Non Performing Notes – The old ‘Holder-in-Due-Course Question’ or: Can I get sued if someone originated a ‘bad’ loan and I bought it?

This is a classic and very appropriate question in this day and age.

First, a general caveat … I’m not an attorney, and if you’re asking yourself this question because of a very specific peculiarity or blemish or risk you feel exists on a loan, then check with an attorney first.

That said, here’s an abridged comment on liability and the Holder-in-due-Course Doctrine.

In a nutshell, yes, you are liable for a seller’s mistakes when it comes to origination fraud (e.g. high interest rate loans that violate some law governing how much a loan can cost). In more complicated terms (explained below), a borrower can come at you with what are called “real” defenses.

And no, you are not liable if a borrower claims that the lender misrepresented the terms of the loan to them, or that the lender forced them to sign the loan documents, or that they just didn’t really know what they were getting into when they signed. Those are called a borrower’s “personal” defenses. And no, you aren’t liable if they raise those arguments.

For the more nutty of you, here’s a more detailed explanation. For a detailed drill-down on the HDC Doctrine and its applicability to residential mortgages, read Kurt Eggert’s “Held Up in Due Course” 2 articles in the Creighton Law Review from February and April, 2002.

In the 17^th century, with advances in commerce and industrialization, came significant growth in financial contracts, and in what is known as “negotiable instruments”.

A negotiable instrument is an assignable promise to pay an amount of money at a particular time. The two most common forms of a negotiable instrument are a check and a promissory note (a real estate note is a promissory note, a note in which one party makes a promise to pay another party an amount of money over a period of time, hence the name “promissory”).

Both checks and notes are negotiable instruments for the simple fact that both can be “endorsed” or assigned. You can endorse a check to someone, just as you can endorse a real estate note to someone.

The 3 basic rules for transferring a negotiable instrument were, for all intents and purposes, refined by a Scot by the name of William Murray in the 18^th Century, better known as Lord Mansfield, first Attorney General then Chief Justice of England.

Those rules were as follows:

a)      the instrument is transferable, and the one receiving the instrument (the buyer) can sue in his own name

b)      “consideration” was given for the instrument (have you ever noticed that on every single deed ever signed, there’s something referenced called “consideration” even if it’s for $10? That is fundamental here – the instrument changes hands in exchange for money)

c)      Even if the person transferring the instrument die not have clean title, the recipient acquires good title if they acquired the instrument “in good faith and for value”

That last paragraph, by the way, is what’s called the Holder-in-due-Course Doctrine.

So, let’s review that one again. IF there was something deficient with regards to the note, the buyer of that note gets clean title as long as they acted in good faith (e.g. as long as they didn’t know about those mistakes or errors or omissions on title) and as long as they paid something for that note.

How did this doctrine ever come to pass?

Because without it, people would never have been able to buy someone else’s contract.

It’s what protected buyers of contracts from having to do all kinds of due diligence on what happened between the signer of the note, and the provider of the note (e.g. the money) at the time the contract was written.

If that were a requirement today, then no contracts would ever change hands.

Imagine you receive a check from John Smith, written on a Bank of Tuscaloosa check. And John Smith endorses it to you. But then John sues the Bank of Tuscaloosa for fraudulent checking activities.

And he decides to sue you too, for no reason other than that you were next in line.

Without the HDC protections for the note buyer, John would be able to sue you simply because you bought a contract from Bank of Tuscaloosa, whom he has a dispute with!

OK, if it were that simple, this would be a 50-word answer.

But it isn’t.

Here’s some more detail on the “defenses” that either are or are not “cut off” with the HDC.

Those protections I mentioned above for the note buyer are of two varieties: there are the “real defenses” and the “personal defenses”. The real defenses here refer to cases of outright fraud or illegality of an instrument.

If a borrower can claim these (in general, tough to claim, but in the era of crooked subprime mortgage lenders and brokers, this hasn’t been all that hard!), then the note buyer MAY BE liable for the note seller’s fraudulent or illicit activity.

If, however, a borrower tries to assert the “personal defenses” described below, then the note buyer IS NOT liable alongside the note seller’s.  The personal defenses are the more common and easier to prove claims such as the borrower:

a)      wasn’t competent at the time they signed the note (incompetence)

b)      the provider of the note misrepresented certain parts of it – a classic argument against the greedy mortgage lender (misrepresentation)

c)      the provider of the note forced the borrower to sign the note (coercion)

So what did the HDC really do, given all this language above?

“It is sometimes said that the holder-in-due-course doctrine is like oil in the wheels of commerce and that those wheels would grind to a quick halt without such lubrication.” (quoted from the Feb ‘02 article by Kurt Eggert  – Holder-in-due-Course, in the Creighton Law Review, 363, p. 376).

Well, it looks like I’m safe then as a buyer of non-performing notes, if the lender originating the loan wrote an illegal loan and charged too many points or interest, right?

It’s not that simple.

If the borrower on the note that you’ve bought can claim that the note you bought has either (a) been lost OR (b) that you don’t have the rights of a holder in due course, then the borrower may get out of their obligation to pay you.

See Article 3, Part of the Uniform Commercial Code – section 305 – quick link here: http://www.law.cornell.edu/ucc/3/3-305.html#content#content.

Let me take these two points one at a time.

(a) Lost Note. This does NOT mean that if you’re missing the original note, that you can NEVER collect on your note, it just means that you need to be EXTRA CAREFUL when you’re dealing with a lost note situation.

(b) Holder in due course. In order to become a holder in due course on a note, you need to have the note endorsed over to you. What document does that for you? The Note Allonge. What risk do you run if the note isn’t endorsed over to you? A litigation-happy borrower might force you to spend some bucks on an attorney if you don’t have a note properly endorsed. I give you a Note Allonge template in the Note Buying Document Toolkit (which btw is also a FREE Bonus in the ‘A-Z Profiting from Discounted Mortgages Business-in-a-Box‘ Course) – so USE IT.

Remember – most note sellers will want to add the language “without recourse” on an Allonge – it’s in your interest not to have that language in there.

Why?

Because a seller of a note is automatically liable for the debt (for most, though not all notes), if the borrower defaults on their payments.

This is a little-known fact that can be used to your advantage if a borrower defaults on their loan. But if the seller adds the words “without recourse” to their endorsement or Allonge, then you’ll have no recourse to them.

In most cases, the seller (the larger banks at least), will all include “without recourse” or “without warranty” language in all endorsements.

Nothing ventured, nothing gained.

Dean