The Continuing Saga of the Perils of Inadequate Documentation in Loan Transfers

Contributed by Lee Jason Goldberg
Widespread documentation problems in the mortgage industry have dominated headlines this fall, as major financial institutions have frozen (and since resumed) foreclosure proceedings against troubled borrowers.  While the nature of documentation problems has varied, their common denominator is lenders’ failure to prove that they satisfy state law requirements for commencing foreclosure proceedings.  Bankruptcy courts have begun responding by refusing to grant certain relief, including denying stay relief and disallowing claims, to lenders who fail to prove their standing to pursue state law remedies, such as foreclosure, against the debtor.  Such denial of relief adversely affects lenders’ (and investors’) ability in bankruptcy cases to realize value from their purported collateral, especially as to mortgage-backed securities and related derivatives, where the debtor’s note (i.e., loan) and mortgage may have been transferred multiple times without strict observance of legal transfer requirements.

In a recent post we observed that the “devil is in the details” when a putative secured creditor moves for relief from the automatic stay to foreclose on a debtor’s mortgage.  See In re Tandala Mims aka Tandala Williams, Case No. 10-14030 (MG) (Bankr. S.D.N.Y. Oct. 27, 2010) (Dkt. No. 13) (denying lender’s stay relief motion for lack of standing because, despite debtor scheduling lender as secured creditor, lender did not provide sufficient documentation proving that it possessed note, which is a requirement for foreclosure under New York law).  While Mims creates an obstacle for lenders trying to realize value from their collateral by seeking stay relief to institute state law foreclosure proceedings, the decision by Chief Judge Wizmur of the United States Bankruptcy Court for the District of New Jersey in John T. Kemp v. Countrywide Home Loans, Inc. (In the Matter of John T. Kemp), Case No. 08-02448 (JHW) (Bankr. D. N.J. Nov. 16, 2010) (Dkt. No. 25) likewise creates an obstacle for lenders trying to realize value from their collateral through the claims process.
In Kemp, the chapter 13 debtor scheduled Countrywide Home Loans as a holder of secured claims, namely as first and second mortgagee against a property in which the debtor held an ownership interest.  Prior to Kemp’s chapter 13 filing, Countrywide Home Loans sold the debtor’s note and mortgage to the Bank of New York (“BNY”) as trustee of a certain asset-backed securitization vehicle pursuant to a pooling and servicing agreement (“PSA”).  Another Countrywide entity (“Countrywide Servicing”) remained as the servicer.  The debtor’s initial chapter 13 plan proposed to, among other things, cure arrearages on three separate mortgages, including the two Countrywide Home Loans mortgages.  Countrywide Home Loans, identifying itself as the servicer for BNY, filed a secured proof of claim with respect to one of the mortgages and notes, identifying the subject property as collateral for the claim.  The debtor filed an adversary complaint against Countrywide Home Loans seeking to expunge its proof of claim by asserting that BNY could not enforce the underlying obligation.  Under the Bankruptcy Code, a claim is allowed unless a party in interest objects, and if an objection is made, the claim is disallowed to the extent that “such claim is unenforceable against the debtor and property of the debtor, under any agreement or applicable law for a reason other than because such claim is contingent or unmatured.”  11 U.S.C. § 502(b)(1).
Although the mortgage had been assigned to BNY, which assignment had been recorded with the country clerk and had purportedly assigned the note as well, Countrywide Home Loans had failed to comply with the requirements under the PSA that it indorse the note in blank and deliver it to BNY.  At trial, Countrywide Home Loans produced an undated allonge to the note directing the debtor to pay BNY as trustee.  Countrywide Home Loans admitted, however, that it only executed and attached the allonge in anticipation of the trial; not only were these steps taken after the proof of claim was filed, but the note was still not transferred to BNY.  Additionally, the proof of claim was filed by Countrywide Home Loans, which originated the loan, and not Countrywide Servicing, which was the servicer under the PSA.
The court disallowed Countrywide Home Loans’ claim on two grounds:  (1) under the New Jersey Uniform Commercial Code, that the owner of the note, BNY, never had possession of the note was “fatal to its enforcement” and (2) the failure to properly indorse the note to BNY also defeated its enforceability.  Under New Jersey law, enforcement of a note secured by a mortgage is governed by the UCC.  The court determined that the subject note was a negotiable instrument under the New Jersey UCC.  To enforce a negotiable instrument under the New Jersey UCC, a party must be a (i) 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 it pursuant to certain other sections of the UCC.
The court held that BNY did not meet any of the three statutory predicates to enforcement of the note.  As a transferee, BNY failed to attain status as a holder because the note was neither transferred to it nor indorsed by the holder.  Because BNY never had possession of the note, under the New Jersey UCC, it could not qualify as a holder of the instrument or a nonholder in possession of the instrument who has the rights of a holder.  Additionally, the note was not properly indorsed, and the allonge was not executed until after the proof of claim was filed.  The court observed that even if the newly executed allonge were recognized as a valid indorsement of the note, BNY still could not qualify as a holder because it never came into actual possession of the note.
As to the third statutory predicate, which, among other things, permits enforcement of a lost, destroyed, or stolen instrument, the court relied on the decision of the United States District Court for the District of Massachusetts in Marks v. Braunstein, No. 09-11402-NMG, 2010 WL 3622111 (D. Mass. Sept. 14, 2010) (affirming the bankruptcy court’s decision).  In Marks, the bankruptcy court denied a motion by an assignee of a secured note to credit bid the amount owed to him under it toward his purchase of the underlying collateral at auction.  Although the assignee stated that the note was lost, he acknowledged that he was never in possession of the note, thereby precluding his reliance on the “lost, destroyed, or stolen” exception to the possessory requirement for enforcement of the note, which requires that the person seeking to enforce the instrument have had both the right to enforce it and possession of it prior to its being lost, destroyed, or stolen.  The Marks and Kemp courts each noted that the purpose of the possession requirement in Article 3 of the UCC, which governs negotiable instruments, is to protect a maker from multiple enforcement claims to the same note.  Despite conflicting enforcement claims not being a concern in Marks, the court nonetheless refused to allow the assignee to enforce the note because he did not meet any of the statutory predicates for enforcement.
While the Kemp court held that BNY was not entitled to enforce the note and disallowed the claim on that basis, the court made two additional important observations.  First, the court distinguished the right to enforce an instrument from ownership of the instrument.  Although BNY had a valid ownership claim on the basis of the reference to the note in the recorded assignment of the mortgage, such assignment did not entitle BNY to enforce the note because BNY did not meet any of the three statutory predicates for enforcement under the New Jersey UCC.  Second, even though a servicer may file a proof of claim on behalf of a creditor, the servicer acts only as the agent of the owner of the instrument and has no greater right to enforce the instrument than its principal.  The court concluded that “[b]ecause the Bank of New York has no right to enforce the note, Countrywide [Home Loans] as its agent and servicer cannot enforce the note.”  The court did not indicate who was entitled to enforce the note.
Like Mims, both Kemp and Marks demonstrate that failure to comply with state law requirements for the enforcement of a note can have grievous consequences for mortgage lenders and investors in bankruptcy cases.  Because every state except New York has adopted revised Article 3 of the UCC, bankruptcy courts may look to Kemp and Marks for guidance as debtors and creditors increasingly spar over potentially flawed mortgage documentation.  Additionally, even though New York is the only state that has not adopted revised Article 3, the old Article 3 and caselaw from New York state courts, as well as Mims itself, show that New York’s requirements for enforcement of a note are very similar to other states’ requirements.  Based on Kemp, Marks, and Mims, lenders who cannot prove possession of a note (or prior possession if the note is lost, destroyed, or stolen) may find their ability to realize value from their collateral severely constricted in bankruptcy cases, with equally serious knock-on effects for investors in mortgage-backed securities and related derivatives that are backed by such collateral.