A Chapter 7 trustee objected to the proof of claim filed by a downstream assignee of a lost mortgage note. The trustee sought both to reject the claim and to avoid the mortgage (so that he could preserve the mortgage lien for the benefit of the estate). The bankruptcy court held for the trustee with respect to the note and for the mortgagee with respect to the right to enforce the mortgage. Both parties appealed.
The debtor acquired property for a purchase price of $1.00 plus assumption of all encumbrances, including a mortgage given by seller to the trustee of a real estate trust (Hansbury). The debtor did not incur any direct liability to Hansbury.
Hansbury subsequently assigned the note and mortgage to another party (CPIC). Hansbury had lost the note, so he gave CPIC (1) an assignment of the mortgage, (2) a lost note affidavit with a copy of the note, and (3) an allonge transferring rights into the note. The lost note affidavit had typical representations that a full and complete copy of the note was attached, Hansbury was the holder of the note (which had been lost but had not been transferred or discharged), the outstanding balance, and the consideration paid by Hansbury for the note and mortgage. CPIC in turn assigned its rights under the Murphy note and mortgage to another trustee of a trust (Green) as security for a loan.
The note was determined to be a negotiable instrument governed by the applicable state Uniform Commercial Code (UCC). Under Section 3-301 of the UCC, a “person entitled to enforce” a note meant (1) the holder of the note, (2) a non-holder in possession with the rights of a holder, or (3) a person not in possession of the note who was entitled to enforce under UCC 3-309 (regarding lost notes) or 3-418(d) (regarding payment or acceptance by mistake).
Since Green was not the holder or a non-holder in possession of the note, his right to enforce the note turned on whether he was entitled to do so under UCC 3-309. Under the UCC as in effect in the applicable state, a lost, destroyed, or stolen note can be enforced only if all of the following criteria are met:
(i) the person was in possession of the instrument and entitled to enforce it when loss of possession occurred, (ii) the loss of possession was not the result of a transfer by the person or a lawful seizure, and (iii) the person cannot reasonable obtain possession of the instrument because the instrument was destroyed, its whereabouts cannot be determined, or it is in the wrongful possession of an unknown person or a person that cannot be found or is not amenable to service of process.
In this case, the note was lost by Hansbury, so Green was not in possession of the note at the time it was lost. Consequently, the Bankruptcy Appellate Panel agreed with the bankruptcy court that Green was not entitled to enforce the mortgage note under UCC 3-309.
After the bankruptcy was filed, the property was been sold free and clear of liens, with liens to attach to proceeds. So, the question with respect to the mortgage was whether the mortgagee was entitled to the proceeds. The court’s analysis began by noting that under state law, a mortgagee may assign its mortgage unless there is a restriction in the mortgage. The mortgage was assignable since there was no restriction, and the Chapter 7 trustee had constructive notice of the mortgage based on the original recording.
The trustee argued that since Green could not enforce the note, he also could not enforce the mortgage: “[u]nless a mortgage secures an obligation, it is a nullity.” So the mortgage should be avoided since Green could not enforce the note. However, the court concluded that the mortgage was not a nullity since it still secured the note held by Hansbury before it was lost.
The court further noted that the note and mortgage did not have to be held by the same entity. “The two instruments exist on separate planes, and the transfer of the note does not automatically transfer the mortgage.” However, when they are held by separate entities, the mortgagee holds the mortgage in trust for the noteholder. Since Green was not the true holder of the note, it held the mortgage in trust for the noteholder. Although Green could not foreclose the mortgage on his own behalf, the lien did attach to the sale proceeds, which would now be held in trust for the noteholder.
Thus, the Bankruptcy Appellate Panel agreed with the bankruptcy court that Green was not entitled to collect on the mortgage note, but the trustee could not avoid the mortgage, and the sale proceeds were to be held in trust for the true noteholder (which was an issue to be decided outside of the bankruptcy).
The 2002 amendments to UCC Article 3 amended Section 3-309 to overturn this result. As amended, a person can enforce the lost note if it either (1) was entitled to enforce when the loss occurred or (2) “has directly or indirectly acquired ownership of the instrument from a person who was entitled to enforce the instrument when loss of possession occurred.”
Although a dozen or so states had adopted this amendment by 2015, a number have not. This highlights the danger of basing an analysis on review of your trusty copy of the Portable UCC instead of checking the UCC as adopted in all applicable states. Although generally the Uniform Commercial Code is pretty uniform, those pesky little state variations can turn an analysis on its head.