Real Estate Law – What happens When Two Distinct Notes Are Secured By The Same Mortgage?

August 26, 2015


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I. What Is The Difference Between A Mortgage And A Promissory Note?

When you are looking to take out a loan to purchase a home, you are required to sign numerous documents, including: (1) a promissory note; and, (2) a mortgage (or deed of trust). Homebuyers usually think of the mortgage as the contract they are signing with a lender to borrow money to purchase a house but it is actually the promissory note that contains the promise to repay the amount borrowed.

A promissory note can be compared to an IOU that contains the promise to repay the loan, as well as the terms of repayment. The note includes the: (1) name of the borrower (2) property address (3) interest rate – fixed or variable (4) late charge amount (5) amount of the loan, and (6) the term of the loan – number of years. Unlike a mortgage, the promissory note is not recorded in the county land records. The lender holds the promissory note while the loan is outstanding. When the borrower (known as the mortgagor) pays the loan back, the note will be marked as paid in full and returned to the borrower.

On the other hand, the purpose of a mortgage is to provide security for the loan that is evidenced by the promissory note. The mortgage is the instrument which allows the bank to foreclose on your home if you default on the mortgage payments. In other words, although you may have actual possession of your home, the mortgage gives a legal security interest of the property to the bank in order to make sure someone does not run off with their money. As such, mortgages must be recorded with the county land records to put all others on notice of the security interests tied to the property.

Issues come up when there are two (or more) separate notes from different lending banks tied to one single mortgage. The result is two loans and two promises to pay, backed by one property, creating an unsecured mortgage – basically one of the banks does not have what they thought they had– collateral on their loan.

II. What Happens When Two Promissory Notes Are Held By Two Banks Allegedly Secured By The Same Mortgage?

Although this type of activity is fraud, issues would not become apparent until the payments to one or both of the two banks stopped coming in (the borrower defaulted on the loans). In this instance, both banks would seek to foreclosure on the property.

Foreclosure is the legal process where real estate secured by a mortgage or deed of trust is sold to satisfy the underlying debt as evidenced by the promissory note. Banks often sell and buy mortgages and deeds of trust from each other. An “assignment” is the document that is the legal record of the transfer of the mortgage from one bank to another. Each assignment is supposed to be recorded in the county land records, but recordation is not required. When two notes are secured by one mortgage, it is necessary to figure out which bank “perfected” title to the mortgage in order to determine to whom the mortgaged property rightfully belongs, when assignments are not recorded purchasers and Associations can find themselves in a heap of trouble

In a recent decision by the Fourth District Court of Appeal, Judge Gross, laid out the legal analysis for such disputes, and how notes are perfected. On May 6 th, the Fourth District Court of Appeal handed down the decision in HSBC Bank USA, N.A., Case. 4D13-3193 (Fla. 4 th DCA May 6, 2015 ) in which two promissory notes were held by two banks, the notes being secured by the same mortgage. The fraudulent scheme came to light when both banks tried to foreclose on the same mortgaged property.

The issue turned on which law governed the perfecting of liens. This was a crucial decision as the Court determined that Article 9 of Florida’s Uniform Commercial Code applied based on §679.1091 Fla. Stat. (2008) and NOT §701.02 (the recording statute) The Court did not assume that the lien to be perfected was the mortgage. Article 9 of the UCC is said to apply to assignments even if the note was originally secured by a real property mortgage. To illustrate this concept consider the following scenario:

  • O borrows $10,000 from M and secures its repayment obligation, evidenced by a promissory note, by granting to M a mortgage on O’s land. [Article 9] does not apply to the creation of the real-property mortgage. However, if M sells the promissory note to X or gives a security interest in the note to secure M’s own obligation to X, [Article 9] applies to the security interest thereby created in favor of X. The security interest in the promissory note is covered by [Article 9] even though the note is secured by a real-property mortgage.

III. Promissory Note Is The Key!

The Court’s decision reminds readers that the promissory note is the operative, primary document in the loan transaction. The security interest (mortgage) is but “incident to the debt” merely providing security for the debt. When a note is transferred even without an assignment of mortgage, the mortgage follows the note.

The promissory note is perfected by taking possession of the note. Possession effectively places everyone else on notice of the possessor’s interest. §679.3131(1) Fla. Stat. (2008). Here is a break down of the case leading up to the decision:

May 2006 The mortgage was recorded.
June 30, 2006 HSBC takes possession of one of the promissory notes, specially endorsed by HSBC.
August 8, 2006 LaSalle Bank obtains possession of the second promissory note which also contained special endorsements.
2008 Borrower DEFAULTS
April 24, 2009 HSBC records its mortgage assignment.
June 5, 2009 LaSalle Bank obtained an assignment of mortgage stating it was effective January 2, 2009
August 12, 2009 LaSalle Bank records its assignment of mortgage.

Thus, HSBC’s possession of one of the promissory notes before LaSalle Bank’s assignment meant that HSBC perfected its security interest in that note and thus the mortgage by mere possession. “Perfecting” can be understood as the process of clearing all prior claims on a title to allow for its sale or assignment. LaSalle could not perfect an interest in that note as HSBC had possession of the note. LaSalle’s possession of the second note after HSBC had possession of the first note prevented LaSalle from perfecting an interest in the mortgage. Thus the court made a key distinction, almost to remind lawyers, judges and consumers that recording statute (§701.02 “First in time, first in right) does not apply to subsequent assignees of a mortgage.

With no recording requirement, the analysis shifts to the UCC “priority scheme” which takes into account perfection of security interests, thus HSBC’s possession of a note before LaSalle, perfects the priority in HSBC. More issues arise as to who bears the risk of loss in cases like these. From this decision it appears that the lender that obtains possession last (the second bank) loses.

IV. Conclusion

The decision reinforces the significance of identifying “the note holder” for Homeowner’s Associations and Condominium Associations, and further that the UCC’s concepts must be considered whenever a promissory note is involved. The decision clarifies some issues but will continue the difficulty experienced by associations of finding who the holder of a mortgage is, because assignments do not necessarily have to be recorded if the mortgage follows the note. For this reason it is crucial that Associations continue to seek assistance in order to locate the actual note holder, before spending thousands on a property with unknown interests.

This article is solely a partial explanation of all the issues related to the topic of this newsletter, and is not to be considered legal advice. The association should consult with its legal counsel to obtain explanations of all issues addressed herein and determine what procedures will most benefit your association.