Do You Know Where Your Notes Are?

On November 16, 2010, a judge of the United States Bankruptcy Court for the District of New Jersey surprised the lending industry by refusing to enforce a mortgage interest on the theory that the lender lacked legal possession of the note. More specifically, the lender, here, the Bank of New York (the "Bank") was deemed unable to enforce a mortgage note it had purchased from Countrywide Home Loans because Countrywide, as originator and servicer, had retained the note and had never given the Bank possession. Since the Bank could not enforce its note, the court, in Kemp v. Countrywide Home Loans disallowed its claim in bankruptcy.

The court's holding is instructive: The bankruptcy court concluded that, under the Pooling and Servicing Agreement, Countrywide (now, Bank of America's BAC Home Loan Servicing unit which assumed servicing rights after Bank of America purchased Countrywide in 2008) was required to transfer possession of the note to the trustee (the Bank) but failed to do so. The Bank's claim was disallowed because under the New Jersey UCC the fact that the Bank, as owner of the note, never had possession is fatal to enforcement. The fact that the note was not properly endorsed to the Bank also served to defeat enforceability. While a servicer has standing to file a proof of claim on behalf of a creditor, the servicer acts only as an agent of the owner of the instrument and has no greater right to enforce the instrument than its principal. Because the Bank had no right to enforce the note, Countrywide as its agent and servicer cannot enforce it. Since neither entity can enforce the note, the Bank will become an unsecured creditor and have to stand in line with the other unsecured creditors and receive only a percentage of what is due under the note.

Compounding the problem for BAC was the testimony of one of its employees who maintained that BAC routinely kept possession of the original notes, although BAC indicated this information was beyond the employee's area of knowledge.

If a mortgage originator does retain possession of the original notes, rather than transfer possession to the trusts that issued mortgage-backed securities, and thus causes the notes to be unenforceable, it may find itself on the hook for millions of loans that it had sold and securitized. Moreover, if the mortgage-backed securities that were issued are not truly mortgage-backed, purchasers of the securities may be able to compel the originator to buy the securities back. Transfer of possession of the notes at a later point will not solve the problem since it is unlikely that the trust documents will allow the subsequent transfer of the notes into the trust, and furthermore, such a transfer would destroy the tax status granted to the mortgage-backed securities.

Similar cases have held that failure to have possession of a note is fatal to its enforcement. Assignees of notes must ensure that the notes they purchase are physically transferred to it or its document custodian. If you are not sure where your original notes are, you would be well advised to ensure they are in your possession.

If you have any questions regarding this Consumer Financial Services Alert, you may contact Richard Gottlieb, Director of the Financial Industry Group, at 312-627-2196, or Arthur Axelson, the author of this alert and leader of Dykema's Financial Services Regulatory practice, at 202-906-8607.

For more information about Dykema's Consumer Financial Services Practice, please contact any of the listed lawyers.  

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