Desmond v. Green (In re Harborhouse of Gloucester, LLC), 505 B.R. 365 (Bankr. D. Mass. 2014) –

The assignee of a mortgage note that was lost prior to the assignment filed a secured proof of claim in a chapter 7 bankruptcy. The trustee asked the court to disallow the claim on the basis that the assignee was not entitled to enforce the note or the mortgage.

The debtor acquired a restaurant and two residential apartments in consideration for $1.00 and assumption of encumbrances of record. At that time the property was subject to a mortgage securing a note in the original principal amount of $360,000.

The original mortgagee (Hansbury) assigned the note and mortgage, and the assignee (CPIC) in turn reassigned the note and mortgage to a third party (Green) as security for a loan from Green to CPIC. However, the original note was lost before the first assignment. Consequently, in connection with the initial assignment to CPIC, Hansbury executed a lost note affidavit. Attached to the affidavit were (1) a copy of the note, (2) an allonge to the note purporting to transfer rights under the note, and (3) an assignment of the mortgage. In connection with the second transfer, CPIC executed an assignment of the mortgage and an allonge to the note transferring its rights to Green.

The trustee objected to the claim filed by Green in the bankruptcy. The trustee contended that neither CPIC nor Green had the right to enforce the note, and accordingly Green had no right to enforce the mortgage. (This became important because Green asserted a ~$796,000 claim and another party asserted a ~$248,000 claim, in each case secured by a lien on the property. The trustee ultimately sold the property free and clear of liens for only $245,000.)

The court’s decision turned on Article 3 of the Uniform Commercial Code as adopted in the applicable state. This article applies to negotiable instruments, and all agreed that the mortgage note was a negotiable instrument. Under Section 3‑301, the note may be enforced by a person that is:

(i) the holder of the instrument,

(ii) a non-holder in possession of the instrument who has the rights of a holder, or

(iii) the person not in possession of the instrument who is entitled to enforce the instrument pursuant to section 3‑309.

Under state law both a holder and a non-holder were defined in part as someone who currently possesses a negotiable instrument. Thus, Section 3‑301 required a person to have actual possession of the note unless it was entitled to enforce under Section 3‑309. Under the applicable version of Section 3‑309(a) (emphasis added):

A person not in possession of an instrument was entitled to enforce the instrument if

(i) the person was in possession of the instrument and entitled to enforce it when loss of possession occurred,

(ii) the loss of possession was not the result of a transfer by the person or a lawful seizure, and

(iii) the person cannot reasonably obtain possession of the instrument because the instrument was destroyed, its whereabouts cannot be determined, or it is in the wrongful possession of an unknown person or a person that cannot be found or is not amenable to service of process.

The court concluded that under the plain language of this section, a person seeking to enforce a lost note must have had possession of the note at the time the loss occurred. Since neither CPIC nor Green ever had possession of the note, they were not entitled to enforce it. (Note that not all courts have agreed with this interpretation; and as noted below, this approach was rejected in the 2002 amendments to Article 3.)

However, although Green was not entitled to enforce the note, it did not follow that Green was not able to enforce the mortgage. But since the mortgage secured the lost note, which was not held by Green, the court concluded that if Green received proceeds as the assignee of the mortgage, he would be required to hold those proceeds in trust for the true holder of the note.

Consequently, the court ruled that (1) Green was not the holder of the note and could not enforce it; (2) accordingly Green had no claim against the bankruptcy estate per se; (3) however Green did have a valid interest in the mortgage, and therefore was entitled to proceeds of the sale; but (4) Green must hold any proceeds for the benefit of the true holder of the note.

This left Green in a no win situation. The court commented in a footnote that Green had asked that the original noteholder be added as a proper and indispensable party to the action. However, this request had to be made by separate motion and the court warned that the motion should explain why the court had subject matter jurisdiction over a dispute between Green and Hansbury. Thus, the bankruptcy court ordered Green to hold any proceeds in trust for Hansbury, but did not provide him a forum for determining their respective rights to the proceeds.

As noted above, Section 3‑309 of the UCC was amended to reject this result. Section 3-309(a)(i) has been replaced with the following:

A person not in possession of an instrument is entitled to enforce the instrument if:

(1) the person seeking to enforce the instrument:

(A) was entitled to enforce the instrument when loss of possession occurred; or

(B) has directly or indirectly acquired ownership of the instrument from a person who was entitled to enforce the instrument when loss of possession occurred;

Thus, in states where the 2002 amendments to Article 3 have been adopted, a downstream assignee is no longer precluded from enforcing a lost note. However, states have been very slow to adopt these amendments. So, in evaluating the ability to enforce a lost note, it will be important to determine which version of Section 3-309 is applicable.

Vicki R. Harding, Esq.