Last week I blogged on the continuing problem U.S. lenders are facing when trying to foreclose on delinquent mortgages. This week I want to finish out that thread by analyzing a federal court decision which was just handed down, that illustrates the complexity of the “new normal” property law, and that points out some important real world lessons relevant to anyone involved in domestic home sale programs.
The case is Merrill Lynch Credit Corp v. Karin Lenz et al.; a decision on a Summary Judgment Motion, which means that it did not even have to go to trial, the issues were so clear to the judge. Because it is a U.S. District Court case from Florida some of the fine points are based on Florida law, but the general holding should be of almost universal applicability in the United States.
What is interesting in this case is not that the judge ultimately ruled that the lender could not prove that it really owned the note, and therefore that it had the right to sue in foreclosure, though this in fact was one of the holdings. Rather, it is interesting because it illustrates the interplay between multiple lien holders in foreclosure, an issue which used to be easily determined. But not necessarily so in the modern world, as this case proves.
The case arose in 2009 when Merrill Lynch foreclosed on a $3M Florida property first purchased in 1987. The original note and mortgage were transferred (and modified) through several banks, mortgage companies, and investors, with the documentation apparently done properly most of the time; one of the documented holders of the note as early as 1994 was the plaintiff, Merrill Lynch, which then transferred it to a REMIC (Real Estate Mortgage Investment Conduit). These entities are the trusts which hold mortgages and issue shares or bonds—the infamous MBS (mortgage backed securities) or CMO (collateralized mortgage obligations). Merrill’s problem first arose when the REMIC was dissolved in 2004, at which time it repurchased the note; no transfer document was recorded at this point, and the evidence of Merrill’s ownership at trial was limited to just its physical possession of the original note itself. All of this was a common occurrence during that period, and as far as Merrill knew, it still owned the note and the mortgage. Then in 2009 the borrower defaulted and Merrill filed for foreclosure, just as it was doing in thousands of cases nationwide.
The distinguishing part of this case arose in 2005 when the IRS filed a tax lien against the borrower (for about $3M). Because of this lien, the IRS intervened in the foreclosure suit to recover its money out of the proceeds from the sale of the property; that, of course would leave nothing left for Merrill., because of the law of lien priority which, prior to the current foreclosure mess, was pretty much cut and dried.
The legal dogma of lien priority is relatively simple, the general rule being: “priority in time is priority in right”, this means that the lien which is recorded first has priority over those that follow it. This applies to all nongovernment liens. Government liens are only slightly more complicated. Federal tax liens are the most common federal lien; they follow the general rule as to priority, but have special rules regarding foreclosure sales. Unless the District Director of the IRS is given advance notice, the lien is not extinguished by the sale, and thus survives the sale; but if proper notice is given, the lien is extinguished just like private liens.
Thus, in an ordinary foreclosure, Merrill would have prevailed because it believed it possessed a superior lien (it had given the IRS the required notice); after all, it had purchased the note and had evidence of that. But this was not an ordinary foreclosure because there was no direct proof of the transfer of the note and deed of trust back to Merrill after the dissolution of the REMIC in 2004, There was no recording in the clerk’s office, there was no written transfer on the note itself, nor was there any other clear written public evidence of that transfer that other lien holders could have found to prove that Merrill in fact owned the property again.
Because of this fact, the IRS’ 2005 lien was considered superior, and the government won. This was the law, the court ruled, even after Merrill found the actual note and produced a copy at the very last minute. The court came to this conclusion in part because of the Kafkaesque nature of Merrill’s trial of the case (which I have not described in detail in order to save several hundred words), which included claiming there was no note, that it didn’t own the note, that someone else had the note, and finally that it did, indeed .have the note – without an endorsement, however. This was not bad faith or incompetence on the part of the bank; rather it is an example of the monumental problems caused by courts’ demands for proof, something which has been a facet of real property transfers since the country began.
So in the end, it was the fact that Merrill could not sufficiently prove its ownership that lost the motion. This was not an issue raised by the MERS system, as discussed in last week’s blog. It was simply a result of the flurry of paperwork which arose during the heyday of the mortgage bubble. But it does have some very practical lessons.
Lien priorities may not always be what they seem, and this applies to short sales, foreclosure sale/purchases, and should be pointed out in predecision counseling. The IRS, or indeed other secondary lien holder, is now more likely to challenge foreclosures and short sales, especially where there is a large interest at stake. By throwing the foreclosure into something other than a slam dunk through a challenge to the documentation, secondary lien holders now have garnered an important tactical advantage which they did not have in the past. This is an effect which needs to be considered in making risk assessments of any distressed property sale or purchase.