Daily Development for
Monday, June 17, 1996

by: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law

Today's Daily Development is the editor's effort to describe the current hubbub concerning proposed reforms to Article Nine of the UCC in areas of concern to real estate practitioners. The discussion is ongoing, and it appears that all current drafting proposals containing specific language are now "off the table." We should be seeing a new proposed draft of Article Nine provisions within six months, maybe sooner. But even though we don't have specific language to pick apart, there are some interesting questions of philosophy in uniform laws drafting that are worth discussing.

1. The Problem: Bankruptcy Perfection of Secured Interests in Real Estate Mortgages:

Article Nine, of course, deals with security interests in personal property. It does not cover security interests in real property. But there is the "crossover interest" - a security interest taken by a lender in the borrower's right to be paid on an obligation secured by a mortgage.

Assume that a local mortgage banker originates a mortgage loan. In order to generate cash, it may collect that loan with a number of other loans in a "pool" and use that pool as security for a borrowing from an upstream lender. More typically, the originator would actually sell all or a participation in the pool to upstream parties, but under various circumstances there will be secured loans instead. The position of the upstream lender, providing a secured loan to a mortgage loan originator/borrower, is the focus of the UCC interest.

If the borrower should not pay the lender, the lender will be able to execute upon the security interest and take over the borrower's position as obligee of the mortgage note. The borrower's right to be paid is a contract right, not a real estate interest, and is within the scope of Article Nine. So far, no problem.

What if, however, the borrower should go bankrupt? The bankruptcy trustee has a "strongarm" power to avoid security interests in the bankrupt's property that have not been "perfected" under state law. Our secured lender will have to demonstrate more than just a promise by the debtor that the lender had a security interest in that mortgage note. The lender will have to show that it had met the requirements of "perfection" of that security interest for purposes of state law. State law, of course, means the UCC. Without such perfection, the secured lender will become an unsecured lender - the proverbial "pennies on the dollar" situation, even though the debtor never attempted to cheat the lender and even though no one ever actually was misled by the lender's failure to perfect.

The traditional way to perfect a security interest in a note is to take possession of the note. The traditional way to perfect a transferee's interest in a real property interest (like a mortgage) is to record an assignment in the real estate records. Some states view the mortgage as an interest separate from the note, and would require both possession and recording of the assignment. Historically, many lenders who have taken security interests in mortgage notes have used the "belt and suspenders" approach: recorded the assignment in the real property records, recorded a UCC financing statement (which has been of questionable value), taken possession of the note, or required that the note be held by a trustee, and also notified the borrower. (Notifying the borrower is not "perfection," but in some states - particularly where the note is not negotiable - it is necessary to protect against wrongful prepayment or modification.)

But recently certain industry parties have come to complain that life has become too complex for these practices. "No one is doing it that way anymore" goes the argument. Parties who give security interests in mortgage paper are unwilling to release control of the note, as they want control over servicing (either they want to service themselves or sell servicing rights to others). Lenders who take security interests in mortgage notes deal in such volume that recording in the land records is impractical. Notifying the borrower merely creates confusion, and probably isn't perfection anyway. Recording a UCC financial statement also is probably a meaningless act currently except to the extent that it gives actual notice to parties seeking to take an interest in the same paper. Further, the secured upstream lender may very well transfer its loan to another, and so on, and so on, so the requirement that the UCC financial statement be signed by the borrower becomes problematic, with all these serial holders of the obligation.

II. The Proposed Solution:

The UCC mavens have proposed revisions in Article Nine that would make it possible for holders of security interests in mortgage notes to "perfect" by a UCC filing. That way the borrower gets to keep the note and the lender doesn't have the "muss and fuss" of having to record in the county records of the mortgaged property. State law - the revised UCC, would declare that recording in the statewide UCC records where the borrower is located is "perfection," and viola! - avoidance is avoided. (Note that the UCC filing will be in the state of the borrower (who is the lender under the mortgage) and that party may well be located in a state other than the state of the original mortgage borrower or the state where the land security is located.)

Anticipating the flap that would ensue when real estate lawyers discovered that the only notice of the true holder of rights in a mortgage note would be located in inaccessible and unknown recordings, the UCC drafters proposed that this "perfection by recording" rule would not affect the rights of parties who dealt in good faith with the actual possessor of the note. It would be significant primarily only where two purported secured lenders were quarreling and neither had possession of the note or where a secured lender is arguing priorities with a judgment creditor of the secured borrower. This way, they argued, there never would be an greater title problems than already existed, but we could have convenient perfection.

To address another aspect of the problem, the UCC drafters also proposed that the secured lenders be permitted to file financing statements that only they had signed, so that there wouldn't be the need for the borrower to continually provide new signed financing statements as the loan transfers around.

III. The Real Estate Community Reacts:

Money is the fuel that makes the real estate machine work. Real estate lawyers want to see money flow in the system, and are not interested in throwing up obstacles to lenders wanting to provide funds to real estate mortgage lenders. The reaction of many real estate lawyers to these proposals has been to note only that care should be taken that the UCC revisions don't mess up the title chain. Beyond that, they didn't care.

III.A. The Official Comments Qualification:

Some of these lawyers have urged that the UCC drafters, make very clear in the official comments that the new "perfection concept" only deals with disputes between holders of loans secured by the borrower's pool of mortgage notes, and would in no way affect any concepts of ownership of the mortgages or the mortgage notes beyond that concept, even after execution. Whenever ownership of a title encumbering mortgage or obligations of the mortgage debtor were at stake, traditional rules, unaffected by this UCC filing, would apply. It is thought that the UCC drafters are symphathetic to this proposal, but I never heard any of them come right out and agree to it.

Obviously the language of the Official Comments would not superceded specific language in the provisions of the UCC itself, so everyone agrees that real estate lawyers will have an additional opportunity to study the final draft of any proposed language as well.

III.B. Mortgage Follows the Note:

Further, all real estate commentators seemed to agree with one proposal of the UCC drafters - that the UCC provide clearly that the mortgage would follow the note, and that there was no separate interest in the mortgage alone. This is the law in most states anyway. It makes sense for all parties.

III. C. Concerns About the "Self Actuating Financing Statement."

As to some of the other issues, however, some leading real estate lawyers have voiced difficulty in envisioning how the proposed system could work without at least creating the risk of gumming up clarity of title.

First, many lawyers felt that it was unnecessary to have a provision that an upstream secured lender could achieve a perfected security claim in a mortgage pool simply by filing a UCC financing statement signed by the lender alone. They felt that this would needlessly increase the risk of fraud. Although, of course, the fraud might be limited to disputes among the secured parties, real estate lawyers were concerned that there would be "spillover" impacts from fraudulent practices in this area that would inevitably have an impact of the real estate itself.

Some who supported the proposal argued that the risk of fraud from a self activating statement is no different from the risk of fraud from a forged statement. But others responded that with the self actuating statement there is an increased risk of "low level" fraud - deceptive practices designed to establish temporary advantage in disputes in which the recording party feels it has some legitimate position but otherwise couldn't prove it. Such parties might not stoop to forging a signature, but might make a filing of a security interest claim of questionable integrity.

Some "middle ground" positions were discussed - such as having the borrower - the originating mortgage lender - sign a general power of attorney that subsequent holders of the secured creditors rights could use to place the borrower's name on financing statements. Another proposal was having the borrower sign bundles of financing statements in blank.

No final resolution of this issue was reached, but the editor feels there was good exchange on the point.

III.D. The Basic Concept of Multiple Means of Perfection.

Another group of real estate lawyers expressed a similar concern with the fundamental concept of permitting a party to achieve perfected status through what was essentially an "invisible" UCC filing. ("Invisible" insofar as concerns parties interested in the status of the title to the mortgage real estate.) They would not be reassured by protestations that all issues concerning the real estate would be resolved by the old rules. They pointed out that where two or more parties might legitimately feel that they had a perfected interest in the same mortgage - such as where one party had possession of the note or recorded an assignment of the mortgage and the other had recorded a financing statement - disputes would arise that ultimately would affect the ability of the borrower or others interested in the property to clear title.

These lawyers question whether "the game is worth the candle." Isn't the problem really with the strongarm powers in the Bankruptcy Act, they argue. Why mess up the UCC in an effort to patch a weakness that would better be resolved by a full scale replacement?

Whether these lawyers will be satisfied with the "Official Comments Disclaimer" approach remains to be seen.

IV. Payment Obligations of the Borrower:

Another problem that has been discussed at some length is the fundamental conflict between the reality of the marketplace and the theory of the UCC concerning the payment rights under a mortgage loan. Although, for one reason or another, many mortgage notes (particularly commercial mortgage notes) are not negotiable instruments, a large number of mortgage notes at least contain language that purports to establish negotiable status. The payment obligation of a maker of a negotiable instrument (and in some cases even of an instruments that lacks negotiability) is to look for and pay only the physical holder of the instrument.

Of course, in practice, this is virtually never done. Mortgage borrowers routinely pay the originating lender long after physical possession of the note has migrated elsewhere. Mortgage borrowers will respond to notices of change in servicing agents, but rarely will require production of the note. Closing and payoffs usually are accomplished through dealing with the recorded holder of the mortgage, without any effort to check on whether that party in fact is in possession of the note. Many times the actual note is never produced.

The system relies upon the assumptions that widespread fraud in this area is not a problem and that all other issues can be resolved through estoppel and agency concepts.

The proposal has been made that Article Nine ought to provide that payment to the originating lender is good payment, and that the originating lender has the authority to modify or cancel the mortgage debt, until the borrower has been notified of a change in ownership of the note. These proposed doctrines would apply regardless of recordation of the rights of parties either in the real estate or UCC records, and regardless of who had actual possession of the note.

Real estate lawyers seemed to favor this proposal, as they felt that it would bring the law into greater conformity with practice. (Note the similarity between this argument and the argument that the upstream lenders themselves made as to the earlier proposals.) At the meeting the editor attended, however, the UCC drafters voiced the view that the place to solve this problem was not in Article Nine, but in a redraft of some other Article of the UCC, where it could be made in a more comprehensive fashion.

Norm Geis, Co-Chair of the Joint Editorial Board for Uniform Real Estate Laws, pointed out an inconstistency between the provisions of the UCC and the provisions of the Uniform Land Security Interest Act. ULSIA does provide that a mortgage borrower makes good payment on a mortgage note by paying the original lender until notified otherwise. A conflict between two already approved and promulgated Uniform Laws is an issue of some concern to NCCUSL, and undoubtedly this issue will receive further attention.

V. Editor's Comment:

This was the Editor's first exposure to the inner workings of the NCCUSL drafting process. Particularly as compared to the process by which Congress drafts its laws, including the Federal Foreclosure proposal, the process gives one some confidence in the integrity of that body's efforts. It was quite heartening to see the careful analysis and weighing of various policy concerns, the effort to try to bring all parties to a comfortable consensus, and the attempts to seek out and receive input from representatives of all practice areas affected by a proposed change.

The result, of course, is a long, slow process of law reform, more akin to synthesizing sausage in a laboratory than grinding it out of a fast moving machine. But the result is likely to be more digestible. This is a necessary characteristic of course, for Uniform Law proposals, which must be palatable to each state legislature. One can't just ram the law down their throats, as some federal preemption proposals would do.

Items reported here and in the ABA publications are for general information purposes only and should not be relied upon in the course of representation or in the forming of decisions in legal matters. Accuracy of data and opinions expressed are the sole responsibility of the DIRT editor and are in no sense the publication of the ABA.