Transfers of Mortgage Notes under New Article 9
By Dale Whitman

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The new version of UCC Article 9, approved by NCCUSL at its 1998 Annual Meeting, makes important changes in the treatment of promissory notes, including notes secured by real estate mortgages. Perhaps the most significant change is the fact that outright sales of notes, as well as the use of notes as collateral security for other obligations, are now covered by Article 9 and subject to its concept of "perfection."

I propose here to outline briefly the practical effect of these changes on certain common types of mortgage transactions. The transactions fall into two categories:

First, "outright" sales, which include:

• Ordinary secondary market sales of whole mortgages (e.g., to FNMA & FHLMC or
   to other investors.

• Transfers to securitization vehicles, such as trustees or custodians, pursuant to the
   issuance of mortgage-backed securities.

• Sales of participation interests, representing fractional shares of ownership in one or
   more underlying notes and mortgages.

Second, transfers of security or collateral interests, which include:

• "Warehouse" lines of credit commonly made available by commercial banks to
   mortgage bankers.

• Other collateral pledges of mortgage loans by mortgagees.

Outright sales of promissory notes. As observed above, even outright transfers of promissory notes are now subject to Article 9 and its rules concerning perfection. This is accomplished in a rather counterintuitive way, by virtue of the definition of "security interest" in § 1-201(37), which new Article 9 amends. Under new §1-201(37), "security interest" includes "an interest of a buyer of accounts, chattel paper, a payment intangible, or a promissory note." Of course, the use of notes as collateral securing other obligations has always been covered by Article 9; see, e.g., In re Southern Oregon Mortg. Co., 125 B.R. 625 (Bankr.D.Or. 1991). Thus, the concepts of outright transfers and collateral transfers of notes are largely merged together for purposes of perfection under new Article 9.

This might initially seem to place outright transfers in greater jeopardy than at present, since when the transferor becomes bankrupt, the trustee in bankruptcy would now seem to be in a position to argue that the transfer was unperfected and thus subject to being set aside in favor of the bankruptcy trustee using his or her "strong-arm" powers under Bankruptcy Code § 544 as a perfected lien creditor.

However, new Article 9's treatment of such outright transfers eliminates this risk very effectively, for it provides (in § 9-309) that the rights of a buyer in the sale of a promissory note are automatically "perfected when they attach." Hence, as against a subsequent trustee in bankruptcy, an outright buyer of promissory notes need not take any other action to be fully perfected. Indeed, the apparent purpose of this change was to insulate issuers of mortgage-backed securities and other securitization vehicles from attacks by the trustees in bankruptcy of original payees of the obligations in question.

Pledges of promissory notes as security for other indebtedness. Two other methods of perfection are available both to outright buyers of promissory notes and to persons who take security interests in them. Those methods are (1) filing of a financing statement (§ 9-312(a)) and (2) taking possession of the note (§ 9-313(a)). From the viewpoint of one who makes an outright purchase of a note, filing seems to offer no advantages over the automatic perfection mentioned above, and presumably such buyers will not bother to file. However, the automatic perfection provisions are not available to one who takes a collateral security interest (rather than outright title) in a note. Hence, filing of financing statements by such creditors will probably become common, and will accomplish the very important objective of insulating them from the trustees in bankruptcy of their debtors (mortgagees/note payees). It is significant that they can get this insulation without the bother of taking physical possession of the notes in question, a process that they often consider irksome, especially when only a short-term line of credit is involved.

But while filing is useful to a creditor who takes a security interest in a note, it does not provide the creditor with the full protection it might wish. The creditor remains subject to the risk that, if its debtor retains possession of the promissory note in question, the debtor will "double pledge" it, giving a second security interest to another creditor, and this time transferring possession of the notes to the new creditor. Under new § 9-330(d), "a purchaser [and the definition of "purchase" in § 1-201(32) has been amended to include the taking of a security interest] of an instrument has priority over a security interest in the instrument perfected by a method other than possession if the purchaser gives value and takes possession of the instrument in good faith and without knowledge that the purchase violates the rights of the secured party." The knowledge mentioned here is actual knowledge.

Hence, if Creditor 1 files but does not take possession of the note, and Creditor 2 takes possession of the note, Creditor 2 will prevail (assuming it gives value) unless Creditor 2 happens to know in fact about Creditor 1's rights. Creditor 2 is not expected to do a UCC-1 search, and is not held to constructive notice of the information that such a search would disclose. By filing but omitting to take possession of the notes, Creditor 1 has protected itself against the mortgagee/payee’s bankruptcy, but not against the risk of the mortgagee/payee’s "double-pledging" the notes. Creditor 1 should be willing to take this position only if it has reasonably strong confidence in the mortgagee/payee’s honesty.

Creditor 1 has a further reason for getting possession of the note rather than merely filing a financing statement. Only if Creditor 1 has possession can Creditor 1 become a holder in due course under UCC Article 3. If the note is negotiable in form (as some but not all real estate loan notes are), becoming a holder in due course can sometimes be a very useful status, and it can only be obtained if the creditor gets possession of the note. Even if the note is nonnegotiable, so that holder-in-due-course status is unavailable, the creditor may still find it useful in some settings to take possession of the note in order to help establish that the creditor is a bona fide purchaser under ordinary contract law.

In the past, when a creditor made a loan to a real estate mortgagee and took the real estate note and mortgage as collateral, a question existed as to whether the creditor’s rights with respect to the real estate mortgage were as firmly established as its rights to the note itself. This question is put to rest by new § 9-308(e), which provides: "Perfection of a security interest in a right to payment or performance also perfects a security interest in a security interest, mortgage, or other lien on personal or real property securing the right." This language confirms that the mortgage "follows the note," and that no separate act (such as recording an assignment in the real estate records) is necessary to ensure perfection with respect to the mortgage. New Article 9 includes a legislative note recommending that the state’s recording act be amended to make it clear that recording is unnecessary in this setting.

Loan Participations. The impact of the changes in new Article 9 on mortgage loan participations is significant. A participation typically involves the outright sale of one or more partial or fractional interests in one or a pool of promissory notes and their associated mortgages. Since the sale is only of a fractional interest, new Article 9 characterizes the interest received by the participants as a "payment intangible." A payment intangible is a new subspecies of the category termed "general intangible," which is carried over with some changes from the old version of Article 9. A "general intangible" is a catch-all category— that is, it’s any type of right that doesn’t fit into one of Article 9's specific categories, such as accounts, instruments, etc. The definition of general intangible is found in new § 9-102(a)(42). Since there’s no specific category in new Article 9 for fractional interests in promissory notes, they seem to fit the definition of "general intangible." A "payment intangible" is simply a general intangible in which the principal underlying obligation is the payment of money, and that is certainly the case with a mortgage loan participation. Hence, a mortgage loan participation seems to be a "payment intangible."

What are the consequences of this categorization? If the participation is indeed an outright sale of an interest in the underlying mortgage note, perfection of the participants’ interests is automatic under new § 9-309(3) (just as perfection is automatic in the sale of a promissory note, as discussed above, under § 9-309(4)). Thus, the participants need do nothing special to assure themselves that their interests are perfected.

Even though mortgage participations are invariably described in their documentation as "sales," there is a long history of bankruptcy trustees attempting to persuade courts to recharacterize the participations as loans if the lead lender later becomes bankrupt. Under this view, the participants are regarded as having made loans to the lead lender, and the lead lender’s obligation to repay those loans is secured by the pledge of fractional interests in the underlying real estate note and mortgage. This argument has been rejected by some courts and accepted by others, and its probability of success is strongly affected by the precise details of the participation. For example, if the lead lender guarantees payment to the participants or covenants to buy back the participation shares in the event of a default on the underlying mortgage loan, or if the interest rate earned by the participants is different than the rate on the mortgage loan, the probability increases that a court will recharacterize the participation as a loan. See, e.g., In re Coronet Capital Co., 142 B.R. 78 (Bankr. S.D.N.Y. 1992).

In the past this sort of recharacterization could prove disastrous to the participants, since there was a high risk that the court would also find their supposed "security interests" in the underlying mortgage loan were unperfected; if this occurred, they became unsecured creditors of the lead lender’s bankruptcy estate. It was difficult for the participants to perfect under the old version of Article 9, since perfection could be accomplished only taking possession of the underlying note, and possession could not readily be transferred to multiple parties. (Sometimes the participants would have the note transferred to a trustee or custodian who acted on their behalf, but there seems to be no case deciding whether this would accomplish a perfection.)

The automatic perfection provision of § 9-309(3) won’t apply if the participation is recharacterized as a loan, since it is applicable only to outright sales. However, under § 9-309(2), an assignment (including a security assignment) of a payment intangible is automatically perfected if it "does not by itself or in conjunction with other assignments to the same assignee transfer a significant part of the assignor’s outstanding accounts or payment intangibles." Where the assignor is a financial institution, it is exceedingly improbable that any given loan participation will, either alone or combined with other loan participations sold to the same participant, be a "significant" part of the assignor’s total payment intangibles. Hence, automatic perfection will follow under § 9-309(2). If a loan participant is concerned that the "significant part" test will be met and thus that automatic perfection will be precluded, it can completely eliminate this risk simply by filing a financing statement and thereby complying with the generic perfection rule of § 9-310(a). Since this is a simple and inexpensive precaution, all loan participation purchasers are probably well-advised to follow it as a matter of course.