Revised UCC Article 9: Impact on “Wet Funding” Mortgage Loan Transactions

Stuart Goldstein and Lech Kalembka

Revised Article 9 of the Uniform Commercial Code applies to security interests in mortgage notes and includes provisions that significantly affect the perfection of security interests in wet funding transactions.

s most readers are probably aware, the Uniform Commercial Code (“UCC”) is a comprehensive body of state commercial law, Article 9 of which governs the creation, perfection and enforcement of security interests in most forms of personal property. A substantially revised version of Article 9 of the UCC (the “Revised UCC”)1 has been adopted in all 50 states and, as of October 2001, is in effect in 47 states2 and the District of Columbia.


to the creation or transfer of interests in real estate,3 Article 9 is not rendered inapplicable to a security interest in a secured obligation merely because such obligation is itself secured by property excluded from Article 9.4 Accordingly, Article 9 applies to security interests in mortgage notes (“Mortgage Notes”), even though it excludes the creation and transfer of interests in mortgages.5 In a typical “wet funding” transaction, the lender (the “Lender”) either: (1)lends money to an originator or purchaser of mortgage loans (either is referred to as an “Originator”) in return for a pledge of a portfolio of residential mortgage loans, or

(2)enters into a “reverse repurchase” transaction (a “Repo”) under which the Lender “purchases” mortgage loans (including the related Mortgage Notes) from an Originator with a concomitant obligation to “sell” such assets to the Originator in the future. The Revised UCC includes provisions which significantly affect the perfection of security interests in wet funding transactions. Before discussing the new rules, this article briefly outlines the previously applicable provisions.

Wet Funding UCC Issues
Although Article 9 does not apply
Mr. Goldstein is a partner resident in the Charlotte office of Cadwalader, Wickersham & Taft. Mr. Kalembka is special counsel resident in the firm’s New York office. The authors gratefully acknowledge the contributions of Charlie Bryan and Joshua Yablonski to the preparation of this article.

Prior UCC
Under the prior version of the UCC (the “Prior UCC”), a security interest in Mortgage Notes and other “instruments”6 was perfected either:



1. through direct possession by the Lender,7 or 2. through possession by a “bailee” with notification of the security interest of the Lender.8 In the case of Mortgage Notes held by a bailee, perfection would, however, be jeopardized if the bailee was controlled by, or even closely affiliated with, the Originator.9 Wet funding practices and servicing needs may make strict compliance with these rules impossible, however. Accordingly, the Prior UCC included rules that accommodate the practical impossibility of the Lender’s obtaining immediate possession of the Mortgage Notes at closing and the necessity for the Lender or its bailee to relinquish possession at times to the Originator to permit servicing and enforcement. In particular, under the Prior UCC, a security interest in Mortgage Notes was automatically perfected for 21 days from the time it attached without possession by the Lender or a bailee if the security interest was given for “new value” under a written security agreement.10 In addition, a perfected security interest remained perfected for 21 days if the Lender transferred possession to the Originator “for the purpose of ultimate sale or exchange or [for] presentation, collection … [or] renewal ….”11

The Revised UCC also provides for temporary perfection to accommodate wet funding and servicing necessities, but shortens the period during which the security interest remains automatically perfected from 21 days to 20 days.15

Perfection by Filing
In an important development, the Revised UCC permits the perfection of security interests in Mortgage Notes and other instruments by filing a UCC Financing Statement.16 This should facilitate the servicing of Mortgage Notes by permitting the Originator or servicer to retain possession for more than 20 days,17 and will also afford protection in the event that the Mortgage Notes are lost. Lenders must be aware, though, that exclusive reliance upon filing will entail risks. In particular, the security interest of a secured party that perfects solely by filing will be subordinate to the security interest of a third party that gives value and takes possession “in good faith and without knowledge that the purchase18 violates the rights of the secured party.”19 This priority rule subjects the Lender to the risk that, through fraud or negligence, an Originator or servicer in possession of Mortgage Notes will transfer possession to a third party that meets the quoted criteria.20 As a result, a Lender relying solely on filing should consider taking steps to notify prospective lenders that acquiring a security interest in the Mortgage Notes would violate the Lender’s rights. Such steps would include incorporating language in an attachment to the Financing Statement and, if possible, on the Mortgage Notes themselves to the effect that any acquisition by a third party of a security interest in the Mortgage Notes “violates the rights” of the Lender.

Revised UCC
The Revised UCC similarly provides for perfection of a security interest in Mortgage Notes and other instruments through actual and constructive possession. The rules regarding perfection through possession by a bailee have changed significantly, however. Specifically, where the Mortgage Notes are held by a third person, that person must “authenticate a record”12 in which it “acknowledg[es] that it holds possession of the collateral for the secured party’s benefit.”13 In contrast to the Prior UCC, simple notification to a bailee in possession, with the exception discussed below, will be inadequate to perfect the security interest of the Lender in Mortgage Notes. Fortunately, the drafters of the Revised UCC realized that this rule would, if applied indiscriminately, disrupt “take-out” practices in the secondary market. Therefore, a secured party in possession of Mortgage Notes that wishes to transfer possession to a prospective purchaser need only instruct the purchaser “to hold possession of the collateral for the secured party’s benefit” to maintain perfection and, therefore, need not obtain any acknowledgement from it.14

Miscellaneous Changes
Several additional changes deserve mention. First, the Revised UCC provides that the sale of a “promissory note”21 is automatically perfected,22 without the need for filing or possession. Literally, this rule provides the Lender with automatic perfection in Mortgage Notes in, for instance, a Repo transaction. Given the uncertain characterization of a Repo as a “true sale” or disguised financing,23 however, Lenders should continue taking the steps necessary to perfect their security interests to mitigate the consequences of a judicial recharacterization. Second, the Revised UCC codifies the “mortgage-follows-the-note” doctrine24 under which the perfection of a security interest in a Mortgage Note

Revised UCC Article 9: Impact on “Wet Funding” Mortgage Loan Transactions

automatically perfects a security interest in the related mortgage.

which is “stored in an electronic medium,” adopting a symbol or using an encryption process with the “present intent … to … adopt or accept a record.” Revised UCC § 9-102(a)(7), (69). 13. Revised UCC § 9-313(c)(1). According to the Official Comment to this provision, such an acknowledgement is unnecessary if the third party in possession is an “agent” of the secured party, which is not also an agent of the debtor. Revised UCC Off. Cmt. 3, § 9-313. Nevertheless, given the possible difficulty of determining agency status, and the potentially disastrous consequences of an erroneous determination, a prudent Lender will obtain an acknowledgement along the lines of the quoted text whenever it does not itself hold the Mortgage Notes. 14. Revised UCC § 9-313(h); see also Revised UCC Off. Cmt. 9, § 9-313. 15. Revised UCC § 9-312(e), (g). Such a filing must be made in the jurisdiction in which the debtor is “located.” Revised UCC §§ 9-301(1), 9-501(a)(2). A debtors location, in turn, is determined pursuant to the rules specified in Revised UCC § 9-307. 16. Revised UCC § 9-312(a). 17. Revised UCC Off. Cmt. 2, § 9-312. 18. We note that “purchase” includes acquiring an interest in property through a pledge or lien. UCC § 1-201(32). 19. Revised UCC § 9-330(d). 20. It is important to note that the Revised UCC does not impose any obligation upon prospective lenders to inspect the UCC records. Moreover, mere notice that the Lender has a security interest in the Mortgage Notes is insufficient to disqualify the prospective lender from taking advantage of the priority rule described in the text. Nonetheless, if such a lender did inspect the UCC records, then language indicating that any security interest in the Mortgage Notes it obtains “violates the rights” of the Lender would be sufficient to preserve the priority of the security interest of the Lender. See Off. Cmt. 7, § 9-330. 21. Revised UCC § 9-102(a)(65). 22. Revised UCC § 9-309(4). 23. See Revised UCC Off. Cmt. 4, § 9-109. 24. Revised UCC § 9-308(e). The secured party will not, however, become the mortgagee of record under this provision. Instead, its rights regarding the mortgage will be senior to a subsequent lien creditor of the mortgagee, including a bankruptcy trustee. Revised UCC Off. Cmt. 6, § 9-308.

The Revised UCC permits greater flexibility in the wet funding market, in particular by providing for perfection of security interests in Mortgage Notes through UCC filings. Although this innovation carries with it some risk for Lenders, it will surely increase efficiency, and therefore reduce transaction costs, in this important market. s

1. Revised Article 9. Secured Transactions (With Conforming Amendments to Articles 1, 2, 2A, 4, 5, 6, 7, and 8). 2. The version of the Revised UCC enacted in Alabama, Florida and Mississippi has an effective date of January 1, 2002. 3. Prior UCC § 9-104(j); see also Revised UCC § 9109(d)(11). 4. Prior UCC § 9-102(3); see also Revised UCC § 9-109(b). 5. Id. 6. “Instrument” was defined in prior UCC § 9-105(1)(i) as “a negotiable instrument … or any other writing which evidences a right to the payment of money … and is of a type which is in ordinary course of business transferred by delivery with any necessary endorsement or assignment.” A substantially identical definition is included in Revised UCC § 9102(a)(47). In most cases, Mortgage Notes will be “instruments.” 7. Prior UCC §§ 9-304, 9-305. 8. Prior UCC § 9-305. 9. Prior UCC Off. Cmt. 2, § 9-305. Although the topic is beyond the scope of this article, we note that perfection may be achieved under Article 8 of the UCC in certain cases even where the bailee is affiliated with the Originator. 10. Prior UCC § 9-304(4). 11. Prior UCC § 9-305(5)(b). 12. Authentication of a record includes manually executing a traditional paper record and, with respect to information



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