motion for rehearing (final) r1

7/31/2019 Motion for Rehearing (Final) r1

http://slidepdf.com/reader/full/motion-for-rehearing-final-r1 1/46

Cause No. 12-0342

IN THE SUPREME COURT OF TEXAS==================================================

JAMES ALLEN MCGUIRE

Petitioner,

vs.

FANNIE MAE F/K/A FEDERAL NATION MORTGAGE

ASSOCIATION,

Respondent.

=================================================

ON PETITION FOR REVIEW FROM THE SECOND COURT OF

APPEALS, FORT WORTH, TEXAS

On appeal from cause no. 02-11-00312-CV

Second District Court of Appeals

Fort Worth, Texas

=================================================

PETITIONER'S MOTION FOR REHEARING

=================================================

JAMES ALLEN MCGUIRE (Pro Se)

902 Rusk Dr

Euless, Texas 76039

817 420-4151



IN THE SUPREME COURT OF TEXAS

====================================================

JAMES ALLEN MCGUIRE

Petitioner,

vs.

FANNIE MAE F/K/A FEDERAL NATION MORTGAGE

ASSOCIATION,

Respondent.

=====================================================

ON PETITION FOR REVIEW FROM THE SECOND COURT OF

APPEALS, FORT WORTH, TEXAS

=====================================================

PETITIONER'S MOTION FOR REHEARING

======================================================

TO THE HONORABLE JUSTICES OF THE TEXAS SUPREME

COURT:

COMES NOW, JAMES ALLEN MCGUIRE, Petitioner herein, and

files this Motion for Rehearing, because he believes his Petition for

Review was dismissed for want of jurisdiction by the Court, in error.

I.

Basis for Motion



The Court's August 17, 2012 Order of Dismissal for Want of

Jurisdiction, in the above-referenced cause, did not state reasoning for

why the Court felt it lacked jurisdiction over this matter. Given the

nature of the case, the only plausible reasoning that the Petitioner

perceives having caused the dismissal for want of jurisdiction, is a

mistaken belief by the Court, that the Appellant's Petition for Review

failed to provide the court with jurisdiction as provided for in 22.001.

Petitioner McGuire inadvertently failed to include the case of West v.

First Baptist Church of Taft, 71 S.W. 2d 1090, 1098 (Tex. 1934) in the

statement for jurisdiction, but such failure to include did not take away

the fact that the Supreme Court had jurisdiction and such failure to

include was a curable error and is so done in this filing of a Motion for

Rehearing.

The Texas Supreme Court opined West v. First Baptist Church of Taft,

71 S.W. 2d 1090, 1098 (Tex. 1934) and cited the United States Supreme

Court’s opinion Carpenter v. Longan - 83 U.S. 271, Mortgage follows the

Note and as to where the Second Court of Appeals adjudicated that the

Note follows the Mortgage flies in opposite to and upends the statutory

and legal precedence of this state that the Mortgage (lien) follows the

Note.

Such error committed by the Second Court of Appeals is in contradiction

to well established commercial financial laws and in opposite of statutes



within the Texas Business and Commerce Code/Uniform Commercial

Code and opposite of West v. First Baptist Church of Taft.

Whereas if the Second Court of Appeals opinion is not corrected then a

party would never be assured that their financial investment could be

secure from the party in possession of the security of taking ownership

of the Note and thus such security holder would then become the

Noteholder. Per Texas Local Government Code 22.001(6), the opinion

authored by the Second Court of Appeals is of such importance that this

court must use its jurisdiction to right a wrong that can result in

commercial finance nightmare.

The Texas Supreme Court cited Carpenter with approval in a 1934

decision – West v. First Baptist Church of Taft, 71 S.W. 2d 1090, 1098

(Tex. 1934); [Exhibit A]

(“The trial court’s finding and conclusion ignore the settled

principle that a mortgage securing a negotiable note is but an

incident to the note and partakes of its negotiable character. .

. .’The note and mortgage are inseparable; the former as

essential, the latter as an incident.’” (quoting Carpenter). The

West case goes on to state that the mortgage securing the

negotiable note (i.e., the deed of trust), is but an incident to

the note “and partakes of its negotiable character”, which

appears to directly contradict the notion that you can

foreclose without satisfying the UCC requirements.



Texas Rules of Appellate Procedure §56.1. (a) (2) states; “whether there

is a conflict between the courts of appeals on an important point of law;”

whereas Texas Government Code §22.001 Jurisdiction (a) (2) states; “a

case in which one of the courts of appeals holds differently from a prior

decision of another court of appeals or of the supreme court on a

question of law material to a decision of the case;”

By statutory authority, Texas Government Code §22.001 provides that

it is not only contradictory appellate opinions that invoke the Supreme

Court’s jurisdiction but also that of contradiction of a prior opinion by

the Supreme Court that invokes the Supreme Court’s jurisdiction.

The Texas Supreme Court does have jurisdiction over this appeal

because the Court of Appeals did commit an error of substantive law,

and the error is of such importance to the jurisprudence of this state

that it requires correction under § 22.001 (a)(2) or (6) of the Texas

Government Code, which provides in relevant part:

§ 22.001. Jurisdiction

(a) The supreme court has appellate jurisdiction, except in

criminal law matters, coextensive with the limits of the state and

extending to all questions of law arising in the following cases

when they have been brought to the courts of appeals from

appealable judgment of the trial courts:...



(2) a case in which one of the courts of appeals holds differently

from a prior decision of another court of appeals or of the supreme

court on a question of law material to a decision of the case.....

(6) any other case in which it appears that an error of law has

been committed by the court of appeals, and that error is of such

importance to the jurisprudence of the state that, in the opinion of

the supreme court, it requires correction, but excluding those

cases in which the jurisdiction of the court of appeals is made final

by statute.

Whereas it appears the courts fail to opine according to statutory

law as presented by a pro se, I attached an advanced writing (with

permission) that will be published this fall by Professor Whaley of

Mortiz College of Law, Ohio State University. [Exhibit B]

II.

Prayer

Based on the above and foregoing, this Court has/had jurisdiction

and should reverse the Second Court of Appeals and overturn the Trial

Court Judgment.

WHEREFORE, PREMISES CONSIDERED, Petitioner prays thatupon considering this Motion, the Court will set aside its previous order

in which it dismissed this case for want of jurisdiction, consider the

merits of this case on a substantive basis, and after doing so reverse the

holding of the Second Court of Appeals in this case, and set aside and/or



overturn the Trial Court's Judgment, and for such other and further

relief to which the Petitioner is entitled.

Respectfully submitted,


By: /s/ James McGuire

902 Rusk Dr

Euless, Texas 76039

817 420-4151

CERTIFICATE OF SERVICE

I do hereby certify that a true and correct copy of the foregoing

Petitioner's Motion for Rehearing was served on the following counsel of

record, via facsimile, on the _______ day of _________, 2012:

Counsel RepresentingJanna W. ClarkeBroude, Smith & Jennings, P.C. 309 West 7th StreetSuite 1100Fort Worth, Texas 76102


By: /s/ James McGuire

902 Rusk Dr

Euless, Texas 76039



817 420-4151



Change View

1 Bills and Notes Burden of Proof as to Bona Fides in General

Payee's agreement not to negotiate construction loan notes until completion of

building and payment of money to maker constituted infirmity in notes, and

negotiation thereof in violation of agreement rendered seller's title defective, as

respects necessity of proof of good faith (Vernon's Ann.Civ.St. art. 5935, §§

52-55).

2 Bills and Notes Knowledge as to Consideration or Collateral Agreements

or Securities

Knowledge that note was given in consideration of executory agreement by

payee will not deprive indorsee of character of holder in due course, unless he

has notice of breach of agreement (Vernon's Ann.Civ.St. art. 5935, §§ 52, 56).

3 Bills and Notes Good Faith and Payment of Value

Evidence in suit to cancel notes held not to support trial court's finding that one

purchasing them knew of infirmity therein and defect in seller's title because of

premature negotiation thereof in v iolation of payee's agreement (Vernon's

Ann.Civ.St. art. 5935, §§ 52-56).

4 Bills and Notes Good Faith in General

One purchasing negotiable instrument in good faith for valuable consideration

may recover thereon, even if grossly negligent, regardless of how seller acquired

possession thereof (Vernon's Ann.Civ.St. art. 5935, § 56).

3 Cases that cite this headnote


Knowledge of facts merely sufficient to cause person of ordinary prudence to

make inquiry as to infirmity in negotiable instrument and defect in holder's title,

WEST et al. v.

FIRST BAPTIST CHURCH OF TAFT et al.

No. 6149. May 16, 1934 .

Error to Court of Civil Appeals of Fourth Supreme Judicial District.

Suit by the First Baptist Church of Taft against Mrs. Ethelyn West, a Mrs. Morris,

individuals constituting the Taft Bank, Unincorporated, and others, in which defendants

Morris and another filed a cross-complaint. A judgment canceling plaintiff's notes and trust

deeds, held by cross-complainants and a codefendant, and a judgment for the bank against

plaintiff, were affirmed by the Court of Civil Appeals (42 S.W.(2d) 1078), and defendants

West and others bring error.

Reversed and remanded.

West Headnotes (25)

RELATED TOPICS

Bills and Notes

Actions

Character of Bona Fide Holder of Note

Question of Good Faith of Holder of Note

Requisites and Validity

Bona Fide Holder of Mortgage Notes

West v. First Baptist Church of TaftSupreme Court of Texas. May 16, 1934 123 Tex. 388 71 S.W.2d 1090 (Approx. 16 pages)

1 of 22 results Search termReturn to list

v. First Baptist Church of Taft - WestlawNext https://a.next.westlaw.com/Document/I83ae2a55ee3f11d9b386b2

3 8/19/2012



with failure to make such inquiry before purchasing it, is not evidence of

purchaser's bad faith barring recovery thereon by him (Vernon's Ann.Civ.St. art.

5935, § 56).



Even gross negligence does not establish bad faith in purchasing negotiable

instrument from holder whose ti tle was defective (Vernon's Ann.Civ.St. art. 5935,

§ 56).


To constitute evidence of bad faith in purchasing negotiable instrument from

holder whose title is defective, facts known to taker must reasonably warrant

inference that he acted in dishonest disregard of payee's rights (Vernon's

Ann.Civ.St. art. 5935, § 56).



To support finding of bad faith in purchasing negotiable instrument from holder

whose title is defective, unheeded suspicious circumstances must be so

substantial and strong that bad faith, rather than mere negligence, can reasonably

be inferred therefrom (Vernon's Ann.Civ.St. art. 5935, § 56).


9 Evidence Importance in General

Evidence may be admissible as tending to prove fact without being sufficient to

support finding of such fact.

10 Bills and Notes Good Faith and Payment of Value

Evidence in suit to cancel notes held not to support trial court's finding of bad faith

of one paying full value therefor in purchasing them from corporation prematurely

negotiating them in violation of payee's agreement (Vernon's Ann.Civ.St. art.

5935, § 56).


“Gross negligence,” as in acquiring negotiable instrument from holder with

defective title, consists of omission of care which even inattentive and

thoughtless men never fail to take of their own property.

12 Mortgages Bona Fide Purchasers of Negotiable Instruments Secured by

Mortgage

Mortgage securing negotiable note is but incident to note and partakes of latter's

negotiable character.

1 Case that cites this headnote


Mortgage

Bona fide purchaser of notes for value before maturity became bona fide holder

of trust deed securing them.


14 Mortgages Necessity

Trust deed must be delivered to be effective.


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15 Mortgages Evidence

Undisputed evidence in suit to cancel notes and trust deeds securing them held

to establish constructive delivery of deeds to payee.

16 Mortgages Record or Delivery for Record

Mortgagor's filing for record in proper office of mortgage given pursuant to parties'

previous agreement to place and accept mortgage on specific property is

sufficient delivery thereof.



Sufficient delivery of mortgage by mortgagor's filing thereof for record is not

counteracted by fact that mortgagor subsequently obtained possess ion thereof

from recorder's office and retained it.


Mortgagor's retention of trust deed, executed and filed for record by mortgagor for

purpose of creating lien securing latter's notes, held unimportant in determining

question of constructive delivery thereof.

19Mortgages Necessity

Title may pass by trust deed without actual manual delivery thereof; controlling

question being grantor's intention.


Mortgage

Trust deeds, filed for record by mortgagor with intention to create liens securing

construction loan notes, which payee corporation orally agreed to hold until

completion of building, passed to one purchasing notes from payee's parent

corporation discharged of equities, to which subject while in payee's hands, to

same extent as notes.


21 Mechanics' Liens Advances of Money

Mechanic's or materialman's lien does not exist in favor of person advancing

money to pay for labor or material furnished (Vernon's Ann.Civ.St. art. 5452;

Const. art. 16, § 37).


22 Liens Express

Lien on realty cannot be given by parol agreement.


23 Mortgages Priorities of Mortgages in General

Bank's lien on realty for money advanced to owner after latter's execution of

notes to mortgage company for loan of money, agreed to be paid church when

building on property was completed, and filing of trust deeds securing them, held

inferior and subordinate to lien of such deeds.


24 Estoppel Acts Making Injury Possible as Between Actor and Another

Equally Blameless

If one of two innocent persons must suffer by deceit, one who puts trust and

confidence in deceiver, rather than stranger, would be loser.


3 8/19/2012




25 Mortgages Necessity and Sufficiency of Writing in General

Mortgage on realty cannot be given by parol agreement.


Attorneys and Law Firms

*390 **1091 Milling, Godchaux, Saal & Milling, of New Orleans, La., John C. North, of

Corpus Christi, and Robert W. Stayton, of Austin, for plaintiffs in error.

*391 Gordon Boone and Felix Raymer, both of Corpus Christi, and Templeton, Brooks,

Napier & Brown, of San Antonio, for defendants in error.

Opinion

SMEDLEY, Commissioner.

The First Baptist Church of Taft, for the purpose of constructing a church building on lots

owned by it in Taft, Tex., made application to Southern Mortgage Company, of Abilene, Tex.,

for a loan of $20,000. Before the building was begun, the church, on the request of the

mortgage company, executed and **1092 delivered to the mortgage company, for the

purpose of ‘closing the loan,’ twenty-two promissory negotiable notes aggregating the

principal sum of $20,000, payable to Southern Mortgage Company, at the office of Mortgage

& Securities Company in New Orleans. At the same time the church executed a deed of

trust securing the notes and covering the lots upon which the church was to be built and

also other lots owned by the church upon which a parsonage was situated. This deed of

trust expressly provided that it covered also all brildings, fixtures, furniture, and equipment

then located or thereafter to be located upon the lots upon which the church was to be *392

built. A second and subordinate deed of trust was executed securing the two other

promissory negotiable notes payable to Southern Mortgage Company, aggregating the

principal sum of $1,000. The notes and deeds of trust, while dated March 9, 1929, were in

fact executed May 2, 1929. On the same day, at the request of Southern Mortgage

Company, the church caused the two deeds of trust to be filed for record in the office of the

county clerk of San Patricio county, and on May 8, 1929, pursuant to the same request, the

church mailed the notes to Southern Mortgage Company at Abilene, together with a

certificate of the county clerk showing that the two deeds of trust had been filed for record.

It had theretofore been agreed, in the course of the negotiations for the loan, that none of

the money should be paid to the church until the building had been entirely completed

according to the plans and specifications. It had further been agreed by Southern Mortgage

Company that the notes would be held by it in Abilene ‘until after the money was furnished

on the loan.’

The church made arrangements with the Taft Bank, Unincorporated, whereby the bank

agreed to furnish money to the amount of $20,000 to pay for labor and material in the

construction of the building, the money to be advanced as the work progressed and to be

repaid the bank when the proceeds of the loan from Southern Mortgage Company were

procured. There was an oral agreement between the church and the bank that the bank

should have a lien to secure the money so advanced.

Building operations were begun about May 2, 1929, the bank advancing something more

than $20,000, which was used in payment for labor and material. The building was

completed about October 1, 1929, after the trial of this suit in district court.

A short time after receiving the notes, Southern Mortgage Company forwarded them to

Mortgage & Securities Company at New Orleans, advising that the construction of the

building had just begun, and that some time would elapse before the loan would be ready for

closing. Southern Mortgage Company was a subsidiary of Mortgage & Securities Company,

being wholly owned by it and organized by it for the purpose of doing business in Texas, and

all the money loaned by Southern Mortgage Company was procured from Mortgage &

Securities Company.

On June 25, 1929, the company last named sold and delivered the twenty-two first lien


3 8/19/2012



1

notes to plaintiff in error Mrs. *393 Ethelyn West, who bought them for her sisters, plaintiffs

in error Mrs. Morris and Mrs. Barham, paying for the same their full face value, the principal

and accrued interest. The notes had been indorsed without recourse by Southern Mortgage

Company, and their payment was guaranteed by Mortgage & Securities Company. A short

time thereafter Mortgage & Securities Company failed, and its property was placed in the

hands of a receiver. The church received nothing for the notes.

This suit was filed by the church against the two mortgage companies, the receiver of

Mortgage & Securities Company, the manager of Southern Mortgage Company, Mrs. West

and her sisters, Mrs. Morris and Mrs. Barham, and several individuals who constituted the

Taft Bank, Unincorporated. The relief sought is cancellation of the notes and the deeds oftrust and the removal of clouds from the property of the church. In the alternative, and in

the event and notes and deeds of trust are determined to be valid obligations and liens, the

church seeks judgment against the two mortgage companies and the manager of Southern

Mortgage Company for the amount so determined, with foreclosure of a lien upon any

property of the two companies which might be disclosed or discovered.

By cross-action, Mrs. Morris and Mrs. Barham allege their ownership of the twenty-two

notes, and of the lien securing them, and that they purchased the notes before maturity for

value and with no knowledge or notice of the alleged infirmities, and they pray for judgment

for the principal of the notes, interest, attorney's fees, and for foreclosure of lien.

The Taft Bank alleges the advancement of funds by it for labor and material aggregating

about $24,000, that it has a lien securing same which is superior to the lien claimed by Mrs.

Morris and Mrs. Barham, and prays for judgment against thechurch

for the amount**1093

advanced, with interest and attorney's fees, and for foreclosure of lien.

The case was tried without a jury, the trial court making elaborate findings of fact and

conclusions of law. Judgment was rendered canceling the twenty-two notes held by Mrs.

Morris and Mrs. Barham and the deed of trust executed to secure the notes, and also

canceling the two notes aggregating $1,000 held by Southern Mortgage Company and the

deed of trust executed to secure them; and judgment was rendered in favor of the Taft Bank

against the church for $22,300, with interest, and for foreclosure of lien upon the property

of the church. The church dismissed its suit against the manager of *394 Southern

Mortgage Company, and it was adjudged that it take nothing by its alternative suit.

The trial court found that the notes were negotiated and sold by the two mortgage

companies to Mrs. West in violation of the agreement under which they were executed and

delivered, and in fraud of the rights of the church; that the proceeds of the notes were

appropriated by Mortgage & Securities Company; and that the church never received any

part of the proceeds of the notes, or any consideration for them.

The trial court further found that, at the time she purchased the notes for her sisters, Mrs.

West ‘had actual knowledge of the fact that the notes were for a construction loan, that said

loan was not completed, that said notes were not ready for negotiation, and that same were

not in fact then negotiable’; and also that ‘defendants Mrs. West, Mrs. Morris and Mrs.

Barham, at the time the notes were purchased by them and delivered to them, as aforesaid,

took same with notice of the defects in the title of Mortgage and Securities Company

mentioned in preceding paragraphs of these findings, and did not purchase same without

notice in good faith and are not purchasers in good faith for value or holders in due course.’

The Court of Civil Appeals on first hearing reversed and remanded the cause, holding that

there was no evidence charging Mrs. West and her sisters with fraud or bad faith, and that

they were innocent purchasers of the notes for value before maturity. On rehearing, the

judgment of the trial court was affirmed, the majority of the Court of Civil Appeals holding that

there was evidence sufficient to sustain the finding of the trial court upon the issue of bad

faith. 42 S.W.(2d) 1078.

Within the terms of the Negotiable Instruments Law there was infirmity in the notes,

and the title of Mortgage & Securities Company which negotiated them was defective,

because it had been agreed that the notes were to be held and not negotiated until the

building was completed and the money represented sented by the notes paid, and because

the notes were negotiated in violation of this agreement, in breach of fai th and in fraud of

the church. Sections 52-55, art. 5935, R. C. S. 1925.


3 8/19/2012



2 3 The important question presented is whether there is any evidence to sustain

the findings of the trial court that Mrs. West had actual knowledge of the infirmity or of the

defect in the title, and that she did not act in good faith in acquiring the notes.

By the terms of section 52 of of article 5935 one is not a holder in due course who, although

he purchased a negotiable instrument before maturity and for value, had notice at the time it

*395 was negotiated ‘of any infirmity in the instrument or defect in the title of the person

negotiating it.’

Section 56 of the said article is as follows: ‘To constitute notice of an infirmity in the

instrument or defect in the title of the person negotiating the same, the person to whom it is

negotiated must have had actual knowledge of the infirmity or defect, or knowledge of such

facts that his action in taking the instrument amounted to bad faith.’

The first inquiry is whether there is any evidence that Mrs. West at the time she purchased

the notes had actual knowledge of the infirmity or defect.

As has been stated, the infirmity in the notes was the agreement of Southern Mortgage

Company that they would be held and not negotiated until the building was completed and

the money represented by the notes paid to the church, and the defect in the title of

Mortgage & Securities Company, which negotiated the notes, was that it negotiated them

violation of that agreement.

Neither Mrs. Morris nor Mrs. Barham had any connection with the negotiations by which the

notes were acquired. Mrs. West acted for her two sisters, buying part of the notes for one

and part for the other. The three sisters resided in Louisiana. None of them had anyacquaintance with or in Taft, Tex. They had no communication with the church at Taft. Mrs.

West had bought other notes from Mortgage & Securities Company. The representatives of

that company knew that she would take no construction loans, that is , loans secured by

buildings to be completed.

**1094 The notes were first presented to Mrs. West in the early part of May, 1929, by one

Wood, who was a salesman for Mortgage & Securities Company. He submitted to her and

left in her possession for examination a prospectus of the loan, the written application of the

church to Southern Mortgage Company for the loan, and certain other written and printed

information. The application described the notes to be executed, stating that they were to be

dated on or about May 1, 1929, and would be secured by a deed of trust upon the property

owned by the church, describing it, and that the lots would be improved by a two-story and

basement brick church building estimated to cost $37,500. It stated that the building would

be completed on or before July 1, 1929. Contrary to the agreement between the church

and Southern Mortgage Company that no money would be advanced until the building was

finished, the application stated that the proceeds of the loan would be available as the

construction proceeded, no payment *396 to be made, however, until construction had

reached the point where the net proceeds to be advanced by the mortgage company would

complete the building, and that 15 per cent. of the total amount of the contract price should

remain in the hands of the mortgage company until completion of the work and final

inspection.

Mr. Wood testified substantially as follows: That he showed Mrs. West the data which he

had received from the files of Mortgage & Securities Company, including the application for

the loan; that he discussed the merits of the loan with Mrs. West, but did not recall making

any particular statements or representations to her concerning the notes or the deed of trust

other than what was shown in the data submitted to her; that he was informed while handling

the account of Mrs. West and her sisters that all securities purchased by them must be on

completed properties and not on properties in process of construction; that when he made

the preliminary offering of the loan he knew that the building was in process of construction,

but, when the notes were delivered to her, he was convinced that the building had been fully

completed; and that at the time he delivered the notes and accepted payment for them he

did not know that the money represented by the notes had not been paid to the church, and

did not advise Mrs. West that it had not been paid.

Mr. Jackson, vice president of Mortgage & Securities Company, testified that some time

before the notes were sold Mrs. West asked him whether or not he considered the Taft

church loan a sound one, and he told her he considered it a good loan when ready for

delivery, and that he made no other statements to her as to the loan, the notes, of the deed


3 8/19/2012



of trust.

Mrs. West, after going over the instruments left with her and considering the loan for three

or four days, advised Mr. Wood that she would take the loan when it was ready for delivery.

About six weeks after her first conversation with Mr. Wood he telephoned her that the loan

was ready for delivery. Thereupon she went to the office of the Mortgage & Securities

Company, examined the notes, the indorsement of Southern Mortgage Company, and the

guaranty of Mortgage & Securities Company, and completed the purchase. She made no

inquiry about the building or the loan of any other person than those who represented the

mortgage company with which she dealt. She did not undertake by correspondence or

otherwise to ascertain whether the building had been completed or whether it had beenerected at all. She testified that she relied upon the statement made to her by Mr. Wood that

the loan was ready *397 for delivery; that nothing had occurred to cause her to be

suspicious about the legality or validity of the notes; and that she did not know that the

church had raised any question as to the notes until a short time before this suit was filed.

Mrs. West, when interrogated on cross-examination as to her knowledge with respect to the

notes, testified as follows:

‘As to whether or not it struck me as being worthy of investigation that the application

showed that it was a construction loan, I desire to state that the loan was not to be bought

by me until it was a finished thing. I knew at the time it was first presented to me that it was

not a finished thing. When Mr. Wood first approached me with reference to buying these

notes and exhibited to me the papers, including the application, I did look it over. I wanted to

see what security I was getting. From that application I saw it was on a building not yetcompleted. I thought the application stated that the building had not yet been completed. I did

not know that it had not been started. At the time he first presented the loan to me he did

not offer it for sale. He gave me these notes, if I wanted the loan, when it was a finished

thing. He gave me that prospectus and this descriptive matter and this application so I could

go over it and consider it and determine if I wanted the loan when it was finished. With

reference to my taking his word for it when he told me the loan was **1095 finished, I had no

reason to doubt his statement. I took the notes. I had this application in my possession at

the time, but I had every reason to believe the building was completed. * * *

‘With reference to my making any attempt to ascertain whether or not this church building

had been erected as contemplated to be erected and completed, I desire to state that Mr.

Wood had called me and said that the building was completed and that the loan was ready

for delivery. It was perfectly understood by me and everybody in the Mortgage & Securities

Company that I would take no loan except completed loans. * * *

‘With reference to whether or not I made any attempt to ascertain from the officials of this

church whether or not that building had been completed, and with reference to whether or

not I merely took the word of Mr. Wood that the loan was ready for delivery, I desire to state

that I took the word of a supposedly reputable man. * * *

‘I did ask for a picture of the completed church. When the notes were being delivered to me

I saw Mr. Ogden when I got up to leave with the notes. He asked me if Mr Wood fixed me up

all right and I said, ‘Yes, but I want a picture of *398 the finished church.’ I told him that I

had just bought the First Baptist Church of Taft notes, and he said, ‘You have not got it?’

and I said ‘No, and I want it,’ and he said, ‘We will have to get it for you,’ and I said, ‘I want

Mrs. Morris and Mrs. Barham to see the churh upon which they have loaned their money.’

He told me that he thought he would get it for me in about a week. * * *

‘With reference to whether or not it occurred to me that the best source of information with

reference to the character of the building and as to whether or not the building had been

completed and had been accepted by the First Baptist Church of Taft as completed would

be the officers of that church, I desire to state that I had no reason to doubt any of the

representations that were made by an entirely responsible company. * * * With reference to

whether or not I knew as a matter of fact that if that building had not been completed there

would have been a question raised about those securities, I had no knowledge of any

dealings between Mortgage & Securities Company and the Church of Taft, Texas. * * *’

Mrs. West testified with reference to another loan offered her: ‘I said to him, ‘That loan was

offered to us before, and it is a construction loan, and I said I would not touch a construction

loan with a forty foot pole.‘‘’'


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4

It is apparent from the testimony of Mrs. West and the other two witnesses, as above

quoted and stated, that in their use of such phrases as ‘the loan is not ready for delivery,’

‘the loan is not a finished thing,’ and the like, they were referring to the fact that the building

was not completed, and that, knowing that Mrs. West would not accept a construction loan

or one secured by an unfinished building, they meant to say that the notes therefore were

not ready for delivery to her. Thus the information which she acquired from the application

for the loan and from the statements made to her by the representatives of Mortgage &

Securities Company was that when the notes were first presented to her the building was

not completed, and that at least a part of the consideration for the notes had not been paid

by the mortgage company. She knew that the consideration was executory or in part

executory. But this did not amount to knowledge that there would be a breach of the

mortgage company's executory obligation. Knowledge that a note was given in

consideration of the executory agreement of the payee will not deprive the indorsee of the

character of a holder in due course unless he has notice of a breach *399 of such

agreement. In the absence of knowledge or notice of a breach he may presume that the

agreement will be performed as stipulated. Lozano v. Meyers (Tex. Com. App.) 18 S.W.(2d)

588; C. H. Mountjoy Parts Co. v. San Antonio National Bank ( Tex. Civ. App.) 12 S.W.(2d)

609; Foster v. Enid, etc., R. Co. (Tex. Civ. App.) 176 S. W. 788; Buchanan v. Wren, 10 Tex.

Civ. App. 560, 30 S. W. 1077; 3 R. C. L. p. 1067.

The fact that the building was unfinished, in the absence of knowledge of the oral agreement

to hold the notes, in no way affected the negotiability of the notes. There is no evidence that

Mrs. West ever knew of the agreement between the church and Southern Mortgage

Company that the notes would be held at Abilene and not negotiated until the building had

been completed and the money paid. The finding of the trial court that Mrs. West and her

sisters knew at the time of their purchase of the notes of the infirmity in them and of the

defect in the title of the mortgage company is not supported by evidence.

The second inquiry is whether there is any evidence that Mrs. West, at the time the notes

were acquired, had knowledge of such facts **1096 that her action in taking them amounted

to bad faith.

The trial court found both actual knowledge of the infirmity and defect in title and bad faith on

the part of Mrs. West. The affirmance by the Court of Civil Appeals appears to rest upon the

conslusion that there was evidence sufficient to support the trial court's finding that Mrs.

West acted in bad faith in acquiring the notes.

Judge Garrett, in Wilson v. Denton, 82 Tex. 531, 535, 18 S. W. 620, 622, 27 Am. St.

Rep. 908, thus stated and explained the settled rule in this state and in practically all of theother states, and of which section 56 of article 5935 is but a restatement: ‘The ordinary rule

of constructive notice which applies to the purchaser of property is not applicable in the

case of negotiable instruments. As promotive of their circulation, a liberal view is taken,

which makes the bona fides of the transaction the decisive test of the holder's right. He is

entitled to recover upon it if he has come by it honestly. Greneaux v. Wheeler, 6 Tex. 525; 1

Daniel, Neg. Inst. s 775. It matters not how the vendor came in possession of the bill or

note, whether by theft or fraud or honestly. The title of the transferee does not depend upon

the title of the vendor, but upon his possession; and if the buyer has acted in good faith, and

paid a valuable consideration, his title cannot be impugned. An early English case (Gill v.

Cubitt, 3 Barn. & C. 466) laid down the *400 principle that, although the holder had given

value for the bill or note, yet, if he took it under circumstances which ought to have excited

the suspicions of a prudent and careful man, he could not recover. This was a departure

from the earlier rule, which regarded the bona fides as the crucial test by which it was to be

determined whether or not the purchaser should be protected against defenses that would

be valid against the transferrer of the note. But the earlier rule was soon again reverted to,

and afterwards made even more liberal; and it became the law that, while gross negligence

might be evidence tending to show mala fides, and, as such, admissible, it did not in itself

amount to proof of mala fides, and was not sufficient to deprive the holder of his right to

recover. If it should be left to a jury to determine as to the degree of caution which a prudent

man must exercise on taking such an instrument, it would lead to much perplexity, and to

frequent injustice. Thus is the law deduced from the English decisions by Mr. Daniel in his

admirable work on Negotiable Instruments (section 770 et seq.).’ (Italics ours.)

In that case, Wilson, the payee, intrusted negotiable notes to Denton to sell for him to a

designated person. Denton, in violation of his trust, sold the notes to Cotter and McMullan


3 8/19/2012



5

6

7

8 9

for their two notes payable to Denton's wife, and at a substantial discount. The purchasers,

although they met both the payee and the maker daily, did not speak to them about the

transaction or about the notes. They relied implicitly upon the statements made to them by

Denton. A judgment in favor of the purchasers of the notes was affirmed, the court holding

that they did not have actual knowledge of the invalidity of Denton's title, and that the facts

were not sufficient to charge them with a want of good faith.

In the comparatively recent case, Campbell v. Rosenow (Tex. Civ. App.) 32 S.W. (2d) 372,

in which application for writ of error was refused, it was held that there was not even a

circumstance to sustain the judgment of the trial court that an indorsee of promissory notes

was not a purchaser in good faith, although the evidence was that notes in the principal sumof $9,050 payable to the order of the maker and bearing no other indorsement than his in

blank were bought for $7,500 from a stranger a short time after their execution and without

any inquiry whatever.

Goodman v. Simonds, 20 How. 343, 15 L. Ed. 934, one of the leading cases on the question

under consideration, announces substantially the same rule as that quoted above from

Wilson v. Denton. It holds that facts and circumstances which *401 would excite the

suspicion of a careful and prudent man are not sufficient to destroy the title of the purchaser

of a negotiable instrument for value. It approves what the opinion states to be the settled

law in all English courts that proof that the plaintiff had been guilty of gross negligence in

acquiring the bill ought not to defeat his right to recover.

The case last referred to is approved and followed in Murray v. Lardner, 2 Wall. 110, 121,

17 L. Ed. 857, 859, in which the court thus states its conclusion: ‘Suspicion of defect of titleor the knowledge of circumstances which would excite such suspicion in the mind of a

prudent man, or gross negligence on the part of the taker, at the time of the transfer, will not

defeat his title. That result can be produced only by bad faith on his part.’ The same rule is

announced in Cromwell v. County of Sac, 96 U. S. (6 Otto) 51, 24 L. Ed. 681, 686.

In **1097 Foster v. Augustanna College & Theological Seminary, 92 Okl. 96, 218 P. 335,

337, 37 A. L. R. 854, the court, after stating there must be either actual knowledge or bad

faith to deprive a purchaser before maturity and for value of the privilege of being a holder in

due course, said: ‘Even gross negligence on the part of a taker of a negotiable instrument

will not defeat the title of a holder for value and before maturity.’

A carefully written article by George W. Rightmire, entitled ‘The Doctrine of Bad Faith in the

Law of Negotiable Instruments,’ appearing in volume 18, pp. 355 and following, of Michigan

Law Review, contains, among others, the following conclusions: That when bad faith is the

point of inquiry, suspicious c iscumstances must be of a substantial character, and, if such

circumstances do not appear, the court can arrest the inquiry; that we are not brought

nearer to an answer to the inquiry, Did he take in bad faith? by considering matters of being

put upon inquiry and the reasonably prudent man; that it is not failure to inquire, but the

dishonest purchase which establishes bad faith, that is, the facts known to the taker must be

such that his buying with such knowledge amounts to dishonest dealing toward the

defendant. The views expressed are in harmony with the rules announced by the authorities

which have been cited.

To summarize:

1. Knowledge of facts merely sufficient to cause one of ordinary prudence to make inquiry,

with failure to make such inquiry, is not evidence of bad faith. To apply the contrary *402 rule

would be to return to the rejected doctrine of the earlier English case, that one acquiring a

negotiable instrument under cirsumstances which ought to excite the suspicion of a prudent

person could not recover, for, in the application of such contrary rule, the jury would be

permitted to find bad faith where the evidence proves only ordinary negligence.

2. Even gross negligence is not the same thing as bad faith and does not of itself

amount to proof of bad faith, although it may be evidence tending to prove bad faith.

3. To constitute evidence of bad faith, the facts known to the taker must be such as

reasonably to form the basis for an inference that in acquiring the negotiable instrument with

knowledge of such fac ts he ac ted in dishonest disregard of the rights of defendant.

Statements are found in the declsions, as for example in Kaufman Oil Mill v.


3 8/19/2012



10

11

North Texas National Bank (Tex. Civ. App.) 16 S.W.(2d) 143 (application for writ of error

refused), to the effect that such evidence, as would be admissible in an ordinary case to

show that the purchaser had knowledge of facts that should put a reasonably prudent person

upon inquiry, is admissible as tending to prove that the purchaser of a negotiable instrument

in taking it with knowledge of such facts acted in bad faith. This does not mean, however,

that knowledge of suspicious cirsumstances of whatever character constitutes evidence

from which bad faith may be inferred. The consummation of the purchase of a negotiable

instrument with knowledge of suspicious circumstances sufficient only to put an ordinarily

prudent person upon inquiry would convict the purchaser of negligence, not of dishonesty. To

serve as evidence to support a finding of bad faith, the unheeded suspicious circumstances

must be of a substantial character and so strong that bad faith rather than merely negligence

can reasonably be inferred from them. Evidence may be admissible as tending to prove a

fact to be established without being sufficient of itself to support a finding of the fact.

Applying the rules which have been discussed to the facts in the record, we are

unable to find any evidence supporting the trial court's finding of bad faith on the part of Mrs.

West. A circumstance indicating good faith in her payment of full value for the notes. Such

fact is not conclusive evidence, but it tends strongly to prove good fai th. Canajoharie

National Bank v. Diefendorf, 123 N. Y. 191, 25 N. E. 402, 10 L. R. A. 676; Kelso & Company

v. Ellis, 224 N. Y 528, 121 N. E. 364. She was not dealing with a stranger, but with a

mortgage company from which she had bought other notes and which, as *403 she testified,

she believed responsible. While she did learn six weeks before she bought the notes that

they represented a construction loan, the proceeds of which were to be advanced as

construction proceeded, and that the building was not then completed, the information thus

acquired gave her no knowledge of an infirmity in the notes. Furthermore, she was assured

at the time of her purchase, and by the salesman from whom she obtained her first

information about the notes, that they were then ready for delivery. In the absence of

anything to cause her to doubt the truth of the representations last made to her, she must

reasonably have believed from them that during the six weeks the building had been

completed and the proceeds of the loan paid. There is not evidence that Mrs. West knew or

**1098 had reason to believe that the mortgage company was in financial straits, and no

evidence of any statements or acts by representatives of the company which should have

aroused suspicion.

Even if Mrs. West, in buying the notes without making inquiry of the maker, or of some

person other than the seller, in order to ascertain with certainty that the building had been

completed and the consideration fully paid, failed to exercise that care which a cautious

person, or even one of ordinary prudence, would have exercised (which we need not and do

not decide), her action in acquiring the notes without such inquiry would be nothing more

than negligence; it would not amount to dishonesty, and would not be evidence of bad faith.

Nor do we believe that the facts in the record constitute evidence of gross negligence

which, as said in Goodman v. Simonds, 20 How. 343, 367, 15 L. Ed. 934, 942, ‘is defined to

consist of the omission of that care which even inattentive and thoughtless men never fail to

take of their own property.’

The trial court found that the deeds of trust, although filed for record by the church upon the

request of Southern Mortgage Company, were not filed with the intention to deliver the

same, but with the intention that they were not to take effect as liens unless and until the

amount of money evidenced by the notes had been advanced by Southern Mortgage

Company to the church; and further found that the deeds of trust after they were recorded

were not forwarded to the mortgage company or to the trustee, but remained in the

possession of the church. Following this finding the trial court concluded that the deeds of

trust were ineffective and did not create any lien.

Based upon this finding and conclusion defendants in error contend that no lien was created

by the deed of trust securing *404 the twenty-two notes because there was not an effective

delivery.

There is no direct testimony that the deed of trust was not to become effective until the

money represented by the notes was paid. Although there is a general statement in the

testimony of the witness Binford to the effect that in the preliminary negotiations a

representative of Southern Mortgage Company stated that all papers and notes would be

held until the completion of the building, the testimony of the witness Tackett to the particular


13 8/19/2012



12

13

14 15

16 17

18 19

agreement relied upon by the church and definitely stated is that Mr. Polk, acting for

Southern Mortgage Company, agreed that the notes would be held in Abilene until the money

was paid. Later the mortgage company prepared the notes and deeds of trust and forwarded

them to the church, requesting that after the execution of them the deeds of trust be filed

for record and the notes and a certificate of the county clerk, showing that the deeds of trust

had been filed, be returned to the mortgage company. These instructions were followed, and

the church, a few days later, mailed the notes and the clerk's certificate to the mortgage

company, with a letter stating that it was mailing ‘all closing papers pertaining to the First

Baptist Church loan.’ Thereafter the church caused the deeds of trust to be included in a

supplemental abstract and sent it to the mortgage company. If a condition attached to the

deeds of trust, it was but the one and same condition that attached to the notes. The deeds

of trust were executed for the purpose of securing the notes and were intended to be

effective for that purpose and to the same extent that the notes were effective.

The trial court's finding and conclusion ignore the settled principle that a mortgage

securing a negotiable note is but an incident to the note and partakes of its negotiable

character. As stated in the opinion in Carpenter v. Longan, 16 Wall. 271, 274, 21 L. Ed.

313, 315: ‘The note and mortgage are inseparable; the former as essential, the latter as an

incident.’

The Supreme Court of Texas, in Pope v. Beauchamp, 110 Tex. 271, 219 S. W. 447,

448, held that the rule of lis pendens does not affect the right to the debt or lien of the bona

fide purchaser of a negotiable note, basing its decision upon the necessary inseparability of

the note and lien. Justice Greenwood quoted with approval from the opinion of the Supreme

Court of the United States in the case last cited, and said: ‘We are further of the opinion thatthe protection which the law gives the bona fide holder of negotiable paper extends *405 to

a lien which is a mere incident of the debt evidenced by the paper, in the absence of actual

or constructive notice of some defect in the lien. The bona fide purchaser has the same

right to rely on an incidental and inseparable lien as on any other feature of a negotiable

note. Hamblen v. Folts, 70 Tex. 135, 7 S. W. 834. We therefore regard as thoroughly sound

the declaration of the Supreme Court of Missouri, in Mayes v. Robinson, 93 Mo. 114, 5 S.

W. 611, that-‘If the defendant took the note discharged of any equities to which it **1099

was subject in the hands of the payee, the deed of trust passed to him discharged of such

equities to the same extent. Logan v. Smith, 62 Mo. 455. The deed of trust, being incident to

the note, partook of the negotiability of its principal. Hagerman v. Sutton, 91 Mo. 519, 4 S.

W. 73, and authorities cited. If the defendant was a bona fide holder of the note, for value,

before maturity, without notice, he was in equal measure such bona fide holder of the deed

of trust.“ (Italics ours.)

On this authority we conclude that, when Mrs. West became the bona fide holder of the

notes for value before maturity, she became in equal measure such bona fide holder of the

deed of trust which was executed to secure them.

It is, of course, true that a deed of trust to be effective must be delivered, but

we are of the opinion that a constructive delivery was proven by the undisputed evidence.

‘If the mortgage is made in pursuance of a previous agreement of the parties to

place a mortgage on the specific property, which the mortgagee has agreed to accept, then

the act of the mortgagor in filing it for record in the proper office is a sufficient delivery of it. *

* * And when a sufficient delivery has thus been effected, it is not counteracted by the fact

that the mortgagor obtains the possession of the mortgage from the recorder's office, after it

is recorded, and retains it.’ 41 C. J. p. 427.

See, also, the following authorities which hold that the filing for record by the grantor at the

request or with the consent of the grantee or mortgagee amounts to a contructive delivery.

Newton v. Emerson, 66 Tex. 142, 18 S. W. 348; Russell v. Beckert (Tex. Civ. App.) 195 S.

W. 607; Red River National Bank v. Summers (Tex. Civ. App.) 30 S.W.(2d) 726; 8 R. C. L.,

p. 1006.

The retention of the deed of trust by the church after it was filed for record is

unimportant if, as clearly appears to be true, it was executed and filed for record for the

purpose of creating a lien to secure the notes. Title may pass without actual manual delivery

of the instrument. The controlling question is *406 the grantor's intention. Taylor v. Sanford,

108 Tex. 340, 345, 193 S. W. 661, 5 A. L. R. 1660; McCartney v. McCartney, 93 Tex. 359,


13 8/19/2012



20

21

22

23

24

364, 55 S. W. 310.

In Koppelmann v. Koppelmann, 94 Tex. 40, 57 S. W. 570, it is held that the depositing

of a deed for record by the grantor is sufficient evidence of delivery, but that it is not

conclusive, and that, in the absence of actual delivery to the grantee, the effect of a deed

thus recorded depends upon the intent with which the acts relied upon as taking the place of

actual delivery were done. In the instant case the filing of the deeds of trust was a part of

the closing of the loan, and the intention of the grantor undoubtedly was to create liens fully

effective to secure the notes if and when they were effective. There is nothing in the record

to limit or qualify the grantor's intention, except the oral agreement that the notes would be

held until the church was completed. By reason of that oral agreement, the notes and thedeeds of trust were subject to equities while the notes were in the hands of the payee, but

under the rule announced in Pope v. Beauchamp, above discussed, the deed of trust

securing the twenty-two notes sold to Mrs. West passed to her discharged of such equities

to the same extent that the notes were discharged of them.

Since there is no assignment by the First Baptist Church complaining of the

judgment in favor of the Taft Bank for foreclosure of lien, the only question presented here

with respect to such lien is whether the bank has a lien superior to that securing the notes

purchased by Mrs. West.

A lien is asserted to exist in favor of the bank, first, on the ground that it advanced money to

pay for labor and material in the construction of the building; and, second, on the ground that

the church orally agreed that the bank should have a lien to secure the repayment of the

money so advanced.

The Constitution and the statute give liens to mechanics and materialmen for the value of

labor done and material furnished. They do not provide for liens in favor of persons

advancing money to pay for labor or material. Constitution, art. 16, s 37; Revised Civil

Statutes, 1925, art. 5452. It was held in Gaylord v. Loughridge, 50 Tex. 573, that a

mechanic's lien statute in substantially the same terms as article 5452 did not protect a loan

of money made and used for the purchase of material and the payment of labor. That case is

cited with approval in Hess & Skinner Engineering Co. v. Turney, 110 Tex. 148, 156, 216 S.

W. 621, and in *407 Employers' Casualty Co. v. County of Rockwall, 120 Tex. 441, 448, 35

S.W.(2d) 690, 38 S.W. (2d) 1098. See, also, note and citation of many authorities in 74 A.

L. R. pages 522 and following, supporting the general rule that a mechanic's or

materialman's lien does not exist in **1100 favor of a third person advancing money with

which to pay for labor or material.

As to the oral agreement, a mortgage or other lien upon real estate cannot be given

by parol. Allen v. Allen, 101 Tex. 362, 107 S. W. 528; Home Investment Co. v. Fidelity

Petroleum Co. (Tex. Civ. App.) 249 S. W. 1109 (application for writ of error refused); Aaron

Frank Clothing Co. v. Deegan (Tex. Civ. App.) 204 S. W. 471 (application for writ of error

refused); 20 Tex. Juris. p. 288, 25 Tex. Juris. p. 796.

The bank was fully informed about the negotiations for the loan to be made upon the

church property by Southern Mortgage Company, and did not agree to make the temporary

advancement to the church until it was shown the definite commitment of the loan company

to pay the $20,000 to the church when the building was completed. Two of the members of

the partnership constituting the bank were signers of the written instrument guaranteeing the

payment of the notes to the Southern Mortgage Company, which instrument described the

notes and the deed of trust to be executed. The money advanced by the bank was

evidenced by notes executed by the church, the first of date June 4, 1929, and on which

date the first money was advanced by the bank. This was long after the execution of the

notes to Southern Mortgage Company and the filing of the deeds of trust securing them.

Without determining, as between the church and the bank, the correctness of the trial

court's judgment that a lien exists in favor of the bank, we conclude, from the facts in the

record and under the authorities above cited, that such lien, so adjudged to exist, is inferior

and subordinate to the lien created by the deed of trust securing the twenty-two notes.

Any decision of this case would work a regrettable hardship upon one or more of the

parties. This unfortunate result has its source in the misplaced confidence of the church

and the bank in the mortgage company, and more particularly it flows from the act of the

church in intrusting the negotiable notes to the mortgage company. ‘If one of two innocent


13 8/19/2012



persons must suffer by a deceit, it is more consonant to reason that he who ‘puts trust and

confidence in the deceiver should be a loser rather than a stranger. “ Carpenter v. Longan,

16 Wall. 271, 273, 21 L. Ed. 313, 315.

The judgment of the Court of Civil Appeals and that of the *408 district court are reversed,

and the cause is remanded for trial in accordance with this opinion.

Opinion adopted by the Supreme Court.

Parallel Citations

71 S.W.2d 1090

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Douglas J. Whaley

Contact Information

[email protected]

EducationB.A., University of Maryland,

1965

J.D., University of Texas, 1968

(with honors )

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Curriculum Vitae

Bibliography

Related Links

Douglas Whaley Blog

Summer 2012 Courses

Debtor & Creditor

Moritz Law / Faculty / Directory / Douglas J. Whaley

Douglas J. Whaley

Professor Emeritus of Law

Professor Whaley teaches Contracts, Consumer

Law, Commercial Paper, Sales, Secured

Transactions, and Debtor-Creditor Law.

Prior to joining the Ohio State faculty in 1976, he

practiced law in Chicago with Chapman and Cutler

and taught at Indiana University Law School inIndianapolis. Professor Whaley has won nine awards

from three universities for outstanding teaching,

including an Ohio State University Distinguished

Teaching Award in 1978.

He is the author of seven casebooks (Contracts,

Sales, Commercial Paper, Consumer Law, Debtor-Creditor Law, Secured

Transactions, and Commercial Law) and a book on warranties.

Professor Whaley also travels around the country giving lectures for bankers and

their attorneys on "The Law of Checking Accounts."

The Ohio State University | Michael E. Moritz College of Law

55 West 12th Avenue | Columbus, OH 43210-1391 | (614) 292-2631

z College of Law - Faculty: Douglas J. Whaley http://moritzlaw.osu.edu/faculty/bios.ph

8/20/2012



Mortgage Foreclosures, Promissory Notes, and the Uniform Commercial Code

Douglas J. Whaley∗

As is true of many things in life the Uniform Commercial Code’s statutes concerning the

role of promissory notes in a mortgage foreclosure are both simple and at the same time

complicated. The purpose of this article is to draw out the matter in detail, but let’s begin with

the simple (and basic) rule first. Indeed let’s call the Golden Rule of Mortgage Foreclosure: the

Uniform Commercial Code forbids foreclosure of the mortgage unless the creditor possesses the

properly-negotiated original promissory note. If this can’t be done the foreclosure must

stop.

Of course there are exceptions and situations in which problems with the note can be

addressed and cleared up, and those will be explored as we progress. The difficulty is that all too

often the Golden Rule of Mortgage Foreclosure is simply ignored and the foreclosure goes aheadas if the rule were not the statutory law of every jurisdiction in the United States.

1

Why is that? The answer is almost too sad to explain. The problem is that the Uniform

Commercial Code is generally unpopular in general, and particularly when it comes to the law of

negotiable instruments (checks and promissory notes) contained in Article Three of the Code.

Most lawyers were not trained in this law when in law school (The course on the subject,

whether called “Commercial Paper” or “Payment Law,” is frequently dubbed a “real snoozer”

and skipped in favor or more exotic subjects), and so the only exposure to the topic attorneys

have occurs, if at all, in bar prep studies (where coverage is spotty at best). Thus many

foreclosures occur without it occurring to anyone that the UCC has any bearing on the issue.

Judges are frequently similarly unlearned when the matter arises, and loath to hear more.

If the defendant’s attorney announces that the Uniform Commercial Code requires the

production of the original promissory note, the judge may react by saying something like, “You

mean to tell me that some technicality of negotiable instruments law lets someone who’s failed

to pay the mortgage get away with it if the promissory note can’t be found, and that I have to

slow down my overly crowded docket in the hundreds of foreclosure cases I’ve got pending to

hear about this nonsense?” It’s a wonder the judge doesn’t add, “If you say one more word about

Article Three of the UCC you’ll be in contempt of court!”

∗ Professor Emeritus, The Ohio State University Moritz College of Law. The author would like to thank ProfessorStephen McJohn of the Suffolk University Law School for his help in researching this article, and the manyattorneys (often former students) whose contacts and questions has gotten him involved in these issues. ProfessorWhaley's blog has a post which updates current developments in mortgage foreclosure matters; seehttp://douglaswhaley.blogspot.com/2010/11/update-mortgage-foreclosure-and-missing.html.

1Article 3 of the Uniform Commercial Code has been adopted in all jurisdictions in the United States. New

York has adopted only the original version of Article 3, but in that state the relevant citations and the law remain thesame with only minor variations in language.



But the law is the law. If the judge doesn’t like what the state statute says that is no

excuse for ignoring it. If the statute reaches a bad result then the legislature should repeal the

statute, and until that occurs the courts must follow it. As it happens there are good and sufficient

rules for Article Three’s mandates, as we shall see below.

I. The Landscape of the Mortgage Mess

Let's begin with what a mortgage actually is. Properly defined it is a consensual lienplaced by the home owner (called the "mortgagor") on the real estate being financed in ordersecure the debt incurred by the loan in favor of the lender/mortgagee. The debt is created by thesigning of a promissory note (which is governed by Article Three of the Uniform CommercialCode); the home owner will be the maker/issuer of the promissory note and the lendinginstitution will be payee on the note. There is a common law maxim that "security follows thedebt." This means that it is presumed that whoever is the current holder of the promissory note

(the "debt") is entitled to enforce the mortgage lien (the "security"). The mortgage is reified as amortgage deed which the lender should file in the local real property records so that the mortgageproperly binds the property not only against the mortgagor but also the rest of the world (thisprocess is called "perfection" of the lien).1

What happens to the promissory note? In the good old days, the twentieth century, it waskept down at the bank so that when the time for payment arrived the bank could present it to themortgagor when due, and, if it wasn't paid, the mortgagee could then use legal process (or insome states self-help) to foreclose on the mortgage lien. But during the feeding frenzy that thereal estate mortgage community indulged in for the last decade, more bizarre things happened.The mortgages themselves were no longer kept at the originating bank, nor were the notes.

Instead they were bundled together with many others and sold as a package to an investmentbanking firm, which put them in a trust and sold stock in the trust to investors (a process called“securitization”). The bankers all knew the importance of the mortgage, and supposedly keptrecords as to the identity of the entities to whom the mortgage was assigned. But they were damncareless about the promissory notes, some of which were properly transferred whenever themortgage was, some of which were kept at the originating bank, some of which were deliberatelydestroyed (a really stupid thing to do), and some of which disappeared into the black hole of thefinancial collapse, never to be seen again.

In recent years the combination of subprime lending, securitization of mortgage loans, ahousing market that first boomed then busted, rapacious predators who worked hard to take for

themselves the equity people had built up in their homes, and foreclosure mills that operated withneither proper paperwork, nor attention to the rules of law, much less common decency, led to anexplosion of laws and legal actions designed to deal with these matters.

1 The "mort" portion of the word mortgage comes from Latin for "death" (as in "mortician,""morgue," "mortal," etc.) because on the payment of the promissory note debt, the mortgagedeed dies.



The collapse of the housing market in 2008 was a direct consequence of these greedy andunwise business practices. Gullible consumers were encouraged to take out mortgages theycould not afford on property that turned out to be worth far less than the mortgage indebtedness.Minority communities were particularly hard hit, often targeted by shady lenders because peopleof color are more likely to store their wealth in home equity in many USA communities. Things

went fine until real property stopped appreciating in value and its worth dropped to alarminglylow levels, with a recession that engulfed the country and, indeed, the world. Not just subprimeborrowers were affected; the recession reduced the value of almost all property, and perfectlyresponsible mortgagors (many of whom were also laid off from their jobs) began to struggle tomake payments and avoid foreclosure. According to one monitoring agency, a record number of homes received foreclosure filings in 2010 (over 2.9 million).2

Ten years or so ago the bank that made the mortgage loan filed the mortgage deed in thelocal real property records so as to perfect its interest in the realty. But when the mortgagesthemselves began to be assigned, changing the real property records at the time of each transferwould be both expensive and awkward. Filing fees in real property record offices average $35

every time a new document is filed. The solution was the creation of a straw-man holdingcompany called Mortgage Electronic Registration Systems [MERS]. MERS makes no loans,collects no payments, though it does sometimes foreclose on properties (through local counsel).Instead it is simply a record-keeper that allows its name to be used as the assignee of themortgage deed from the original lender, so that MERS holds the lien interest on the real property.While MERS has legal title to the property, it does not pretend to have an equitable interest. Atits headquarters in Reston, Va., MERS (where it has only 50 full time employees, but deputizesthousands of temporary local agents whenever needed) supposedly keeps track of who is thetrue current assignee of the mortgage as the securitization process moves the ownership from oneentity to another.3 Meanwhile the homeowner, who has never heard of MERS, is makingpayment to the mortgage servicer (who forwards them to whomever MERS says is the currentassignee of the mortgage). If the payments stop, the servicer will so inform the current assigneewho will then either order MERS to foreclose or will take an assignment of the mortgage interest

2 RealtyTrac Staff, Record 2.9 Million U.S. Properties Receive Foreclosure Filings in 2010

Despite 30-Month Low in December , RealtyTrac (Jan. 12, 2011),http://www.realtytrac.com/content/press-releases/record-29-million-us-properties-receive-foreclosure-filings-in-2010-despite-30-month-low-in-december-6309. This immediatelyfollowed late 2009, where the third quarter saw 937,840 homes receive some sort of foreclosureletter, which at that point was “‘the worst three months of all time.’” Les Christie, Foreclosures:

‘Worst three months of all time’, CNN (Oct. 15, 2009, 7:34 AM),http://money.cnn.com/2009/10/15/real_estate/foreclosure_crisis_deepens/. 3 See HSBC Bank USA, N.A. v. Charlevagne (2008), 20 Misc.3d 1128(A), 872 N.Y.S.2d 691(Table), 2008 WL 2954767, and HSBC Bank USA, Nat. Assn. v. Antrobus (2008), 20 Misc.3d1127(A), 872 N.Y.S.2d 691,(Table), 2008 WL 2928553 (describing “possible incestuousrelationship” between HSBC Bank, Ocwen Loan Servicing, Delta Funding Corporation, andMortgage Electronic Registration Systems, Inc., due to the fact that the entities all share the sameoffice space at 1661 Worthington Road, Suite 100, West Palm Beach, Florida. HSBC alsosupplied affidavits in support of foreclosure from individuals who claimed simultaneously to beofficers of more than one of these corporations .).



from MERS so that it can foreclose in its own name. Amazingly, MERS Corporation holds titleto roughly half of the home mortgages in the country, some 60 million of them!4

II. The Uniform Commercial Code

Article 3 of the Uniform Commercial Code could not be clearer when it comes to theissue of mortgage note foreclosure. When someone signs a promissory note as its maker

("issuer"), he/she automatically incurs the obligation in UCC §3-412 that the instrument will be

paid to a "person entitled to enforce" the note.5 "Person entitled to enforce"—hereinafter

abbreviated to "PETE"—is in turn defined in §3-301:

"Person entitled to enforce" an instrument means (i) the holder of the instrument, (ii) a

nonholder in possession of the instrument who has the rights of a holder, or (iii) a person

4 Things would have gone better for MERS if it had done its job more thoroughly, but in the

speed and volume that was necessitated by the boom/bust economy, it became sloppy, its records

often confused, and eventually courts started blowing the whistle. There are decisions reaching

all possible results, but recently many courts (and particularly bankruptcy ones) are questioning

whether MERS has standing to foreclose on any of the mortgages it holds. The Supreme Court

of Arkansas has even ruled that since it makes no loans MERS cannot be the mortgagee on a

deed filed in the Arkansas property records; see Mortgage Elec. Registration System, Inc. v.

Southwest Homes of Arkansas, 2009 Ark. 152, 301 S.W.3d 1 (2009). In one Utah trial court

decision, reported in news articles, a judge ruled that MERS couldn't prove up its records and

granted the home owner's petition to quiet title and remove the MERS deed from the records.

No one could find the promissory note (on which further liability depends), so that particularhome owner is a major beneficiary of the MERS mess. MERS has been under much greater

attacks lately. News articles have reported that in early February, 2012, the New York Attorney

General filed suit against the major banks charging that their use of MERS was an "end run"

around the property recording system, which was designed so that the identity of the true

mortgagee would be a public record. In 2012, Merscorp, Inc., which operates MERS, was sued

by the Delaware Attorney General who alleged it initiated foreclosures for which "the authority

has not been fully determined and may not be legitimate."

5Uniform Commercial Code §3-412. Obligation of Issuer of Note or Cashier's Check.

The issuer of a note . . . is obliged to pay the instrument (i) according to its terms at thetime it was issued . . . . The obligation is owed to a person entitled to enforce theinstrument . . . .

[Emphasis added.]



not in possession of the instrument who is entitled to enforce the instrument pursuant to

Section 3-309 or 3-418(d) . . . .

Three primary entities are involved in this definition that have to do with missing

promissory notes: (1) a "holder" of the note, (3) a "non-holder in possession who has the rights of

a holder, and (3) someone who recreates a lost note under §3-309.6 Let's take them one by one.

A. "Holder"

Essentially a "holder" is someone who possesses a negotiable instrument payable to

his/her order or properly negotiated to the later taker by a proper chain of indorsements. This

result is reached by the definition of "holder" in §1-201(b)(21):

(21) “Holder” means:

(A) the person in possession of a negotiable instrument that is payable either to bearer orto an identified person that is the person in possession . . . .

and by §3-203:

(a) “Negotiation” means a transfer of possession, whether voluntary or involuntary, of aninstrument by a person other than the issuer to a person who thereby becomes its holder.

(b) Except for negotiation by a remitter, if an instrument is payable to an identifiedperson, negotiation requires transfer of possession of the instrument and its indorsement

by the holder. If an instrument is payable to bearer, it may be negotiated by transfer of possession alone.

The rules of negotiation follow next.

B. “Negotiation”

A proper negotiation of the note creates “holder” status in the transferee, and makes the

transferee a PETE. The two terms complement each other: a “holder” takes through a valid

“negotiation,” and a valid “negotiation” leads to “holder” status. How is this done? There are

two ways: a blank indorsement or a special indorsement by the original payee of the note.With a blank indorsement (one that doesn’t name a new payee) the payee simply signs

its name on the back of the instrument. If an instrument has been thus indorsed by the payee,

anyone (and I mean anyone) acquiring the note thereafter is a PETE, and all the arguments

6 Section 3-418(d) is also referenced in the PETE definition but it has to do with recreating therights of indorsers in instrument paid by mistake, which is not something that arises in mortgageforeclosure cases.



explored below will not carry the day. Once a blank indorsement has been placed on the note by

the payee, all later parties in possession of the note qualify as “holders,” and therefore are

PETEs.7

If the payee’s indorsement on the back of the note names a new payee (“pay to X

Company”), that's called a “special indorsement.” Now only the newly nominated payee can be a

“holder” (a status postponed until the new payee acquires the note—you have to hold to be a

holder). The special indorsee, wishing to negotiate the note to a new owner, may now sign in

blank, creating a bearer instrument, or may make another special indorsement over to the new

owner. Only if there is a valid chain of such indorsements has a negotiation taken place, thus

creating “holder” status in the current possessor of the note and making that person a PETE.

With the exception mentioned next, the indorsements have to be written on the instrument itself

(traditionally on the back).

C. The Allonge.

Sometimes the indorsement is not made on the promissory note, but on a separate pieceof paper, called an “allonge,” which is formally defined as a piece of paper attached to the

original note for purposes of indorsement.8 An allonge has an interesting history, traceable to the

days in which instruments circulated for long periods before being presented for payment.

Consider, for example, the early period in United States history before it was even a country.

People living in the Americas frequently had their banks back in Great Britain. If they drew up

drafts ("check") on these banks and gave them to another American, that person was unlikely to

immediately send it across the Atlantic to the mother country. Instead, the payee would simply

indorse it over to one of the payee's creditors, who would do the same. In those days drafts

would circulate, more or less like money, for extended periods of time. But the drafts quickly

ran out of room on which to place indorsements, so a separate piece of paper, called an "allonge"was glued to the original draft and the new indorsements were placed on the allonge. There are

cases from Great Britain where the allonge had over a hundred indorsements before finally being

presented to the drawee for payment.9

The Uniform Commercial Code still allows the use of an allonge, and given the large

number of transfers that some mortgage promissory notes have had in the last few years, there

are many new cases dealing with the allonge. These cases frequently reveal problems with

negotiation that give the current holder of the instrument difficulties in trying to establish "holder

status. For example, the allonge must be “affixed to the instrument” per §3-204(a)’s last

sentence. It is not enough that there is a separate piece of paper which documents the transfer

7 See, e.g., Riggs v. Aurora Loan Services, 36 So.3d 932 (Fla. App. 2010).8 See Official Comment 1 (last paragraph) to §3-204. 9 L.S. PRESNELL, COUNTRY BANKING IN THE INDUSTRIAL REVOLUTION 172-73 (1956), discussed in J.ROGERS, THE END OF NEGOTIABLE INSTRUMENTS 32 (2012).



unless that piece of paper is “affixed” to the note.10 What does “affixed” mean? The common

law required gluing. Would a paper clip do the trick? A staple?11

Thus a contractual agreement by which the payee on the note transfers an interest in the

note, but never signs it, cannot qualify as an allonge (it is not affixed to the note), and no proper

negotiation of the note has occurred. If the indorsement by the original mortgagee/payee on the

note is not written on the note itself, there must be an allonge or the note has not been properly

negotiated, and the current holder of that note is not a PETE (since there is no proper negotiation

chain).

Another difficulty with allonges that has bothered a number of courts occurs in the

following fact pattern. The promissory note apparently has a valid indorsement of the payee's

name either on the back of the note or on the accompanying allonge, but the evidence shows that

when the note was transferred to the current possessor that signature was not then on the note.

Instead it is clear that the current possessor, realizing the problem, went back to the payee and

had it indorse the note over to the current possessor, thus clearing up the negotiation issue. But

some courts have disallowed such a late negotiation by the original payee on the theory that bythe time the payee's signature was added to the note, the payee no longer had an "ownership"

interest in the note and thus no title to convey, which supposedly invalidates the late

indorsement.12 This is simply wrong, and is a misunderstanding of the difference between

ownership and the rules of negotiation. The Code never requires the person making an

indorsement to have an ownership interest in the note13 (though of course the payee normally

does have such an interest), but simply that he/she is the named payee, and the Code clearly

allows for correction of a missing indorsement. Section 3-203(c) provides for it specifically:

10 See Adams v. Madison Realty & Dev., Inc., 853 F.2d 163, 6 U.C.C. Rep. Serv. 2d 732 (3dCir. 1988) (mere folding of the alleged allonge around the note insufficient—$19.5 million lostbecause of this legal error!); Error! Main Document Only.HSBC Bank USA v. Thompson,2010 WL 3451130 (Ohio App. 2010) (unattached pages cannot be an allonge) In re Weisband,427 B.R. 13 (Bkrtcy.D.Ariz. 2010) (same). 11 I know of no paper clip cases, but it does seem unlikely a court would hold that such a clipwould "firmly affix" one piece of paper to another. As for staples, see Lamson v. CommercialCredit Corp., 187 Colo. 382, 531 P.2d 966, 16 U.C.C. Rep. Serv. 756 (1975) (“Stapling is themodern equivalent of gluing or pasting. Certainly as a physical matter it is just as easy to cut byscissors a document pasted or glued to another as it is to detach the two by unstapling”); accordSouthwestern Resolution Corp. v. Watson , 964 S.W.2d 262, 263 (Tex.1997).

I tell my lawstudents that they'll know they've hit the big time if they're in the Colorado Supreme Courtarguing about whether a staple firmly affixes an allonge to the original instrument. One courthas also blessed the used of an Acco fastener; Federal Home Loan Mortg. Corp. v. Madison,2011 WL 2690617 (D. Ariz. 2011).12 The leading (misleading?) case is Anderson v. Burson, 424 Md. 232, 35 A.3d 452 (2011).

13 Thieves can qualify as a "holder" of a negotiable instrument and thereafter validly negotiatesame to another; see Official Comment 1 to 3-201, giving an example involving a thief.



(c) Unless otherwise agreed, if an instrument is transferred for value and the

transferee does not become a holder because of lack of indorsement by the transferor, the

transferee has a specifically enforceable right to the unqualified indorsement of the

transferor, but negotiation of the instrument does not occur until the indorsement is made.

And Official Comment 3 explains: "The question may arise if the transferee has paid in advance

and the indorsement is omitted fraudulently or through oversight. . . . Subsection (c) provides

that there is no negotiation of the instrument until the indorsement by the transferor is made.

Until that time the transferee does not become a holder . . . ."

If the allonge is not in order, or there are other problems with the negotiation of the note

(the original payee’s name is missing, for example), the person suing on the instrument will have

to rely on the “shelter rule” to become a PETE, and so let's turn to that rule.

D. The Shelter Rule.

It has always been a basic rule in commercial law that the sale of anything vests in the

buyer whatever rights the seller had in the object sold. Phrased another way, the buyer takes

"shelter" in the rights of the seller. Even legal rights can pass in this way, including “holder”

status. Say, for example, that the payee fails to indorse the note (so no “negotiation” takes place)

but instead sells the note to a new owner. The new owner is not a “holder” (since there has not

been an indorsement by the payee), but the new owner takes shelter in the holder status of its

buyer, and thus is a PETE according to both §§3-301 (defining PETE) and 3-203(b) (the shelter

rule itself). In this case, the burden of proving proper possession is on the person in holding the

instrument, and until that is done no liability on the note arises (since the maker of the note'sobligation to pay it under §3-412, see above, only runs to a PETE). The shelter rule even acts to

pass on the original holder’s rights completely down the chain as long as the current possessor of

the note can prove the validity of all previous transfers in between.

The shelter rule can be hugely useful to the foreclosing entity. Say that the original payee

on the note was First Bank, which never indorsed the note at all. The note was then transferred

into the hands of Second Bank, which is the plaintiff in the current foreclosure action. Second

Bank, using the shelter rule, is a PETE as long as it proves the chain of transfers of the note,

obtaining the "holder" status of First Bank even without proper indorsements on the note or an

allonge. The courts have had no problem reaching this result.14

E. Lost Notes

14 See In re Veal, 450 B.R. 897 (9th Cir. BAP 2011); Anderson v. Burson, 424 Md. 232, 35 A.3d452 (2011); Leyva v. National Default Servicing Corp., 255 P.3d 1275 (Nev. 2011); In re KangJin Hwang, 396 B.R. 757 (Bkrtcy.C.D.Cal. 2008).



If the note has been lost, §3-309 of the UCC allows for the re-creation of lost or

destroyed notes. It states:

(a) A person not in possession of an instrument is 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 theperson or a lawful seizure, and (iii) the person cannot reasonably obtain possession of theinstrument 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 foundor is not amenable to service of process.

(b) A person seeking enforcement of an instrument under subsection (a) must prove theterms of the instrument and the person's right to enforce the instrument. If that proof ismade, Section 3-308 applies to the case as if the person seeking enforcement hadproduced the instrument. The court may not enter judgment in favor of the person

seeking enforcement unless it finds that the person required to pay the instrument isadequately protected against loss that might occur by reason of a claim by another personto enforce the instrument. Adequate protection may be provided by any reasonablemeans.

15

Note that (b) places the burden of proving a right to payment on the person claiming the

right to enforce the lost instrument. Nothing is presumed. The plaintiff must show the validity of

15 The 2002 version of §3-309 has slightly different wording of (a):

(a) 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 wasentitled to enforce the instrument when loss of possession occurred;

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

(3) the person cannot reasonably obtain possession of the instrument because the instrument wasdestroyed, its whereabouts cannot be determined, or it is in the wrongful possession of anunknown person or a person that cannot be found or is not amenable to service of process.

The 2002 rewrite of (a) was to allow an assignee of the entity which lost the note to enforce it, aresult that most courts reached even without this clarification. See Atlantic Nat. Trust, LLC v.McNamee, 984 So.2d 375 (Ala. 2007).



each transfer of the instrument from the original payee to the current plaintiff, and explain how

and why the note cannot be produced.16 The last sentence in §3-309 (see above) does allow the

court to rule in favor of the entity claiming under a lost note if there is a bond or other security

posted to protect the payor from the risk of double payment to a later party producing the note.

F. The Golden Rule of Mortgage Foreclosure Under the UCC

As stated in the first paragraph of this article, the Golden Rule of Mortgage Foreclosure:

the Uniform Commercial Code forbids foreclosure of the mortgage unless the creditor possesses

the properly-negotiated original promissory note. If this can’t be done the foreclosure must

stop. The maker who signs a promissory note is only liable per §3-412 to a "person entitled to

enforce" (PETE) the note, a term described in §3-301 so that only someone in possession of a

validly negotiated note qualifies. As we saw above, defects in negotiation frequently defeat the

ability to be a PETE, and therefore stop the foreclosure from being successful.17 Let's now turn

to the possession requirement, which is emphasized over and over in §3-301's definition of PETE

and its accompanying Official Comment.An assignee of the mortgage who does not have the promissory note is not allowed to

foreclose on the mortgage18 Without the note, the foreclosing entity does not have "standing" to

sue (and/or—a civil procedure distinction that is not my forte—is not the "real party in

interest").19 As United States District Judge Christopher Boyko explained throwing out a

16 See In re Carter, 681 S.E.2d 864 (N.C. App. 2009). In one major misstep, a bank in Florida,in a "paper reduction effort" is reputed to have deliberately put the notes through a papershredder after making photocopies of them! Any attorney who approved such a practice shouldbe disbarred.17

See Leyva v. National Default Servicing Corp., 255 P.3d 1275 (Nev. 2011); In re David A.Simpson, P.C., 711 S.E.2d 165 (N.C.App. 2011); Fed. Home Loan Mtge. Corp. v. Schwartzwald,194 Ohio App.3d 644, 957 N.E.2d 790 (2011); U.S. Bank Nat. Ass'n v. Kimball, 27 A.3d 1087(Vt. 2011).

18 In re Miller, 666 F.3d 1255 (10 th Cir. 2012); Veal v. Am. Home Mortg. Servicing, Inc. (In reVeal), 450 B.R. 897, 914 (9th Cir.BAP 2011); In re Foreclosure Cases, 2007 WL 3232430(N.D.Ohio 2007); In re Vargus, 396 B.R. 511 (Bankr. C. D. Cal. 2008); Norwood v. ChaseHome Finance LLC, 2011 WL 197874 (W.D.Tex.,2011); Fed. Home Loan Mtge. Corp. v.Schwartzwald, 194 Ohio App.3d 644, 957 N.E.2d 790 (2011); Manufacturers and Traders TrustCo. v. Figueroa, 2003 WL 21007266, 34 Conn. L. Rptr. 452 (Conn. Super. 2003); In re David A.Simpson, P.C., 711 S.E.2d 165 (N.C.App. 2011); U.S. Bank Nat. Ass'n v. Kimball, 27 A.3d 1087(Vt. 2011) ("It is neither irrational nor wasteful to expect a foreclosing party to actually be inpossession of its claimed interest in the note, and to have the proper supporting documentation inhand when filing suit"). 19 In re Miller, 666 F.3d 1255 (10 th Cir. 2012); Veal v. Am. Home Mortg. Servicing, Inc. (In reVeal), 450 B.R. 897, 914 (9th Cir.BAP 2011); In re Foreclosure Cases, 2007 WL 3232430 (N.D.Ohio 2007); ; In re Sheridan, 2009 WL 631355 (Bankr.D.Idaho 2009) (a moving party which hasthe burden of proof must make a showing that it is actually a party in interest to the proceedings);In re Wilhelm, 407 B.R. 392 (Bankr. D. Idaho 2009); In re Weisband, 427 B.R. 13



number of mortgage foreclosure cases, attempts to slide past the jurisdictional issue that arises

from filing without the necessary paperwork is unacceptable:

Plaintiff's, “Judge, you just don't understand how things work,” argument reveals acondescending mindset and quasi-monopolistic system where financial institutions have

traditionally controlled, and still control, the foreclosure process. Typically, thehomeowner who finds himself/herself in financial straits, fails to make the requiredmortgage payments and faces a foreclosure suit, is not interested in testing state or federal jurisdictional requirements, either pro se or through counsel. Their focus is either, “howdo I save my home,” or “if I have to give it up, I'll simply leave and find somewhere elseto live.”

In the meantime, the financial institutions or successors/assignees rush to foreclose,obtain a default judgment and then sit on the deed, avoiding responsibility formaintaining the property while reaping the financial benefits of interest running on a judgment. The financial institutions know the law charges the one with title (still the

homeowner) with maintaining the property.

There is no doubt every decision made by a financial institution in the foreclosureprocess is driven by money. And the legal work which flows from winning the financialinstitution's favor is highly lucrative. There is nothing improper or wrong with financialinstitutions or law firms making a profit-to the contrary, they should be rewarded forsound business and legal practices. However, unchallenged by underfinanced opponents,the institutions worry less about jurisdictional requirements and more about maximizingreturns. Unlike the focus of financial institutions, the federal courts must act asgatekeepers, assuring that only those who meet diversity and standing requirements areallowed to pass through. Counsel for the institutions are not without legal argument to

support their position, but their arguments fall woefully short of justifying theirpremature filings, and utterly fail to satisfy their standing and jurisdictional burdens. Theinstitutions seem to adopt the attitude that since they have been doing this for so long,unchallenged, this practice equates with legal compliance. Finally put to the test, theirweak legal arguments compel the Court to stop them at the gate.

The Court will illustrate in simple terms its decision: “Fluidity of the market”-“X”dollars, “contractual arrangements between institutions and counsel”-“X” dollars,“purchasing mortgages in bulk and securitizing”-“X” dollars, “rush to file, slow to recordafter judgment”-“X” dollars, “the jurisdictional integrity of United States District Court”-“Priceless.”20

(Bkrtcy.D.Ariz. 2010); In re Jacobson , 402 B.R. 354 (Bankr.W.D.Wash.2009) where movantsattempted to show that they were a party in interest with a deed rather than a note, but the courtheld that “[h]aving an assignment of the deed is not sufficient, because the security follows theobligation secured, rather than the other way around.” Id. at 367 (citations omitted) accord IdahoCode § 45–911 (“The assignment of a debt secured by mortgage carries with it the security.” 20 In re Foreclosure Cases, 2007 WL 3232430, footnote 3 (N.D. Ohio 2007).



Nor will a mere copy of the note suffice.21 There could be 100 copies of the original note,

but that would not create a right of foreclosure in 100 plaintiffs. To the bank's argument that a

copy of the promissory note should be enough, ask any banker if he/she would be willing to

accept a copy of check .

There are good practical reasons for the possession requirement. If the maker of the note

pays a "person not entitled to enforce," he/she is not discharged from liability on the note, and

faces the prospect of having to pay the true owner when that person surfaces with proof of

ownership of the note (see §§3-601 and 3-602 above).22 Courts must take special care not to

expose the maker to such double liability.

G. Is the Promissory Note Negotiable?

This is a thorny issue. First of all, as the debtor’s attorney, don’t raise the issue yourself .

Why not? Because if the note is not technically “negotiable” under the rigid rules of UCC §3-104then arguably the Uniform Commercial Code does not apply, and all of the statutory provisions

examined above are not the law. Thus the attorney for the foreclosing entity may think of this

and want to argue it (on the other hand, most attorneys would rather slaughter hogs than

contemplate the elements of negotiability), so what happens if it does comes up?

There have been serious scholarly arguments that most mortgage notes are not technically

negotiable.23 The typical issue concerns what is called the “courier without luggage”

requirement: the note must not contain promises or obligations (with certain exceptions) other

than a bald promise to pay the debt to the order of a named person or bearer.24 Pennsylvania’s

Chief Justice John Gibson once said that a negotiable instrument must be a “courier without

luggage.”25 This oft-repeated description means that the instrument must not be burdened withanything other than the simple and clean unconditional promise or order; it cannot be made to

truck around other legal obligations. If the maker of a note adds any additional promises to it, the

note becomes non-negotiable because the prospective holder is then given notice that the note is

or may be conditioned on the performance of the other promise. Section 3-104(a)(3) specifies the

21 In re Veal, 450 B.R. 897 (9th Cir. BAP 2011) (dueling creditors attempting to foreclose eachheld only a copy of the note, but not the original); In re Adams, 204 N.C. App. 318, 693 S.E.2d705 (2010) (copy of note sufficient as long as possession of the original note is alleged, but if possession challenged it must be proven, along with a valid chain of indorsements todemonstrate proper negotiation). 22 See Leyva v. National Default Servicing Corp., 255 P.3d 1275 (Nev. 2011); In re Adams, 204N.C. App. 318, 693 S.E.2d 705 (2010); Error! Main Document Only.HSBC Bank USA v.Thompson, 2010 WL 3451130 (Ohio App. 2010). 23 See Neil Cohen, "The Calamitous Law of Notes," 68 Ohio St. L.J. 161 (2007); Ronald J.Mann, Searching for Negotiability in Payment and Credit Systems, 44 UCLA L. Rev. 951, 962-85 (1997). 24 UCC §§3-104(a)(3), 3-106. 25 Overton v. Tyler, 3 Pa. 346, 347 (1846).



few additional items that may be mentioned in an instrument without destroying its negotiable

character.26 Since most mortgage notes are cluttered with extraneous promises by the maker, the

contention is at these notes are not “negotiable instruments” as that term is defined in the UCC.

In the article mentioned in footnote 23, Professor Ronald Mann argues that a promise in

the typical mortgage note provides that on electing to make a prepayment, the maker of the note

must give a written notice to that effect to the holder of the note. Is this an extraneous promise

forbidden in a “negotiable” note? He argues it is, but that seems wrong to me. UCC §3-106(b)

allows a references to another document for rights as to prepayment, and while that is not exactly

what is happening here, it is an indication that the Code drafters were unconcerned with

prepayment issues when it came to negotiability (the reason being that prepayment aids the

maker, so the rules should be construed to protect that bias). So far the courts have not agreed

that such promises destroy negotiability.27

Further, what is the harm by so minor a promise, that it should strip away the protection

of the only uniform treatment of the law from what all parties intended to be a promissory note?

Official Comment 2 to §3-104 states that a major test on whether the parties intended to create anegotiable instrument is the inclusion vel non of “order or bearer” language in the note. Since the

typical note is payable to the “order” of a named payee, that should settle it that the parties did

intend for the UCC to apply to their transaction. The same Official Comment goes on to provide

that where the parties intended to create a negotiable instrument but made some minor misstep,

Article 3 could be applied by analogy (since it is the current best thinking of how instruments

should be legally governed—amended most recently in 2002). Courts have been receptive to

this analogy argument.28

Destroying the negotiability of the promissory note is not always a good thing for the

foreclosing entity. If the note is not negotiable, then there can no holder in due course of that

note who will take free of defenses to the note. Such a status is reserved only for negotiableinstruments. A non-negotiable instrument is merely a contract, and like all contracts it travels

with its defenses whenever assigned from one entity to another.29 There is no such thing as a

holder in due course of a non-negotiable instrument. This is important to foreclosing entities

where the homeowner has defenses to payment that can be asserted in contract actions, but which

are not assertable against a holder in due course.30 Say, for example, that the homeowner was

tricked by fraud into signing the mortgage due to extravagant lies told by the lender (which often

26

See also §3-106. 27 See HSBC Bank USA, Nat. Ass'n v. Gouda, 2010 WL 5128666, 73 UCC Rep.Serv.2d 226(N.J.Super. 2010); In re Edwards, 2011 WL 6754073 (Bkrtcy.E.D.Wis. 2011).

28 In re Veal, 450 B.R. 897 (9th Cir. BAP 2011); see also Fred H. Miller & Alvin C. Harrell, The

Law of Modern Payment Systems § 1.03[1][b] (2003). 29 See Restatement (Second) of Contracts §336 (Defenses Against an Assignee). 30 Per UCC §3-305, a holder in due course is free of "person" defenses, and only subject to theshort list of "real" ones, which do not include common law fraud.



happened, particularly in the sub-prime market).31 Such a defense would not be good against a

holder in due course, who could foreclose and take the home free of the fraud allegation. This is

happening over and over.32

Finally, if all else fails and the note is deemed nonnegotiable, then the common law

would apply, and the common law routinely required possession of a promissory note before

foreclosure could proceed, though that's going to take some library research to prove up state by

state.33

III. The Difference Between the Note and the Mortgage

Faced with these daunting UCC provisions, but not possessing the original promissory

note, some entities foreclosing have turned to the mortgage contract itself, and tried to use the

failure of the home owner to make the payments required by that contract as a ground for the

foreclosure. "We can prove that the mortgage was assigned to us, so we'll use it as the groundsfor foreclosure," is their mantra. Let's explore why that possibility won't work.

When the purchaser of real property attends the closing and signs paper after paper the

three primary legal documents that are involved in a later foreclosure are (1) the promissory note

by which the new homeowner, called the maker of the note, promises to pay the lender (the

payee) the amount being borrowed to finance the mortgage, (2) the mortgage contract which

promises the same thing and has a large number of additional contractual obligations and duties,

and (3) the mortgage deed which transfers title to the real estate involved from the homeowner

(“mortgagor”) to the lending institution (‘mortgagee”). The lender keeps the note and the

mortgage contract, and files the mortgage deed in the real property records so as to create a lien

on the property which must be satisfied before the property could later be transferred to someoneelse.

A. "Security Follows the Debt"

31 How these mortgages came to be is delineated in horrible detail in such books as MichaelW. Hudson's "The Monster: How a Gang of Predatory Lenders and Wall Street Bankers FleecedAmerica and Spawned a Global Crisis" (2010).

32 The most egregious case is Brown v. Carlson, 26 Mass.L.Rptr. 61, 2009 WL 2914191(Mass.Super. 2009), in which the mortgage fraud was perpetrated on "a retired crossing guard,widowed and in her sixties, with an eighth grade education," who lost her home to a holder indue course. See also In re Carmichael, 443 B.R. 698 (Bkrtcy.E.D.Pa. 2011); In re Dixon-Ford,2011 WL 6749083 (Bkrtcy.D.N.J. 2011). 33 See the Restatement of Property (Mortgages) §5.4 and its Comments. For a historicaldiscussion of the reification of the underlying obligation in the physical form of a bill or note, seeJ. ROGERS, THE END OF NEGOTIABLE INSTRUMENTS 24-39 (2012).



The common law was clear that the mortgage contract and the mortgage deed are mere

"security" for the payment of the promissory note (the "debt"). It is a common law maxim that

“security follows the debt.”34 This means the mortgage travels along with the promissory note,

and that the note is the important item, not the mortgage itself. Thus whoever has the promissory

note is the only entity that can enforce the mortgage. The courts are more or less unanimous on

this.35 The United States Supreme Court established the basic rule early in the 1873 case of

Carpenter v. Longan:36 "The note and mortgage are inseparable; the former as essential, the latter

as an incident. An assignment of the note carries the mortgage with it, while an assignment of the

latter alone is a nullity. . . . The mortgage can have no separate existence. When the note is paid

the mortgage expires. It cannot survive for a moment the debt which the note represents. This

dependent and incidental relation is the controlling consideration . . . ." A purported assignment

of a mortgage to a bank is not proof of a transfer of a promissory note secured by the mortgage,

since the mortgage follows the note but not vice versa.37

Indeed, Article 9 of the Uniform Commercial Code codifies this idea. Section 9-203(g)

provides that whoever has a perfected interest in the note automatically has a perfected interest inthe underlying mortgage ("security follows the debt"). But Article 9 says nothing about who is

entitled to enforce the note when it comes due, which is left to Article 3; thus the plaintiff in the

foreclosure must still prove it is a PETE, as that term is defined in Article 3. Moreover, even if

§9-203(g) works its magic to transfer the mortgage interest to the possessor of the note, that does

not mean that foreclosure can be had without satisfying the court (in judicial foreclosures) that

the state foreclosure laws requiring a clear chain of mortgage assignments have been met. In

non-judicial foreclosure state, UCC §9-607(b) provides that "if necessary to enable a secured

party [including the buyer of a mortgage note] to exercise the right of [its transferor] to enforce a

mortgage non-judicially," the secured party may record in the office in which the mortgage is

recorded (i) a copy of the security agreement transferring an interest in the note to the securedparty and (ii) the secured party’s sworn affidavit in recordable form stating that default has

occurred and that the secured party is entitled to enforce the mortgage non-judicially. 38 For a

34 Noland v. Wells Fargo Bank, N.A., 395 B.R. 33 (Bankr. S.D. Ohio 2008); Manufacturers andTraders Trust Co. v. Figueroa, 2003 WL 21007266, 34 Conn. L. Rptr. 452 (Conn. Super. 2003). 35 “For nearly a century, Ohio courts have held that whenever a promissory note is secured by amortgage, the note constitutes the evidence of the debt and the mortgage is a mere incident to theobligation. Edgar v. Haines 109 Ohio St. 159, 164, 141 N.E. 837 (1923).. Therefore, thenegotiation of a note operates as an equitable assignment of the mortgage, even though the

mortgage is not assigned or delivered.” U.S. Bank Natl. Assn. v. Marcino, 181 Ohio App.3d 328,908 N.E.2d 1032 (2009).36 83 U.S. 271, 274 (1873). 37 Deutsche Bank Nat. Trust Co. v. Byrams, 2012 OK 4, 2012 WL 130661 (Okla. 2012). 38 Various provisions in Article 9, see §§9-203(b), 9-309(3), provide that the creation of asecurity interest (that is, ownership rights) in a promissory note that is being sold (as opposed tobeing used as collateral) does not require the buyer of the note to take possession of the note if the sale is made pursuant to an agreement reflected in a writing or other record. Some lawyersseem to think that this gets rid of the need to possess the note for foreclosure purposes. It doesn't,



complete discussion of these issues, see the UCC's Permanent Editorial Board's official

explanation: http://www.ali.org/00021333/PEB%20Report%20-%20November%202011.pdf

There has been an attack on this concept recently in a way that might aid homeowners. In

U.S. Bank v. Ibanez,39 handed down on January 7, 2011, the Massachusetts Supreme Judicial

Court ruled that a mortgage cannot be assigned in blank (a common practice in the securitization

of mortgages), so that the holder of a blank mortgage assignment was not the proper entity to

foreclose. “We have long held that a conveyance of real property, such as a mortgage, that does

not name the assignee conveys nothing and is void,” the court said. When the assignee argued

that it held the promissory note, which automatically gave it the appropriate ownership interest in

the mortgage ("security follows the debt"), the court disagreed, saying that a more formal

assignment of the mortgage was necessary for a clear real estate title. “In Massachusetts, where a

note has been assigned but there is no written assignment of the mortgage underlying the note,

the assignment of the note does not carry with it the assignment of the mortgage.” The court then

added that a holder of the note could file a lawsuit to obtain the mortgage. Without a properly

assigned mortgage the mortgage holder remains unchanged, which is why the banks lacked thepower to foreclose. The court refused to apply its decision only to future cases, thus creating a

legal mess in Massachusetts that could undo foreclosures held years ago. Bank stocks fell

instantly. The Massachusetts Supreme Judicial Court did not consider the effect of UCC §9-

203(g), which clearly states that possession of the promissory note automatically creates a

security interest in the mortgage even without a formal assignment of same. Why didn't the court

discuss this very relevant statute? My guess is that no one (not the parties, not the law clerks, not

the judges) came across it in preparing the case or the decision (so here the UCC law professor

emits a sad sigh). The obligation giving rise to the mortgage is reified in the promissory note,

and only the current possessor of the promissory note can bring suit thereon (regardless of who is

the assignee of the mortgage).Interestingly, in Utah some homeowners have been successful in bringing quiet title

actions to strip off the mortgage where no entity can prove a valid chain of assignments of the

mortgage. Doing that would rid the property of the mortgage lien and permit subsequent sale,

though it would not excuse the mortgagor's liability on the promissory note should it finally

surface in the hands of a PETE.

and confuses apples with oranges. The Article 9 rules have nothing to do with the homeownerwho is the maker of the promissory note, but apply only to regulate rights between later partiesclaiming ownership in the note as it passes from one hand to another. The Article 9 rules werewritten so that the note can be sold by contracts without being physically moved around (thusallowing the note to be warehoused somewhere). That has nothing to do with the Article 3 rulesdiscussed in the body of this law review article. For a complete discussion of these issues, see theUCC's Permanent Editorial Board's official explanation:http://www.ali.org/00021333/PEB%20Report%20-%20November%202011.pdf. 39 458 Mass. 637, 2011 WL 38071 (Mass. 2011) ; see alsohttp://www.businessweek.com/news/2011-01-08/massachusetts-top-court-hands-foreclosure-loss-to-u-s-bancorp.html.



B. The Merger Rule

It has always been a basic rule of negotiable instruments law that once a promissory not

is given for an underlying obligation (like the mortgage contract), the underlying obligation is

merged into the note and is suspended while the note is still outstanding. Discharge on the note

would (due to the rule that the two are merged) result in discharge of the underlying obligation.

This makes sense: paying the note would also pay the obligation. Because of the merger rule,

the underlying obligation is not available as a separate cause of action until the note is

dishonored.

This merger rules, with its suspension of the underlying obligation until dishonor of the

note, is codified in §3-310(b) of the UCC:

(b) Unless otherwise agreed and except as provided in subsection (a), if a note or anuncertified check is taken for an obligation, the obligation is suspended to the sameextent the obligation would be discharged if an amount of money equal to the amount of the instrument were taken, and the following rules apply:

* * *

(2) In the case of a note, suspension of the obligation continues until dishonor of the noteor until it is paid. Payment of the note results in discharge of the obligation to the extentof the payment.

Thus until the note is dishonored there can be no default on the underlying obligation (the

mortgage contract). All foreclosure statutes, whether permitting self-help or requiring the

involvement of a court, forbid foreclosure unless the underlying debt is in "default." That meansthat the maker of the promissory note must have failed to make the payments required by the

note itself, and thus the note has been dishonored. Under UCC §3-502(a)(3) a promissory note is

dishonored when the maker does not pay it when the note first becomes payable.40

However, as discussed above, the promissory note itself is owed to a PETE, and only that

person can show that the debt was not paid when due, thus creating a "dishonor" and severing the

note from the underlying mortgage obligation, so as to permit foreclosure under the latter theory.

40 The Code's dishonor rules do not create a right of physical "presentment" of the note, but §3-

501 does create such a right if the maker so demands. Section 3-501(a) defines “presentment” asa demand to pay the instrument made by a “person entitled to enforce an instrument” [the

PETE], and under subsection (b)(2) adds that “Upon demand of the person to whom presentment

is made, the person making presentment must (1) exhibit the instrument” [emphasis added].

Most promissory note have a standard clause waiving the right of presentment, and that would be

effective to obviate the effect of a demand under §3-501—which is why this discussion of

"presentment" is relegated to a mere footnote.



Both the Official Comments to §§3-502 and to 3-310 make it clear that a dishonor can only

occur if the person who wishes to sue is a "holder," i.e., someone in possession of the instrument.

Official Comment 3 to §3-502 states "This [section] allows holders to collect notes in ways that

make commercial sense without having to be concerned about a formal presentment on a given

day," and Official Comment 3 to §3-310 explains: "If the check or note is dishonored, the [other

party] may sue on either the dishonored instrument or [the underlying contract] if [that person is

in] possession of the dishonored instrument and is the person entitled to enforce it" (emphasis

added).

Putting this altogether, were I a mortgagor’s attorney, on getting notice of the intent to

foreclose, I would demand that my client be presented with the original promissory note and that

the note was is the hands of a PETE when failure to pay the note occurred.41 Failing that the

mortgagor is not in default since he/she has not dishonored the note. Until that happens, §3-310

suspends the entire mortgage obligation. The contractual obligation to pay has merged into the

note, and until the note is dishonored it's unavailable as a separate cause of action. Thus if the

entity trying to foreclose cannot produce the promissory note, it cannot prove that payment wasnot made to the PETE, meaning that no "dishonor" of the note has occurred under 3-502, and

thus the underlying mortgage obligation is still merged into the note.

There are some federal cases supposedly applying California law which state that

production of the original promissory note is not required in California since it is not mentioned

in the comprehensive California statute detailing foreclosure procedure in this non-judicial

foreclosure state42 (there are federal California decisions to the contrary43). I looked up the

California foreclosure statute. Cal.Civ.Code §2924(a) clearly states that the power of foreclosure

is "to be exercised after a breach of the obligation for which that mortgage or transfer is a

security." If no dishonor of the note has occurred then there has not yet been such a breach, and

the California statute would not permit foreclosure. The obligation in the statute is either theobligation of the maker of the promissory note (UCC §3-412), which obligation only runs to a

PETE, or the mortgage obligation which is suspended as a cause of action per §3-310 until

dishonor of the note in the hands of the PETE. Either way there is no "breach of the obligation

41 If the foreclosing bank says that the original promissory note had a clause waiving the right of

presentment, I would demand to see the note as proof of that assertion. If the foreclosing entity

cannot produce the original promissory note, how do we know what it says? Even if the court is

convinced that the right of presentment was waived, that does not have anything to do with the

other requirement of dishonor of the note in the hands of a PETE . Until such a dishonor occurs

per §3-502, the underlying obligation is still suspended as an independent cause of action.

42 See Tina v. Countrywide Home Loans, Inc., 2008 WL 4790906 (S.D.Cal. 2008); Castaneda v.Saxon Mortg. Services, Inc., 687 F.Supp.2d 1191 (E.D.Cal. 2009). Interestingly, I can find nostate cases from California agreeing with this federal analysis of the California foreclosurestatute. 43 See, e.g., In re Doble, 2011 WL 1465559 (Bankr. S.D. Cal. 2011).



for which the mortgage or transfer is a security" without the original promissory note being

involved.44

Arizona has a similar dismal history with this issue, where once again some federal

courts have misconstrued Arizona's foreclosure statute so as to permit foreclosure without

production of the promissory note.45 Once again I can't find any state decisions from Arizona on

point, but the federal courts misread the relevant Arizona foreclosure statute in the same way that

the federal courts in California have mistaken the California statute. Arizona Revised Statutes

§33-807 permits a foreclosure sale "after a breach or default in performance of the contract or

contracts, for which the trust property is conveyed as security, or a breach or default of the trust

deed." As above, no such breach or default can exist until there is a failure to pay the promissory

note in the hands of a PETE.46 Finally, it should be noted that the federal courts in Nevada have

made the same error, but so far this misunderstanding of the law appears to be confined to these

three western (federal) jurisdictions. Happily, most states allowing non-judicial foreclosure sales

have rightly required the foreclosing entity to be the owner of the note at the time of the

foreclosure is commenced.

47

IV. How To Resolve These Matters

There are substantial equities in favor of the foreclosing party, and judges should work

hard to preserve these equities. The debtor did take out the mortgage and sign the promissory

note promising to pay off the mortgage amount, and, on failing to do so, must surrender the real

property that is the security for this debt. Further, the foreclosing entity has paid good money for

the right to foreclose, and this investment must be protected. The bank that is foreclosing may

protest that if some technicality (i.e., the rules that are explained in this article) forbidsforeclosure the homeowner might escape from having to pay anyone the mortgage debt, but still

retain possession of the mortgaged property.

44 In any event, the California statutes do not allow the wrong party to foreclose, so someoneattempting to do so must establish PETE status (thus having standing to sue), and that, as we'veseen from the discussion of the merger rule, requires dishonor of the note. There are Californiabankruptcy decisions so saying; see In re Doble, 2011 WL 1465559 (Bankr. S.D. Cal. 2011). 45 See, e.g., Diessner v. Mortgage Electronic Registration Systems, 618 F.Supp.2d 1184(D.Ariz. 2009); Mansour v. Cal-Western Reconveyance Corp., 618 F.Supp.2d 1178 (D.Ariz.2009). Happily the more recent decision by the 9th Circuit Bankruptcy Appellate Panel gets itright in Veal v. Am. Home Mortg. Servicing, Inc. (In re Veal), 450 B.R. 897, 914 (9th Cir.BAP2011) (Arizona law does not allow foreclosure without production of the original promissorynote). 46 Compare Ernestberg v. Mortgage Investors Group, 2009 WL 160241 (D.Nev. 2009), with therelevant Nevada foreclosure statute, which only allows foreclosure " after a breach of theobligation for which the transfer is security" [N.R.S. 107.080]. 47 See Burgett v. MERS, 2010 WL 4282105 (D. Ore. 2010); In re Adams, 693 S.E.2d 705 (N.C.App. 2010); In re Bailey, 437 B.R. 721 (Bankr. D. Mass. 2010).



Of course these equities presume that the foreclosing entity really is the owner of the debt

and can prove it according the standard rules of law, and that the debt truly is in default. At the

symposium presentations that resulted in this issue of the law review, one of the attorneys in the

audience came to the microphone with a horror story about a client who had missed some

payments but then, faced with foreclosure, worked out a repayment agreement with the current

holder of the mortgage, never missed a payment, but was considerably surprised one day to have

the doorbell ring and be faced with the "new owner" of his property which had been purchased at

a California non-judicial sale of which the current owner was unaware. Many homeowners are

caught in a trap whereby one part of the foreclosing bank is engaged in working out an

agreement to save the property, while the other is sending out a foreclosure notice. Basic rules of

contract and estoppel can lead a court of equity to refuse foreclosure in these situations. 48

If a court rules that the bank can’t foreclose, does that mean that the home owner gets

away without paying the mortgage? Not quite. The mortgage deed is still filed in the real

property records, and unless it’s removed the property can never be sold, not even if the home

owner dies and the heirs want to dump it. The home remains collateral for the debt, and thatwon’t go away until the mortgagee agrees to remove it from the records. Thus the homeowner

has an interest in working things out with the entity threatening to foreclose.

If the foreclosing bank cannot prove valid ownership and hence is forbidden the

possibility of foreclosure, the only remedy left for the bank is to pass liability back to the entity

from which the obligation was purchased, and so on until we find a person who really is entitled

to enforce. The common law creates a warranty from the assignor to the assignee that the

obligation assigned exists and is subject to no defenses,49 and this is the remedy the disappointed

assignee should seek if it is not a PETE. If the chain of transactions cannot be undone (the

records are lost, a major player has ceased to exist, or whatever), well, life is hard and sometimes

you purchase a worthless asset. You certainly shouldn’t buy something unless your seller canprove good title.

If the foreclosing bank wins the lawsuit but doesn’t have proper documentation, any

subsequent sale of the property foreclosed upon is going to be problematic and risky for the new

purchaser (and this should be pointed out to judges before they rule). Issues like this present new

difficulties. Consider title insurance companies. At all real estate closings the buyer has to pay

for such insurance, but it’s not common for title insurance companies to actually have to pay off;

the title normally is flawless. But if judges start invalidating foreclosures and ruling that the

house belongs to the original owner, buyers of foreclosure homes are going to be filing claims.

Title insurance companies might have to pay out millions, leading them to raise rates, cut down

policies, layoff employees, or declare bankruptcy. Certainly no respectable title insurance

company is going to issue a policy for the resale of a foreclosed-upon home where there are legal

48 See PHH Mortgage Corp. v. Barker, 190 Ohio App.3d 71, 940 N.E.2d 662 (2010).49 See Restatement of Contracts (Second) §333(b).



issues about missing notes or improper documentation in the foreclosure proceeding, and,

without title insurance available, what will the foreclosing bank do with an unsalable property?50

If the client wants to pay the mortgage debt, but is leery of paying the wrong entity,

he/she should pay the debt into an escrow account and advise the putative assignee of the

mortgage that the amount deposited will be available on production of the promissory note or the

signing of an indemnity agreement. Such a deposit would be the equivalent of tender of the

amount due, so as to avoid late charges. The amount could also be paid into court in an

interpleader action in appropriate circumstances.

The true solution to the mortgage mess that results from missing notes, inadequate

documentation of mortgage assignment, confusion at the bank, and robo-signing of required

affidavits, is for the foreclosing entity to make sure it has the proper documentation before it files

the foreclosure, and to have contacted the debtor before foreclosing to see if (a) the debt is really

in default, (b) there are no defenses to foreclosure (such as an existing workout arrangement), (c)

the debtor can pay the debt without the necessity of foreclosure), or (d) some option to

foreclosing exists. The banks are overwhelmed by the ownership of worthless homes on whichthey have foreclosed. In truth it would be smarter for the foreclosing banks to put their money

into creating a negotiation program that takes troubled transactions and works them out by

mutual agreement with the home owner, so that the title can be cleared and the property resold.

These negotiations might include a voluntary waiver of the home owner's rights in return for

forgiveness of the mortgage debt, or renegotiated payments on the mortgage, or whatever the

parties can construct as a compromise. With all of the above defenses on the table, the home

owner has some leverage to make the bank listen to his/her concerns and not just steamroller

over them in the rush to foreclose. Judges faced with foreclosing entities that do not have the

original promissory note should at least use the mechanism for lost notes described above and

require the foreclosing entity to post bond protecting the homeowner form later claimants to theproperty who do possess the original note.

There are tons of unintended consequences from the current procedures. If you are a

respectable bank official caught up in all this, how many new mortgages would you be willing to

make to people who are not already well off? Then, without readily available mortgage loans,

what will happen to the whole idea of home ownership? Or the ability to move to take a job in

another town? Or the economy? Or the American Dream of a better life than one’s parents? If

you are a consumer considering buying a new home, think again. Doing so can be asking for

50 Sometimes, faced with such ownership, the foreclosing entity will conduct the sale, but neverrecord its deed, thus leaving the now-homeless former owner with continued liability for taxesand other major expenses. Since he/she can't afford these, the properties just deteriorate further.Urban blight is already a major problem in many communities, even upscale ones, as house afterhouse sits abandoned, leading to dropping real estate value of others, and a vicious cycle of neighborly collapse. What do municipalities do about the resulting crime, fire hazards, disease,etc.? They can’t raise taxes in today’s economy. Chapter Nine of the United States BankruptcyCode provides for municipal bankruptcies, but we never teach those rules in law school becauseactual cases were rare in the past.



trouble even if you can afford to pay cash—will the neighborhood self-destruct? Could you sell

it if you want to? How good is the title on this new property?

For troublesome transactions (the paperwork is a mess, the note is missing, the home

owner alleges he/she has defenses) it’s time to sit everybody around a table and work out a

satisfactory solution through negotiation. Judges might well order this. All involved need a

resolution that will end in a resumption of the payments, or an agreed-upon foreclosure with

indemnities to the home owner against future troubles (say from the real owner of the original

promissory note), or some contractual arrangement that ends up with a salable property in the

local community.

V. Conclusion

This article has not gotten into a host of other issues affecting mortgage foreclosures, and

those matters must be dealt with elsewhere. Here is a brief list of some legal difficulties: proof

the assignment of the mortgage,

51

robo-signing and foreclosure mills,

52

proof of business records

51 The assignment itself may have difficulties with a chain of title, and that should beinvestigated with vigor. The leading case requiring a clear chain of title in assignments is U.S.

Bank v. Ibanez, 458 Mass. 637, 2011 WL 38071 (Mass. 2011). 52 Affidavits of those filing foreclosure actions that the debts have been reviewed and verified

must, of course, be true. In the foreclosure mills these swearings are often pro forma and, due to

the volume involved, frankly impossible, being done by humans acting like robots. Where this

can be proven, the lawsuit should be dismissed, and, indeed, massive publicity over this practice

led to the suspension of many foreclosures nationwide in 2010. Notary stamps are required on

assignments in many states or the assignment is invalid, and if the evidence demonstrates thestamp was added much later, that is fraud [see http://4closurefraud.org/2010/08/04/mother-jones-

andy-kroll-exclusive-fannie-and-freddies-foreclosure-barons/]. Indeed there is out and out fraud

in many foreclosures as phony documents are created, signatures forged, false affidavits of lost

instruments sworn to, and newly “discovered” allonges solve negotiation difficulties. If the

lawsuit was filed by someone who didn’t have standing and the attorney who filed it should have

known that, he/she should be reported to the bar association, and the misfiling should also be

called to the judge’s attention as a reason to dismiss. This is also criminal conduct, of course, and

should be prosecuted, including as a defendant any attorney participating in deception of the

court. Recently the Florida courts have become disgusted by improper documentation and have

insisted upon it, causing major foreclosures to be abandoned and the courts to strip the properties

from their mortgages (!): see http://www.squattable.com/news/040311/foreclosure-crisis-fed-

judges-dismissing-cases-giving-homes-back-homeowners-and-boldly-a. On April 6, 2011, the

Ohio Supreme Court dismissed a complaint filed by lawyers against three trial court judges who

recently began requiring lawyers to personally verify the authenticity of all documents used in

foreclosures. The judges have refused to grant summary or default judgments without such

certification, though a trial can still go forward. The attorneys are not happy.



establishing the right to foreclose,53 and fraud.54 The footnotes give some guidance to these

difficulties, which have little or nothing to do with the Uniform Commercial Code.

The truth is that the current lending mess was sloppily run for years, with greed as the

fuel, and no one paid any attention to details, and increasingly complex transactions led to the

loss of a paper trail. But now the orgy has ended with major hangovers for the participants who

paid no attention to the basic rules. The borrowers (who also have had to battle this problem at

their end, when they can't figure out who is the proper party to negotiate with over repayment

issues or settlement discussions), have done nothing wrong. They do owe the debt and the house

is still the collateral, so they are not off the hook at all. But the courts won't let someone

foreclose just because that someone thinks they are the right entity to do it, or really, really,

really wants to foreclose. They have to prove they are a PETE by clear evidence. Wishing that

they had that evidence is not enough. Indeed, as discussed above, if the buyer pays the wrong

person, he/she still owes the debt.55

The UCC rules are not just fusty technicalities. They reflect common sense: you can't sue

or foreclose unless you can prove you are entitled to sue or foreclose. What could be more basicin our law than that idea? I tell the Legal Aid lawyers who call me that if the trial judge hates the

UCC and wants to duck all of this, remind him/her that it is the statutory law of this jurisdiction

(indeed, all jurisdictions in the USA have identical UCC provisions to those quoted above). And,

53 Assignees are required to prove up the business records that are the basis of the assignment,and such evidence is an exception to the hearsay rule only where the person proffering thebusiness records can testify to their authenticity. Assignees to whom such records are transferredin the ordinary course of business do not have the requisite personal knowledge of the recordscreation and preservation, and hence cannot so testify to their validity. This rule of evidence canbe a major stumbling block to foreclosure actions and other collection efforts. See AssetAcceptance v. Lodge, 2010 WL 3759538 (Mo. App. 2010); Chase Bank USA v. Herskovits,2010 N.Y. Misc. Lexis 2818 (Civ. Ct. 2010); DNS Equity Group, Inc. v. Lavallee, 907 N.Y.S.2d436 (Dist. Ct. 2010); Palisades Collection, L.L.C. v. Kalal, 781 N.W.2d 503 (Wis. App. 2010);Riddle v. Unifund CCR Partners, 298 S.W.3d 780 (Tax. Civ. App. 2009); Unifund CCR Partnersv. Bonfigil, 2010 Vt. Super. Lexis 24 (2010); but see Simien v. Unifund CCR Partners, 321S.W.3d 235 (Tex. Civ. App. 2010). 54 Outside of the UCC, attorneys should consider filing a lawsuit charging fraud(misrepresentation of a material fact made with knowledge of its falsity or a reckless disregard of its truth, on which there was justifiable reliance causing damages) if it’s indeed present and youcan be proven. Fraud is the civil action for lying, an ugly thing to charge someone with, creatinggreat headlines for the media. If fraud has been at work, well, that's good news for the plaintiff ina lawsuit. The common law maxim is that “fraud vitiates all transactions,” so that nothing canhide fraud. Those guilty of fraud cannot sue on the contract, which is now void for "illegality"(asthat word is used in the law of contracts: void as a matter of public policy), and punitivedamages, including attorney’s fees are also a possibility. Nor is unjust enrichment in favor of theevil-doer a possibility since guilty parties to an illegal contract lose all rights to sue on anytheory—they are truly “outlaws” in the literal meaning of that term. 55 UCC §3-602.



as explained above, the common law is no different from the UCC, so dodging the UCC does not

help the plaintiff trying to foreclose without having possession of the note.

When the consumer agrees to buys a new home and goes to the closing, the lending bank

overwhelms the new homeowner with legal paper, after legal paper, after legal paper which the

borrower must sign or the loan will not go through. At this end of the transaction the bank is

very careful to make sure everything is in apple pie order and that every "i" is dotted and every

"t" is crossed. Call me a madcap fool if you will, but I think that at the other end of the

transaction when banks are attempting to take someone's home, they ought to be required to

follow the law then too. As the Third Circuit has commented in a case where the foreclosing

bank could not produce the necessary proof, "Financial institutions, noted for insisting on their

customers' compliance with numerous ritualistic formalities, are not sympathetic petitioners in

urging relaxation of an elementary business practice."56

motion for rehearing (final) r1

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