Whitman on Transferring Negotiable Notes

Property Scholar Dale Whitman has just published an article, entitled "Transferring Nonnegotiable Notes", explaining where the law is and where it needs to go with respect to the transfer of the right to enforce mortgage loans.  This issue has been one of the most confused and contested questions of legal interpretation in the aftermath of the Foreclosure Crisis.  When the whole housing finance system began to unravel upon the unexpectedly high volume of mortgage defaults, un-tested and unorthodox industry practices regarding loan transfer ran smack into legal uncertainty regarding who held what rights to which loans subject to what defenses.  This legal uncertainty stuck like a rod in the gears of the foreclosure system, causing massive delays and, in some cases, loss of the right to enforce the loan.  

The question of mortgage negotiability and transfer adequacy has caused a "vast amount of litigation" (as Whitman puts it), and this litigation has "greatly expanded our understanding" regarding how negotiable notes are transferred. But there remains a gap in legal comprehension related to the transfer of nonnegotiable notes.  In addition, open questions regarding defenses can destabilize the market and incentivize market player misbehavior. Professor Whitman attempts to bring clarity to the murky legal questions regarding who has (and should have) the right to enforce the loan and what defenses a borrower can (and should be able to) assert against an assignee of a mortgage note. 

Professor Whitman is perhaps the most recognized the national expert on the subject of note negotiability and transfer adequacy.  His most recent article adds an important piece to the secondary mortgage market puzzle, in terms of understanding what went wrong, what rights parties have with respect to defaulted mortgage loans, and how the law should evolve to create a fairer, more stable mortgage capital market.

Here's the abstract:

This article reviews what we know about transferring ownership and the right of enforcement of nonnegotiable notes. The focus will be on notes secured by mortgages, since this is likely the context in which most modern nonnegotiable notes are created. There has been a vast amount of litigation about the transfer of negotiable mortgage notes in the past half decade, greatly expanding our understanding, but there has been little development involving nonnegotiable notes. Hence, it is helpful to compare negotiable and nonnegotiable notes, with particular emphasis on how each is transferred. Perhaps ironically, this means that the bulk of this article discusses negotiable notes as a point of reference, despite the fact that its ultimate focus is nonnegotiable notes. Part I of this article reviews the history of the definition of negotiability, and shows how our current understanding of negotiability came to be. Part II demonstrates how to tell the difference between negotiable and nonnegotiable notes, and why that difference is important. Part III discusses the meaning of “transfer” of a promissory note. Part IV examines specifically how the right to enforce nonnegotiable notes can be transferred under present law, and considers whether changes are needed. Finally, this article concludes with a brief description of a proposed national mortgage registry that has the potential to make transfers of both negotiable and nonnegotiable mortgage notes far more efficient without disrupting the current legal regime.

This article is a good resource not only with respect to the legal requirements for transferring nonnegotiable notes, but also for:

1. The history and background of the Holder in Due Course doctrine.
2. How to identify whether a note is negotiable (including Fannie/Freddie forms and notes secured by FHA and VA mortgages)
3. How negotiable notes (and the mortgages securing them) must be transferred
4. The impact of UCC Article 9 on transfers of both negotiable and nonnegotiable notes.

To me,  a very interesting and important part of the piece,  particularly the part that deals with the current applicability of the Holder In Due Course doctrine to mortgage loan transferees.  Professor Whitman articulates why this doctrine should not apply to mortgage notes, and I wholeheartedly agree.  For one thing, in a typical mortgage transaction, loan buyers are expected to conduct due diligence with respect to the quality of the credit and collateral behind the mortgage loan.  The secondary market players, of course, want the holder-in-due-course doctrine to apply, because it allows for incompetent underwriting by their industry and insulates them to some extent from illegal practices of mortgage originators.  Professor Whitman makes the compelling economic and political argument that the Holder In Due Course doctrine should not continue to apply to mortgage notes. He writes:

If the holder in due course doctrine was abrogated, and secondary market investors were forced to bear the risk of fraudulent conduct by their originators, their costs would doubtlessly rise, either to screen out the “bad apples,” or to suffer the financial losses engendered by the originators’ bad behavior.  If the private securitization industry, which has been virtually shut down since mid-2007, manages to arise again, its economics could be significantly affected by loss of the protection it has hither-to received from the holder in due course doctrine.

Nonetheless, sound economic policy strongly favors repeal or drastic modification of holder in due course. The reason hinges on the relative availability of information about the propensity of particular loan originators to engage in bad conduct. Consumer borrowers, who enter the mortgage market only at infrequent intervals and who typically have only a limited and unsophisticated understanding of its operations, have virtually no factual basis for identifying and avoiding originators who are apt to engage in fraud, and they cannot gain this sort of information at any reasonable cost. Secondary market investors (including securitizers), on the other hand, participate in the market on an ongoing or regular basis, and commonly buy loans by the thousands. Their costs in identifying and policing bad actors, when spread over a large number of loans, are likely to be quite modest. As a matter of sound economics, it is obviously more efficient to impose these risks on the parties who can best identify and avoid them. As a lawyer and an economist from the Federal Reserve Bank of Cleveland put it, if the holder in due course rule were abandoned, we could expect the following result: "By forcing the market to internalize the cost of consumer compliance and spread it across all consumers, the market’s ability to adjust costs [would be] aligned with the incentive to minimize costs that result from a competitive marketplace.” In the absence of assignee liability, these incentives are not aligned. The holder in due course rule artificially lowers the cost of consumer compliance to the market, eliminating the incentive to minimize those costs through competition. Consumers, then, bear the risk of unlawful origination practices, but lack the ability to price them into credit.

These problems arise in the context of residential mortgage loans because of the assumption by courts that mortgage notes on Fannie and Freddie forms (and FHA and VA insured notes) are negotiable.  Although standard form use does not negotiability make, Professor Whitman admits that it is likely that the Fannie/Freddie forms will continue to be seen as negotiable by courts.  The same need not be true, says Whitman, for commercial mortgage notes.

Enforcement rights with respect to negotiable notes generally requires possession of the note, but transfer of nonnegotiable notes is subject to different rules.  There is a concept under UCC Article 3 of a non-owner of the note who can enforce it - the PETE (person entitled to enforce the note).  UCC 3's PETE status is applicable only to negotiable instruments, however.  Therefore, if a note is not negotiable, enforceability by a non-owner turns on principles of the common law as well as UCC Article 9.  Note ownership is based on the principle of "follow the money and see where it goes."  And although that is an interesting question in some contexts, it is irrelevant to the question of who is entitled to collect payments, enforce the obligation, and negotiate a modification with a borrower.  In modern loan securitization parlance, the servicer should be entitled to enforce the note, even though the servicer is not the owner (the owner, of course, is the beneficiary - the entity that owns the securitized pool of mortgages).   

Among the many prior articles that Professor Whitman has written on the broader subject of mortgage loan transfer and enforcement, see:

• Dale A. Whitman, How Negotiability Has Fouled up the Secondary Mortgage Market, and What To Do About It, 37 PEPP. L. REV. 737 (2010).

• Dale Whitman, “THE PERSON ENTITLED TO ENFORCE:” LESSONS LEARNED FROM BAC HOME LOANS SERVICING V. KOLENICH, ABA REAL PROP. NEWS, Dec. 2012.   

• Dale A. Whitman & Drew Milner, Foreclosing on Nothing: The Curious Problem of the Deed of Trust Foreclosure Without Entitlement to Enforce the Note, .66 ARK. L. REV. 21 (2013).

• Dale A. Whitman, What We Have Learned from the Mortgage Crisis About Transferring Mortgage Loans, 49 REAL PROP. TR. & EST. L.J. 1 (2014).