Foreclosing on Nothing: The Curious Problem of the Deed of Trust Foreclosure Without Entitlement To Enforce the Note

Dale A. Whitman*
Drew Milner**

In this article we propose to examine the extent to which a party conducting a nonjudicial foreclosure of a mortgage or deed of trust must establish that it is entitled to enforce a promissory note that the mortgage or deed of trust secures. It may seem patently obvious that such a showing is required, but that proposition turns out to be far from true.

In Part I, we provide background on the law governing the transfer of the right to enforce notes, particularly negotiable notes under UCC Article 3. We also describe the nature and structure of nonjudicial foreclosure in the United States. Part II looks at seven western states that use nonjudicial foreclosure of deeds of trust and investigates whether and how those states require proof of the right to enforce the note. In Part III, we consider the same issue across the rest of the nation, but rather than engage in a state-by-state analysis, we examine only recent judicial decisions addressing this point. Part IV discusses the related issue of enforcement of notes that have been lost, a problem that is addressed by UCC Article 3 but largely ignored by the nonjudicial foreclosure statutes. Finally, our overall conclusions are set out in Part V.

I. THE FORECLOSURE CRISIS
The foreclosure crisis that began in the latter half of 2007 has been a bitter pill to swallow for the American economy at large and for many thousands of families who have lost, or are in the process of losing, their homes to foreclosure.1 But even such pervasively bad news has a good side, for there are many lessons of law, economics, and policy to be learned from this experience. This article addresses one such lesson.

Before the crisis began, most lawyers familiar with the process of mortgage foreclosure in the United States would probably have regarded it as a satisfactory, if not somewhat dull, area of the law. Foreclosure did not generate much appellate litigation, and those few lawyers who specialized in the field, mostly representing lenders, had little difficulty in getting the results they needed from the mechanisms of foreclosure.

That process has now changed radically. The foreclosure crisis resulted in the creation of a new kind of lawyer: the foreclosure-defense specialist. As these specialists began to poke and prod at the foreclosure process, they found plenty of weaknesses. They raised dozens of questions about precisely what sort of evidence or proof, and in what form, needed to be adduced by those instigating foreclosure, particularly when the loan had been sold on the secondary-mortgage market. For example, they forced the courts to focus on issues such as whether a chain of mortgage assignments (recorded or not) was required as a prerequisite to foreclosure.2

In addition, the impact of the Mortgage Electronic Registration System (MERS) became highly controversial.3 MERS was created by a group of major mortgage-market participants in the mid-1990s as mortgage loans were traded on the secondary market, primarily to avoid the necessity of repeated recordings of mortgage assignments.4 MERS holds mortgages as “nominee” for the loan owner, but the scope of MERS’s authority as nominee was unclear.5 For instance, could MERS foreclose in its own name?6 Was it entitled to notice of foreclosures or other actions affecting the property?7 Did the fact that MERS held the mortgage while an investor held the note create a separation of the two documents that would somehow be fatal to the effort to foreclose?8 A whole constellation of related issues arose around MERS’s involvement in the foreclosure process.

While plenty of uncertainty existed, one concept clearly emerged from litigation during the 2008-2012 period: in order to foreclose a mortgage by judicial action, one had to have the right to enforce the debt that the mortgage secured.9 It is hard to imagine how this notion could be controversial. From its earliest beginnings, American mortgage law held that a mortgage must secure an obligation, and since foreclosure is a means for the creditor to realize on the obligation, the foreclosing creditor must be entitled to enforce that obligation.

10 As the Restatement explains, “The mortgage becomes useless in the hands of one who does not also hold the obligation because only the holder of the obligation can foreclose.”11 In the case of a loan that has been sold on the secondary market, this means that the right to enforce the obligation must have been transferred to the party now purporting to foreclose the mortgage, or if the foreclosing party is an agent, to its principal.12

Observe that the obligation must be explicitly transferred, not the mortgage. For this reason, in the absence of a contrary statute, an assignment of the mortgage is not necessary to transfer the power to foreclose.13 As the old cases put it, the mortgage follows the note14 and will automatically inure to the benefit of the party to whom the obligation is owed.15