Creditors May Lose Secured Status Due to Note Problems

American Bar Association, Bankruptcy & Insolvency Litigation Section Newsletter

In Rogan v. Litton Loan Servicing, L.P. (In re Collins), 456 B.R. 284, 2011 WL 4445451 (6th Cir. BAP Aug. 12, 2011), the Sixth Circuit Bankruptcy Appellate Panel ruled that validly perfected mortgages may be invalidated by a bankruptcy trustee if the mortgagee fails to produce a properly indorsed note. The ruling addressed two different mortgages on the debtor’s residence. Both mortgages were validly perfected, but the notes secured by the mortgages were problematic. The court reversed a Rule 12(b)(6) dismissal of the trustee’s complaint.

The bankruptcy trustee conceded that both mortgages were validly perfected. The trustee argued that the mortgagees did not demonstrate that they were the holders of the notes and therefore were not creditors of the debtor. Kentucky state law provides that a mortgage without an underlying debt is ineffective.

The first mortgagee’s note had a chain of title issue. The debtor gave the note to Wilmington Finance, which assigned the note to Popular Financial Services, LLC. The note was then assigned from Popular ABS, Inc. to J.P. Morgan Chase, which eventually assigned the note postpetition to Defendant Bank of New York. The first mortgagee asserted that because the mortgage was concededly valid, any issue relating to the note was irrelevant.

The note underlying the second mortgage was never produced to the court. The second mortgagee did not file the note with a proof of claim or motion for relief from stay. Given the Rule 12(b)(6) context of the ruling, the mortgagee asserted that it was not required to produce a copy of the note because the validity of the note was not relevant to the validity of the second mortgage. The court disagreed.

The court reversed the Rule 12(b)(6) dismissal, holding that the mortgages would be invalid if the trustee could prove that the notes were not properly assigned. Upon remand, the first mortgagee has a chance to repair the issue by obtaining an assignment from Popular Financial Services, LLC to Popular ABS, Inc. The second mortgagee must produce a copy of the note or attempt to locate substitute evidence in order to defend its interest upon remand.

The court’s ruling gives bankruptcy trustees another weapon in the mortgage avoidance battles. This tactic is particularly aggressive because it renders the mortgagee not a creditor of the estate, meaning that the mortgagees cannot participate in the distribution as they do in cases where the mortgage is avoided but the debt is preserved.

The hasty practices during the housing boom gave rise to chain of title issues and, in some cases, lost notes. Secured creditors are sometimes hard pressed to produce the note with all necessary assignments. The problem is compounded in situations where the note and mortgages were transferred multiple times. If the bankruptcy trustee notes a problem with the note’s chain of title, the creditor may be able to cure the issues postpetition by obtaining revised assignments assuming that the relevant entities are still operating and can execute revised assignments. If the creditor cannot produce a copy of the note, then the debt itself may be invalidated and the mortgagee left without a remedy.