-3-104 and UCC 4-1-201(35)
[3] UCC 4-3-102
[4] “Mortgage Documentation Issues Close to (my) Home” by Jean Braucher, Credit Slips, October 28, 2011, http://www.creditslips.org/creditslips/2011/10/mortgage-documentation-issues-close-to-my-home.html#more
[5] UCC 4-9-109 Comment 7: Security Interest in Obligation Secured by Non-Article 9 Transaction. Subsection (b) is unchanged in substance from former Section 9-102(3). The following example provides an illustration. O borrows $10,000 from M and secures its repayment obligation, evidenced by a promissory note, by granting to M a mortgage on O's land. This Article does not apply to the creation of the real-property mortgage. However, if M sells the promissory note to X or gives a security interest in the note to secure M's own obligation to X, this Article applies to the security interest thereby created in favor of X. The security interest in the promissory note is covered by this Article even though the note is secured by a real-property mortgage. Also, X's security interest in the note gives X an attached security interest in the mortgage lien that secures the note and, if the security interest in the note is perfected, the security interest in the mortgage lien likewise is perfected. See Sections 9-203, 9-308.
[6] UCC 4-3-104 Negotiable instrument(a) Except as provided in subsections (c) and (d) of this section, “negotiable instrument” means an unconditional promise or order to pay a fixed amount of money, with or without interest or other charges described in the promise or order, if it: (1) Is payable to bearer or to order at the time it is issued or first comes into possession of a holder; (2) Is payable on demand or at a definite time; and (3) Does not state any other undertaking or instruction by the person promising or ordering payment to do any act in addition to the payment of money, but the promise or order may contain (i) an undertaking or power to give, maintain, or protect collateral to secure payment, (ii) an authorization or power to the holder to confess judgment or realize on or dispose of collateral, or (iii) a waiver of the benefit of any law intended for the advantage or protection of an obligor.
[7] UCC 4-3-204 (a) “Indorsement” means a signature, other than that of a signer as maker, drawer, or acceptor, that alone or accompanied by other words is made on an instrument for the purpose of (i) negotiating the instrument…”
[8] UCC 4-3-109
[9] UCC 4-3-301. Person entitled to enforce instrument: “Person entitled to enforce” an instrument means (i) the holder of the instrument, (ii) a nonholder in possession of the instrument who has the rights of a holder, or (iii) a person not in possession of the instrument who is entitled to enforce the instrument pursuant to section 4-3-309or 4-3-418(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.
[10] Comment 2 to UCC 4-3-102. “The issuer of a negotiable instrument, on the other hand, may discharge its obligation to pay the instrument only by paying a person entitled to enforce under Section 3-301.”
[11] UCC 4-1-201 (35) “Security interest” means an interest in personal property or fixtures that secures payment or performance of an obligation. The term also includes any interest of a consignor and a buyer of accounts, chattel paper, a payment intangible, or a promissory note in a transaction that is subject to article 9 of this title.
[12] Be aware of any outfit who says differently. Mortgage Securitization reports or analysis are not legal documents.
[13] UCC 4-9-102 (68) “Promissory note” means an instrument that evidences a promise to pay a monetary obligation …”
[14] UCC 4-9-102(75) “Secured party” means: (D) A person to which accounts, chattel paper, payment intangibles, or promissory notes have been sold;”
[15] UCC 4-9-203. Attachment and enforceability of security interest; proceeds; supporting obligations; formal requisites(a) A security interest attaches to collateral when it becomes enforceable against the debtor with respect to the collateral, unless an agreement expressly postpones the time of attachment.(b) Except as otherwise provided in subsections (c) to (i) of this section, a security interest is enforceable against the debtor and third parties with respect to the collateral only if: (1) Value has been given; (2) The debtor has rights in the collateral or the power to transfer rights in the collateral to a secured party; and (3) One of the following conditions is met: (A) The debtor has authenticated a security agreement that provides a description of the collateral and, if the security interest covers timber to be cut, a description of the land concerned; (B) The collateral is not a certificated security and is in the possession of the secured party under section 4-9-313 pursuant to the debtor's security agreement;
[16] UCC 4-9-313. When possession by or delivery to secured party perfects security interest without filing (a) Except as otherwise provided in subsection (b) of this section, a secured party may perfect a security interest in tangible negotiable documents, goods, instruments, money, or tangible chattel paper by taking possession of the collateral.
[17] UCC 4-9-601(a) After default, a secured party has the rights provided in this part 6 and, except as otherwise provided in section 4-9-602, those provided by agreement of the parties. A secured party: (1) May reduce a claim to judgment, foreclose, or otherwise enforce the claim, security interest, or agricultural lien by any available judicial procedure;
[18] UCC 4-9-203 (g) The attachment of a security interest in a right to payment or performance secured by a security interest or other lien on personal or real property is also attachment of a security interest in the security interest, mortgage, or other lien.
[19] Curious that this case, with a rather harsh result, applied Article 9 prior to its amendment adding promissory notes as a “secured interest”.
[20] UCC 4-1-204. Value Except as otherwise provided in articles 3, 4, and 5 of this title, a person gives value for rights if the person acquires them:(1) In return for a binding commitment to extend credit or for the extension of immediately available credit, whether or not drawn upon and whether or not a charge-back is provided for in the event of difficulties in collection;(2) As security for, or in total or partial satisfaction of, a preexisting claim;(3) By accepting delivery under a preexisting contract for purchase; or(4) In return for any consideration sufficient to support a simple contract.
[21] (b) If necessary to enable a secured party to exercise under paragraph (3) of subsection (a) of this section the right of a debtor to enforce a mortgage non-judicially, the secured party may record in the office in which a record of the mortgage is recorded:(1) A copy of the security agreement that creates or provides for a security interest in the obligation secured by the mortgage; and(2) The secured party's sworn affidavit in recordable form stating that:(A) A default has occurred; and(B) The secured party is entitled to enforce the mortgage non-judicially. (c) A secured party shall proceed in a commercially reasonable manner if the secured party:
[22] C.R.S. § 38-38-101(f) (f) Any affidavit recorded pursuant to section 38-35-109(5) affecting the deed of trust described in paragraph (c) of this subsection (1), which affidavit shall be accepted by the public trustee as modifying the deed of trust for all purposes under this article only if the affidavit is filed with the public trustee at the same time as the other documents required under this subsection (1);
[23] (3) Any person who offers to have recorded or filed in the office of the county clerk and recorder any document purporting to convey, encumber, create a lien against, or otherwise affect the title to real property, knowing or having a reason to know that such document is forged or groundless, contains a material misstatement or false claim, or is otherwise invalid, shall be liable to the owner of such real property for the sum of not less than one thousand dollars or for actual damages caused thereby, whichever is greater, together with reasonable attorney fees. Any grantee or other person purportedly benefited by a recorded document that purports to convey, encumber, create a lien against, or otherwise affect the title to real property and is forged or groundless, contains a material misstatement or false claim, or is otherwise invalid who willfully refuses to release such document of record upon request of the owner of the real property affected shall be liable to such owner for the damages and attorney fees provided for in this subsection (3).
[24] Comment to UCC 4-3-203 states that: “Because the transferee's rights are derivative of the transferor's rights, those rights must be proved. Because the transferee is not a holder, there is no presumption under Section 3-308 that the transferee, by producing the instrument, is entitled to payment. The instrument, by its terms, is not payable to the transferee and the transferee must account for possession of the unindorsed instrument by proving the transaction through which the transferee acquired it. Proof of a transfer to the transferee by a holder is proof that the transferee has acquired the rights of a holder.”
[25] UCC § 4-9-102(76).
[26] UCC § 4-1-201(35).
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tagged Article 3 UCC, Foreclosure Defense, mortgage backed securities