naked capitalism

A potentially important North Carolina appeals court case, In re Gilbert, has not gotten the attention it warrants.

In very short form, the borrowers, who were unable to obtain a loan modification, tried to halt a foreclosure by arguing that the lenders had failed to make required disclosures under the Truth in Lending Act (which they hoped would allow for recission of the loan, and that the party seeking to foreclose had not proved that it was the holder of the Note with the right to foreclose under the instrument. The judges nixed the TILA argument, affirming lower court decisions, but reversed the superior court on the question of the standing of the petitioner.

In Re Gilbert May 3, 2011 North Carolina Appeals Court Decision

What is interesting is the logic of the decision, which blows a hole in one of the pet arguments of the American Securitization Forum, that possession of a note will suffice. We have argued that the contracts that govern the securitization, the pooling and servicing agreement, sets the requirements for conveyance as is contemplated in the Uniform Commercial Code (its Article 1 allows for parties to make their own arrangements as long as certain conditions are met). But if the parties to a case do not argue that the PSA trumps the UCC (and many do not), most judges will reason from the UCC, and securitization attorneys have blithely assumed this will get them out of trouble. This is the position asserted in the ASF’s white paper last fall:

Under the UCC, the transfer of a mortgage note that is a negotiable instrument is most commonly effected by (a) indorsing the note, which may be a blank indorsement that does not identify a person to whom the mortgage note is payable or a special indorsement that specifically identifies a person to whom the mortgage note is payable, and (b) delivering the note to the transferee (or an agent acting on behalf of the transferee). As residential mortgage notes in common usage typically are “negotiable instruments,” this is the most common method to transfer the mortgage note. In addition, even without indorsement, the transfer can be effected by transferring possession under the UCC. Moreover, the sale of any mortgage note also effects the transfer of the mortgage under Article 9. Securitization agreements often provide both for (a) the indorsement and transfer of possession to the trustee or the custodian for the trustee, which would constitute a negotiation of the mortgage note under Article 3 of the UCC and (b) an outright sale and assignment of the mortgage note. Thus, regardless of whether the mortgage notes in a securitization trust are deemed “negotiable” or “non-negotiable,” the securitization process generally includes a valid transfer of the mortgage notes to the trustee in accordance with the explicit requirements of the UCC.

The North Carolina judges blew a hole in that theory. This particular foreclosure had some of the irregularities that are all too common, but the borrowers were deemed to have abandoned the related arguments. However, the judge focused on a specific failure in this deal which is pervasive in securitizations: the final endorsement was to the trustee, not the particular trust. The judges in the case goes through multiple deficiencies in the transfer process: some transfers were made by parties that did not have clear authority to do so, the affidavits were unreliable (as in they were in some cases non-factual and separately made inappropriate conclusions of law), and there was no evidence provided that the securitization trust was the owner and holder of the note (as in the not exactly compelling endorsements ending with a trustee and not a particular trust were inadequate). The most important part was this statement:

…the Allonge in the record contains no indorsement to Deutsche Bank Trust Company Americas as Trustee for Residential Accredit Loans, Inc. Series 2006-QA6

Few courts have questioned whether the final endorsement needs to be to the trust rather than the trustee; we’ve argued that that is necessary because the trusts elect to be governed by New York law and case law has long stipulated that endorsement to a particular trust is necessary. Interestingly, the North Carolina judges came to a similar conclusion independently. We expect this argument to be made in other courts. Given that endorsement to a specific trust seems to be very rare, this could prove to be a potent argument.