« The Heirs of Karl Lleywellyn: the PEB Report, Green Cheese, and the Hijacking of American Law (Part II) | Main | Soured on Saurman »

The Heirs of Karl Lleywellyn: the PEB Report, Green Cheese, and the Hijacking of American Law (Part III)

posted by Adam Levitin

As I noted in the previous posts on this thread (here and here), I think the Permanent Editorial Board for the UCC's report on the enforceability of mortgage notes is simply irrelevant because it deals with negotiable notes, and virtually all mortgage notes today are not negotiable. But even if the notes were negotiable, there are still some further flaws in the report itself.

I'm not going to attempt a complete catalogue. But I will point out some two highlights:  the failure to address the interaction of the UCC with other law, such as real property law and trust law and agency law; and the failure to address the evidentiary issues that are at the heart of the foreclosure documentation problems.  

(1) Failure to Address the Interaction of the UCC with Other Law. The report puports to deal with the enforceability of the negotiable mortgage note under the UCC. While that is the extent of the PEB’s mandate, it is also sort of ridiculous, which is one reason why the report should never have been issued. Courts are never dealing with the enforcement of the note just under the UCC. Instead, the question is the foreclosure of the mortgage, which may require reference to the enforceability of the note (it’s actually done as an in rem action in Delaware, without reference to the note), but there are many other areas of law that also come into play, including agency and trust law. The outcome might by X under the UCC alone, but when the UCC interacts with other areas of law, the outcome might be completely different. The result is a fundamentally misleading report (on an irrelevant topic). 

The report is also very selective in what it discusses and doesn’t. It discusses the parts of the UCC and official commentary (which is not law, but should at least bind the PEB) that it likes in order to get the “and therefore the banks should win” outcome. For example, the report makes a big deal out of the ability of a transferee who is not a holder (because there is no endorsement) to enforce a note. The point of the report is that lack of endorsements aren’t fatal. Maybe not under Article 3 of the UCC, but they are if a pooling and servicing agreement (PSA) supplements or supplants the UCC, as it is permitted to do per UCC 1-102(3) (current version)/ UCC 1-302 (revised version). No mention of this little problem, however. By framing the issue in UCC-only terms the PEB is able to engineer the desired outcome. But that's highly misleading as the real world outcomes depend on other areas of law as well as the banks' ability to meet the requisite evidentiary showings. 

(2) Evidentiary Issues.  The report doesn’t address what’s really the nub of the matter when enforcing mortgage notes (negotiable or otherwise)—the evidentiary problems. The issues in courts aren’t so much confusion about what the law is, but that the banks are dancing around the law because they don’t have the evidentiary basis to prevail on any of the grounds that the PEB sets forth. All the law in the world won’t help if you don’t have the facts on your side.

If the foreclosing banks were “holders” in the UCC Article 3 sense (which would require the notes to be negotiable, btw), there’d be no issue here. The problem is that the foreclosing banks are generally are not holders or at least not able to show that they are. Instead, they have to rely on other statuses to enforce the notes—lost note status (the dog ate my note!) or nonholder with rights of a holder. I’ll spare you my comments on the lost note issue. But there’s an important point to make about the nonholder with the rights of a holder. The PEB report conveniently fails to mention a line in the official comment 2 to UCC 3-203 about the ability of a transferee who is not a "holder" to enforce a negotiable note: 

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. (emphasis mine.)

So what does this mean as an evidentiary matter? The transferee needs to prove (1) that the transferor was a holder at the time of the transfer and (2) that the transferor delivered the note to the transferee and (3) that the transfer was for the purpose of giving the transferee the right to enforce the instrument. I have never seen a case in which a foreclosing party claims to be a nonholder in possession of the note and even attempts to prove (1) or (3). Proving (2) without proving both (1) and (3) doesn't do anything. In other words, 3-203 is requiring that the chain of title, including the timing of the transfer. Good luck showing that. No discussion of this in the PEB report—wouldn’t want to signal to courts that the UCC actually sets up some real evidentiary roadblocks to note enforcement if taken seriously. So we have two levels of deception. First, the pretense that the law of negotiable notes is what matters and second that the law of negotiable notes is simply "banks win" rather than bank wins if it meets the evidentiary requirements of law. 

Similarly, with the discussion of the ability to transfer a note under Article 9 of the UCC, the report glosses over some huge evidentiary hurdles: to prove a transfer under Article 9, you have to prove that value was given (should be easy enough), that there is an authenticated sale agreement (a problem in the Ibanez case in the Massachusetts Supreme Judicial Court), that it describes the collateral (query what sort of description is needed, again a problem in Ibanez), and that the seller has rights in the collateral.

I think this last point is actually a huge problem because if there has been a chain of transfers depending on Article 9, rather than Article 3 endorsement, the last party in the chain has to prove up the title of all of the prior transferors. It’s not clear to me how easily that can be done, especially if some of the prior transferors have gone bankrupt, etc. The biggest and often overlooked benefit of negotiation is an evidentiary benefit. The zipless Article 9 process loses that benefit.

And that zipless Article 9 process will be the subject of our next post. 


Why are the notes not negotiable? What provision of the UCC 3-104(a) was not met?

Prof. Levitin cites to a 1997 UCLA Law Review article titled "Searching for Negotiability in Payment and Credit Card Systems" by Columbia Law Prof. Ronald Mann, 44 UCLA L. Rev. 951 (1997).

Here is an excerpt from Prof. Mann's article which addresses why mortgage notes are often not negotiable:

"The irrelevance of negotiability to home-mortgage note transactions is best demonstrated by the fact that the standard form of promissory note used for those transactions fails to satisfy the requirements of negotiability. Because of the strong interest in uniformity in the large securitized home-mortgage note transactions, Fannie Mae and Freddie Mac have promulgated a number of standard forms for use in those transactions. Transactions that do not use those forms are not eligible for repurchase by Fannie Mae or Freddie Mac. Accordingly, although a significant number of home-mortgage notes are not securitized for various reasons, the Fannie Mae/Freddie Mac forms dominate the market, even for transactions in which the lender does not contemplate an immediate sale to Fannie Mae or Freddie Mac.

The most basic of these forms is the FNMA/FHLMC Multistate Fixed Rate Note-- Single Family. Section 4 of that Note provides as follows:

4. Borrower's Right to Prepay

I have the right to make payments of principal at any time before they are due. A payment of principal only is known as a “prepayment.” When I make a prepayment, I will tell the Note Holder in writing that I am doing so.

The italicized sentence of that provision appears to constitute an “undertaking . . . to do a[n] act in addition to the payment of money.” For historical reasons codified in section 3-104(a)(3) of the U.C.C., a promissory note cannot be an instrument if it contains such an undertaking: the rules of negotiability apply only to promises to pay money, not to other, nonmonetary undertakings. Sending a notice certainly is an act “in addition to the payment of money,” and the note's language seems to constitute an “undertaking” to perform that act (albeit only on certain conditions). Accordingly, it seems unlikely that the Fannie Mae/Freddie Mac form qualifies as negotiable. Thus, the rules of Article 3 (including its holder-in-due-course protections) do not apply.

Most people to whom I have mentioned that peculiarity find it bizarre. The requirement that a homeowner send a written notice of prepayment does not seem crucial to the administration of a mortgage note. After all, the receipt of a payment that exceeds the required minimum amount should provide some notice to the servicer. The patron of negotiability must wonder why any sensible drafter would allow all the wonderful benefits of negotiability to slip away for such a trivial provision.

But the preceding paragraphs offer an obvious answer: the benefits of negotiability have no practical significance to the operation of the current system. Parties could take advantage of those benefits only if they were willing to be careful to obtain indorsements and take possession of each promissory note that they purchased. Given the practical difficulties that would accompany any attempt to satisfy those requirements and the uncertain prospects for victory even upon full compliance with the technical requirements, it is far more sensible to leave negotiability by the wayside in order to pursue the financial advantages promised by access to a large and highly liquid secondary market. Because the home-mortgage note market cannot practicably assure the benefits of negotiability, there is no reason why the parties drafting the notes that the system uses should take any great care to ensure that the notes retain technical negotiability. Furthermore, the absence of negotiability from the most common form of note suggests that the parties that draft those notes in fact do not take care to protect the negotiability of the obligations in question."

See also Dale Whitman, "How Negotiability Has Fouled Up the Secondary Mortgage Market, and What To Do About It," 37 Pepp. L. Rev. 737 (2010).

Quick question(s) for Adam,

Can a mortgage loan servicer charge off a loan that is still included in a trust?

(EX. Could Litton as servicer for HSBC as Trustee charge off a loan in FHLT2005-E? Would the charge off status require the loan to be removed from the trust? Would the trustee of the trust still be the beneficial holder of the loan if the servicer charged it off?)

I would love your imput on this.
Thanks Jennifer in GA

The comments to this entry are closed.


Current Guests

Follow Us On Twitter

Like Us on Facebook

  • Like Us on Facebook

    By "Liking" us on Facebook, you will receive excerpts of our posts in your Facebook news feed. (If you change your mind, you can undo it later.) Note that this is different than "Liking" our Facebook page, although a "Like" in either place will get you Credit Slips post on your Facebook news feed.

News Feed



  • As a public service, the University of Illinois College of Law operates Bankr-L, an e-mail list on which bankruptcy professionals can exchange information. Bankr-L is administered by one of the Credit Slips bloggers, Professor Robert M. Lawless of the University of Illinois. Although Bankr-L is a free service, membership is limited only to persons with a professional connection to the bankruptcy field (e.g., lawyer, accountant, academic, judge). To request a subscription on Bankr-L, click here to visit the page for the list and then click on the link for "Subscribe." After completing the information there, please also send an e-mail to Professor Lawless (rlawless@illinois.edu) with a short description of your professional connection to bankruptcy. A link to a URL with a professional bio or other identifying information would be great.