Failure to Negotiate Mortgage Note: “Strong Arm” Powers With A Twist

Rogan v. Vanderbilt Mortgage & Finance, Inc. (In re Dorsey), 491 B.R. 464 (Bankr. E.D. Ky. 2013 –

A chapter 7 trustee sought to use his “strong arm” powers as a hypothetical judgment lien creditor, arguing that a mortgage could be avoided because the mortgagee (which was an assignee of the original mortgagee) was not entitled to enforce the note secured by the mortgage.  Although the bankruptcy court did not avoid the mortgage lien, it did conclude that the trustee could sell the mortgaged property free of any claim by the mortgagee assignee.

The debtors (the Dorseys) executed a note in favor of Popular Financial Services, LLC (PFS) that was secured by a mortgage given to Mortgage Electronic Registration Systems, Inc. (MERS) as nominee for PFS.  The debtors executed an Affidavit of Conversion of Real Estate so that the mobile home encumbered by the mortgage was treated as real estate, and the mortgage properly perfected the lien on the mobile home.

A couple of years later Vanderbilt Mortgage & Finance, Inc. (Vanderbilt) acquired certain installment loan agreements pursuant to a purchase agreement with the parent and an affiliate of PFS to purchase.  The schedule of contracts attached to the purchase agreement included a contract with one of the Dorseys, and the Dorsey note was identified as one of the notes that was transferred.

Vanderbilt obtained possession of the Dorsey note, and MERS’ assignment of the Dorsey mortgage to Vanderbilt was recorded.  However, unfortunately for Vanderbilt, there was no indorsement of the note from PFS to Vanderbilt, and PFS was not a party to the purchase agreement.

The court began with an analysis of the trustee’s ability to assert the rights of a hypothetical judicial lien creditor under Section 544(a)(1) of the Bankruptcy Code.  Typically a trustee’s strong arm power is asserted to establish rights in collateral that are superior to liens that are unperfected as of the commencement of the bankruptcy, so that the unperfected liens can be avoided.  (See, for example, Bankruptcy “Strong Arm” Powers: Bye Bye Mortgage.)

However, in this case there was no dispute that the mortgage was valid and perfected.  Rather the only challenge was to Vanderbilt’s right to enforce the note secured by the mortgage.

As the court viewed the issue (cites omitted):  “If a note is pursued by a party that is not entitled to possess and to enforce it, the mortgage is meaningless.  The question, therefore, is not whether the Mortgage is unperfected, but is it enforceable.”  The result is similar to asserting the strong arm powers against an unperfected mortgage: “If Vanderbilt cannot enforce the Note, it is as if the Mortgage does not exist” and the trustee could sell the property as though the mortgage was not in the chain of title.  However, unlike the case where an unperfected mortgage lien is avoided, the mortgage lien is not preserved for the benefit of the bankruptcy estate if it is unenforceable.  (Compare Strong Arm Powers: What Happens When a Mortgage Is Avoided – Does It Go Poof?.)

The court turned to an analysis of Vanderbilt’s right to enforce the note, noting that the issue was governed by the state’s uniform commercial code (UCC).  Under Article 3 of the UCC, a “person entitled to enforce” a note means “(1) The holder of the instrument; [or] (2) A non-holder in possession of the instrument who has the rights of a holder.”  [UCC 3-301]

A “holder” is a “person in possession of a negotiable instrument that is payable either to bearer or to an identified person that is the person in possession.”  [UCC 1-201(21)]  Since the note was specifically payable to PFS, Vanderbilt was required to produce an indorsement to it or to bearer in order to be a holder.  Since it could not produce any indorsements, it was not a holder.

When asked for evidence that it had a right to enforce the note, Vanderbilt argued that the assignment of the mortgage and the purchase agreement were sufficient.  Under the UCC a “transfer” so that the transferee obtains the rights of the transferor can be accomplished in several ways:

  • A note can be transferred by delivering it to a person for purposes of giving that person the right to enforce it.  [UCC 3-203(a)]  Where a note is payable to an identified person, there must be transfer of possession and indorsement of the note by the holder.  [UCC 3-201(b)]  Since the Dorsey note was not indorsed to Vanderbilt, it did not acquire rights as a transferee under this section.
  • If the transferee is not a holder because the transferor did not indorse the note, the transferee nevertheless acquires the transferor’s rights to enforce the note if the transferor was a holder at the time of the transfer.  [UCC 3-203(b)]  However, in this case PFS was not a party to the purchase agreement or the related bill of sale, and there was nothing in the record to show how the PFS related parties that were the sellers obtained the note.  So Vanderbilt did not establish that it acquired the note from a holder.
  • If an instrument is transferred, but the transferee does not become a holder because of a lack of indorsements by the transferor, it has an enforceable right to an indorsement by the transferor.  [UCC 3-203(c)]  However negotiation does not occur until a proper indorsement is made.   In this case, regardless of whether Vanderbilt had any rights against the PFS related parties, there was no evidence that either was a holder, and thus their indorsement would not be sufficient to transfer the note.

The assignment of the mortgage also did not cure the problem.  In this case the mortgage was granted to MERS as nominee for PFS.  When it assigned the mortgage, it could only assign the rights granted by the mortgage, and could not transfer any right with respect to the note.

In sum, Vanderbilt was not able to establish that it had a right to enforce the note, and therefore the mortgage.  Consequently, the court concluded that the trustee was entitled to an order authorizing the sale of the property free and clear of any interests of Vanderbilt under the note and/or the mortgage.

The court specifically did not determine that the mortgage was not perfected, “which means that it is a lien against the Real Property pending sale free and clear of liens, with liens to attach to the proceeds, pursuant to 11 U.S.C. 363(b) and (f).”  It is not at all clear what this will mean when it comes time to distribute proceeds.  PFS remained the only entity entitled to enforce payment of the note.  However, it had assigned its rights under the mortgage.  And in any event, the court noted in a footnote that the trustee had already obtained a default judgment against PFS holding that the bankruptcy estate had priority over the interests if any of PFS.

Once again, the importance of paying attention to detail is brought home with a vengeance.  The failure to include PFS as a seller under on the purchase agreement (and/or to indorse the Dorsey note to its parent or affiliate before the sale) caused Vanderbilt to lose all rights with respect to the note and the mortgage.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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