Mortgagor Claims: If At First You Don’t Succeed, Try, Try Again

In re Jepson v. Bank of New York Mellon, 816 F.3d 942 (7th Cir. 2016)

A creditor requested modification of the automatic stay so that it could proceed with a foreclosure action. The debtor opposed the motion and sought a declaration that the creditor had no interest in her mortgage. The bankruptcy court found in favor of the creditor, the district court affirmed, and the debtor appealed to the 7th Circuit.

The debtor borrowed $336,000 from a lender as evidenced by a note in favor of the lender (using a d/b/a rather than the lender’s legal name) that was secured by a mortgage on her property naming the lender and Mortgage Electronics Registration Systems, Inc. (MERS) as the nominee for the lender.

In a residential mortgage-backed securities (RMBS) trust, residential mortgage loans are pooled and then certificates backed by the mortgages are sold to investors. The rights and obligations of the parties to the trust are set forth in a Pooling and Service Agreement (PSA).

In this case the lender endorsed the note in blank and transferred the debtor’s loan to an RMBS trust. The trustee of the RMBS trust had possession of the debtor’s note and MERS assigned mortgage rights to the trustee. As a result, the trustee claimed an interest in the debtor’s note and mortgage. After the debtor defaulted, the trustee filed a foreclosure action.

Several years later while the foreclosure was still pending, the debtor filed a chapter 7 bankruptcy. The trustee then filed a motion requesting relief from the stay so that it could continue the foreclosure. The debtor responded that the trustee did not have any interest in her mortgage because (1) the note did not have a complete chain of endorsements, and thus could not be assigned to the trustee under the PSA, (2) the note was endorsed after the closing date in the PSA so that the assignment was invalid, and (3) the original lender was a fictitious entity so that the note was void and not negotiable. The debtor also claimed that the trustee lacked authority to act as a collection agency.

The trustee countered that the debtor did not have standing and failed to state a claim. The bankruptcy court agreed that under state law the debtor did not have standing to challenge violations of the PSA. Consequently it dismissed the debtor’s adversary proceeding and granted the trustee relief from the automatic stay. It did not address the claims that were not based on the PSA. The district court affirmed. It also agreed that the debtor lacked standing to assert claims based on the PSA and did not address any other claims.

The 7th Circuit first addressed the debtor’s contention that the trustee could not collect on the note because the assignment violated the PSA. The court agreed with the lower courts that she lacked standing to raise those arguments because she was not a third-party beneficiary of the PSA. The “prudential standing rule … normally bars litigants from asserting the rights or legal interests of others in order to obtain relief from injury to themselves.” Instead a “plaintiff generally must assert his own legal rights and interests, and cannot rest his claim to relief on the legal rights or interests of third parties.”

So, in order to prevail the debtor had to show that she had a cognizable interest in the PSA issues under state law. However, under applicable law (1) only the intended beneficiary of a trust can enforce the terms of the trust, (2) someone who might incidentally benefit from performance of the trust is not a beneficiary that can sue, and (3) in particular a mortgagor is not an intended beneficiary of an RMBS trust, and thus does not have standing to challenge the assignment of a note to the RMBS trustee based on noncompliance with the PSA. With respect to the PSA, the certificate holders are the intended beneficiaries. Mortgagors are not even incidental beneficiaries, but rather have adverse interests.

The debtor attempted to distinguish this precedent by arguing that she had standing to challenge a void (as opposed to voidable) assignment. As a preliminary comment, the court confirmed that the debtor would not have standing to object to on assignment that was only voidable. A beneficiary can ratify a voidable assignment. To allow a mortgagor to object would interfere with the beneficiary’s right of ratification.

The debtor’s standing to challenge a void assignment was less clear. Generally cases appeared to hold that an assignment in violation of a PSA will be voidable, and not void. However, the debtor argued that the terms of the PSA itself presented a special case. Under one of the provisions the trustee in conjunction with certain other parties was authorized to amend the PSA without the consent of the certificate holders. The debtor argued that this meant the certificate holders would not have the right to ratify violations of the PSA

According to the debtor, if certificate holders could not amend the PSA, they could not ratify ultra vires assignments. The court rejected this argument since one of the parties that was required to send was acting on behalf of certificate holders, so that they did in fact have an interest in the amendment process. In addition, certificate holders could contest unauthorized acts in a derivative action. Accordingly, the court concluded that the debtor did not have standing to challenge the assignment based on the PSA.

Just when it looked like all was lost for the debtor, the court made note of her additional arguments that (1) the note was void and not negotiable because the original lender was a fictitious entity (i.e. the name of the original lender used in the documents was a d/b/a instead of lender’s proper name), and (2) the trustee lacked the authority to foreclose the mortgage because it was an unlicensed debt collector. The bankruptcy and district courts found only that the debtor lacked standing to challenge the PSA, and neither of these arguments relate to the PSA.

Accordingly the court affirmed in part and remanded for further consideration of the non–PSA arguments. However, the court also noted that the remaining claims were basically questions of state law. The 7th Circuit suggested that the bankruptcy court should consider whether it would be appropriate to abstain and allow the state court to consider these issues in the context of the foreclosure proceeding.

It is reasonably well-established that a mortgagor is unlikely to be allowed to challenge a mortgage based on issues involving a PSA. However, as suggested by this case, that does not mean that a debtor is necessarily precluded from making claims based on errors and issues that do not directly affect the debtor.

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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