Obstacles to Negotiability of Residential Mortgage Notes, Part II

This is the second installment in Max’s analysis of the issues surrounding negotiability of residential mortgage notes, drawing language and analysis from In re Veal but also addressing issues beyond the context of that case.  This segment discusses why residential mortgage notes are not negotiable instruments. If you haven’t already, you may want to read Part I, a primer on negotiability.



FIRST: Uniform Covenant 2 of the standard Fannie and Freddie fixed rate mortgage note provides that “all payments accepted and applied by Lender shall be applied in the following order of priority: (a) interest due under the Note; (b) principal due under the Note; (c) amounts due under Section 3 (escrow). Such payments shall be applied to each Periodic Payment in the order in which it became due. Any remaining amounts shall be applied first to late charges, second to any other amounts due under this Security Instrument, and then to reduce the principal balance of the Note.” This Covenant further provides that to the extent payments are misapplied the borrower is entitled to a proper credit on the outstanding principal balanced owed. Under 3‐104(a)(3) of the UCC, a promissory note cannot be an instrument if it contains such an undertaking; the rules of negotiability apply only to promises to pay money, not to other, non‐monetary understandings such as principal reductions for the misapplication of payments.

SECOND:Uniform Covenant 4 of the standard Fannie and Freddie fixed rate mortgage note provides that the borrower has “the right to make payments of principal at any time before they are due. A payment of principal only is known as a ‘prepayment.’ When I make a prepayment, I will tell the Note Holder in writing that I am doing so.

The Italicized sentence of Section 4 constitutes an undertaking to do an act in addition to the payment of money. Under 3‐104(a)(3) of the UCC, a promissory note cannot be an instrument if it contains such an undertaking; the rules of negotiability apply only  to promises to pay money, not to other, non‐monetary understandings. Sending a notice certainly is an act “in addition to the payment of money,” and the note’s language clearly constitutes an “undertaking” to perform that act. Thus, the standard Fannie‐Freddie Uniform instrument is not negotiable and thus the rules of Article 3 of the UCC (including the holder‐in‐due‐course protections) do not apply.

THIRD: Section 14 of the Uniform Freddie and Fannie fixed rate mortgage note provides that with respect to loan charges the “Lender may charge Borrower fees for services performed in connection with Borrower’s default, for the purpose of protecting Lender’s interest in the Property and rights under this Security Instrument, including, but not limited to, attorneys’ fees, property inspection and valuation fees. In regard to any other fees, the absence of express authority in this Security Instrument to charge a specific fee to Borrower shall not be construed as a prohibition on the charging of such fee. Lender may not charge fees that are expressly prohibited by this Security Instrument or by Applicable Law. If the Loan is subject to a law which sets maximum loan charges, and that law is finally interpreted so that the interest or other loan charges collected or to be collected in connection with the Loan exceed the permitted limits, then: (a) any such loan charge shall be reduced by the amount necessary to reduce the charge to the permitted limit; and (b) any sums already collected from Borrower which exceeded permitted limits will be refunded to Borrower. Lender may choose to make this refund by reducing the principal owed under the Note or by making a direct payment to Borrower. If a refund reduces principal, the reduction will be treated as a partial prepayment without any prepayment charge (whether or not a prepayment charge is provided for under the Note). Borrower’s acceptance of any such refund made by direct payment to Borrower will constitute a waiver of any right of action Borrower might have arising out of such overcharge.” Sections 3‐104(a) and 3‐106(a) of the UCC clearly provide that a negotiable instrument must constitute an “unconditional” promise to pay and that the obligation to pay must be “unconditional.” Under 3‐106(a), an express condition in a note creates a complete bar to negotiability. Uniform Covenant 14, by expressly justifying the borrower in withholding a portion of the stated principal amount of the note, or by demanding a credit on the stated amount due, creates such an express condition.

FOURTH: The Uniform Freddie and Fannie fixed rate mortgage note includes a “usury savings clause” that provides, “interest paid or agreed to be paid shall not exceed the maximum amount permissible under applicable law and, in any contingency whatsoever, if the Lender shall receive anything of value deemed interest under applicable law which would exceed the maximum amount of interest permissible under applicable law, the excessive interest shall be applied to the reduction of the unpaid Amount of Note or refunded to the  maker.” Because this provision expressly conditions the maker’s obligation to repay the stated principal and interest on the lawfulness of the negotiated payment terms, it deprives the note of negotiability. In short, this language renders the obligation to pay conditional because the borrower is obligated to pay the fixed “stated amount only if the amount is consistent with applicable law.” Section 3‐104(a) of the UCC requires that the note state a “fixed amount of money” due in order to render it a negotiable instrument.

FIFTH: The representations and warranties provided by the Sponsors, the Sellers and the Depositors in the typical securitized transactions effectively do not treat the residential mortgages notes as completely sold due to the continuing repurchase obligations arising out of such representations and warranties. The EPDs (early payment default) covenants are simple examples of such provisions. These conditions render the notes non‐negotiable under Section 3‐302(a)(2)(iii) and (a)(2) (vi) of the UCC.

SIXTH: The so‐called Multiple Option Adjustable Rate Mortgage (MOARM) is yet another example of a non‐negotiable mortgage note. Under these mortgage notes, the borrower has multiple options for the first 2, 3, 4 or 5 years of the 30 year mortgage. The available options include but are not limited to making no payments, making half the interest due that month, making the full interest payment due that month, making the principal payment due that month, etc. Of course, if the borrower elects option one (no payment) or option two (half the contractual interest due) then the principal balance owed on the note goes up. And, if such options are elected during the first month, then the loan quickly converts to a negative amortization loan since the total amount owed is greater than the original amount loaned. Since Section 3‐104(a) of the UCC requires that the note state a “fixed amount of money” due in order to render it a negotiable instrument, the MOARM simply fails this test as does any other note subject to any similar negative‐amortization feature.

Since these notes are not negotiable instruments, the transfer and sale of the notes are subject to the provisions of Article 9 rather than Article 3 of the UCC.

Continue to Part III