The MERS Morass, Part I

Contributed by Lee Jason Goldberg
As mortgage lenders seek to foreclose on troubled borrowers, Mortgage Electronic Registration Systems Inc. (commonly known as “MERS”) has been one of the most controversial players in the ongoing documentation saga plaguing the mortgage industry.  In a three-part series, we will explore some of the issues raised around MERS.  This entry discusses the background of MERS, while the second and third entries will focus on two recent cases in which bankruptcy courts came to opposite conclusions regarding MERS’s role in the mortgage foreclosure process.
A mortgage loan consists of two parts, a promissory note, which is the loan itself, and the mortgage or deed of trust, which secures the note by giving the lender the ability to foreclose on the underlying property.  Both the note and the mortgage are governed by state law:  the note, a negotiable instrument, is governed by Article 3 of the Uniform Commercial Code, and the mortgage, a security interest in real property, is governed by real property law, including recording statutes.
Recording statutes, which generally require interests in real property to be recorded in the locality (usually county) where such property is located, date back hundreds of years and are designed to provide notice to the world that someone claims an interest in a particular parcel of land.  Failure to comply with such statutes, therefore, subjects the lien to avoidance in the borrower’s bankruptcy case, rendering the note a mere unsecured obligation and the lender merely an unsecured creditor.
Looking at it from the other perspective, a borrower cannot default on a mortgage, which is just a security interest that enables the lender to foreclose on the property securing its note.  Instead, as with any other loan, a borrower must default on its obligations under the note for the lender to have the ability to exercise remedies.  To exercise the remedy of foreclosure, the lender must have an interest in the property, which it obtains through the executed mortgage.
To commence foreclosure proceedings against a borrower who defaults on a mortgage loan, therefore, the lender must show that it has a properly executed note and mortgage.  The corollary is that both the note and the mortgage must be held by the same person or an agent of such person in order for a mortgage loan to have any effectiveness as a secured obligation and foreclosure to be a permissible means of enforcing such obligation.
As we have discussed in this blog before, the common denominator in the mortgage documentation saga is lenders’ failure to prove that they satisfy state law requirements for commencing foreclosure proceedings.  Previously, we have examined the consequences of failure to prove possession and proper endorsement of the note, which are generally requirements for its enforcement under Article 3 of the UCC, in both the stay relief and claims contexts.
In this series, we examine the role of MERS in the mortgage recordation process and how it may affect lenders’ ability to foreclose on the underlying properties.  Lenders often use servicers to collect payments on mortgage loans and commence foreclosure proceedings if the borrower defaults.  A servicer is empowered as the lender’s agent to perform these actions provided that the lender actually possesses the note and has recorded the mortgage and, therefore, has the right to perform such actions in its own right.
As new forms of mortgage financing, including securitization trusts, proliferated in the 1990s, major lenders determined that the mortgage recordation system was outdated and incompatible with the needs of modern finance.  It was expensive and inefficient for each mortgage transfer to be recorded on local land records, particularly in light of the “originate-to-distribute” model of mortgage lending, where a lender would sell a loan shortly after it was made.
Mortgage loans were packaged into mortgage-backed securities, and new notes based on the cash flows from the underlying mortgage loans were issued to investors.  Often, these new notes (i.e., mortgage-backed securities) were packaged into securitization trusts known as collateralized debt obligations, which issued yet more notes to new investors.  Nevertheless, Article 3 of the UCC and state real property law, including recording statutes, remained the applicable law governing transfers and enforcement of the underlying notes and mortgages.
Therefore, to avoid the need to re-record a mortgage each time it was transferred, a group of large mortgage lenders determined that it would be more efficient for a single entity to be named as the “mortgagee of record” or “nominee” on a mortgage.  A mortgage could then be transferred without having to be re-recorded because, assuming that the transferee agreed that the “mortgagee of record” or “nominee” would retain its status as such notwithstanding future transfers, then there would be no need for re-recording because the mortgage would remain recorded in the name of the “mortgagee of record” or “nominee.”
MERS was created as an electronic repository for keeping track of holders of mortgages and servicing rights for the mortgage lenders and servicers who joined MERS as members.  MERS, in turn, was named as “mortgagee of record” or “nominee” on its members’ mortgages.  The mortgage would be recorded on local land records in MERS’s name, and then the mortgage could be transferred among MERS members without the need for re-recording the mortgage upon each transfer.  This system was implemented without any statutory authority, but courts have noted that currently MERS is involved with fifty percent of all residential mortgages in the United States.
The MERS system, however, raises the critical question of whether MERS, as the “mortgagee of record” or “nominee,” is an “agent” for the entity that would have been the mortgagee under the traditional mortgage recordation system (i.e., the lender).  If MERS were not considered to be an agent for the lender, then MERS’s recordation of the mortgage would split it from the note ab initio.  In other words, the mortgage would not be recorded in the name of the lender or its agent.  Because of this split, even if the lender held the note, and thus satisfied the possession requirement for its enforcement, the lender would be unable to foreclose on the mortgage and would be left with an unsecured claim.
To say the waters are muddied on this pivotal agency issue is an understatement, with the crux of the issue being whether the mortgages themselves and the agreements governing MERS and its relationship with its members create an agency relationship under applicable state law.  Indeed, while Article 3 of the UCC is fairly uniform from state to state, each state has its own mortgage recordation and agency laws, both of which derive from statutory and case law.  It is unsurprising, then, that a mere day apart, two bankruptcy courts in different jurisdictions came to opposite conclusions as to MERS’s status as agent and, thus, its role in mortgage foreclosures, with the bankruptcy court for the Eastern District of New York in In re Agard finding that no agency relationship existed and the bankruptcy court for the District of Kansas in In re Martinez finding that an agency relationship existed.  We will discuss the Agard and Martinez decisions in future posts.