Secured lenders routinely take pledges of instruments (including negotiable instruments under UCC Article 3 and other promissory notes) as collateral. Instruments are subject to special priority rules. Security interests perfected merely by filing a UCC1 financing statement are junior to security interests perfected by possession, without regard to time of filing or possession. Security interests perfected by “control” (possession plus indorsement) are senior to those perfected merely by filing or possession. Accordingly, secured parties who are relying on instruments as collateral will want to have control over the instruments.
Instruments may be indorsed to secured parties, but it is a cumbersome process that has to be unwound when the loan is repaid as expected. It is, therefore, convenient and common practice to have the requisite indorsements supplied on a separate piece of paper. This keeps the instrument “clean” so that it can be returned clean when the secured obligations are paid. The separate piece of paper is kept with the instrument but is not typically attached to it, though the lender or its custodian has authority to do so, at least upon default.
This practice works well in most cases. Even though the lender is not yet a “holder” under Article 3, because the indorsement is not attached, the lender has possession and the related loan documents should cause the lender to be a “nonholder in possession of the instrument who has the rights of a holder,” that is one who can enforce the instrument as such under UCC §3-301, and compel indorsement under UCC §3-203.
In addition, secured parties in (mere) possession have priority over other secured parties except those who have control (possession plus indorsement), so the failure to achieve full control does not normally impair priority (no one else will have possession except in rare cases). UCC §9-330(d). So, even if a separate indorsement is not initially “affixed” to an instrument, a secured party in possession normally maintains first priority and has the power to negotiate the instrument upon default.
There are occasions, however, when having an indorsement is critically important. One would be the relatively rare case where one competing secured party has possession for itself as well as for the other competing secured party, so both would be in possession and priority could depend on the effectiveness of an indorsement. Another would be where the maker of a negotiable instrument has defenses against the named payee but the secured party, with the indorsement, would be a holder in due course. Yet another would be an assignment of a note or a casual pledge where the related documents do not clearly provide the lender with the rights of a holder.
Under UCC Article 3, which applies to “negotiable instruments” (as defined in Article 3) and which is commonly applied by courts to non-negotiable instruments, “indorsement” means a signature “on an instrument… For the purpose of determining whether a signature is made on an instrument, a paper affixed to the instrument is a part of the instrument.” UCC §3-204(a) (emphasis supplied). Under this rule, a separate assignment document is not sufficient to create the requisite indorsement, unless it is “affixed” to the instrument.
Some Michigan assignees found out the hard way how important it is to have one’s separate indorsement “affixed.” In one case, a separate indorsement was not attached to the note in question and the assignee was unwilling to produce the underlying assignment of loans agreement. The court held the separate indorsement was not effective and, because it referenced the unproduced underlying agreement, it did not prove an absolute assignment was intended. Brown Bark, II, LP v. Bay Are Floor Covering & Design, Inc., Case No. 296660, (Mich. Ct. App. May 31, 2011). In the other case, the assignee ultimately had two problems after it took a note and placed it in an envelope with a separate indorsement. Not only was the separate indorsement ineffective because it was not affixed to the note, it turned out the “note” was in fact a color copy of the original note, so the assignee did not even have possession of the note. Without ever having had possession, the assignee did have standing to enforce the note as a lost note under UCC §3-309. Shaya v. Karam, Case No. 308905 (Mich. Ct. App. May 6, 2014).
Pledgees and other assignees of notes need to ensure that original notes are delivered to them, and if indorsements are separately provided, that transaction documents properly authorize them to attach the separate indorsements when appropriate.