Chink in the Armor: A Foreclosure Defense

The securitization of home loans may provide a new way to contest foreclosures.  An Alabama court recently ruled that a trustee of a pool of home mortgages had no standing to bring a foreclosure action on one of the home mortgages allegedly in the pool despite having possession of the original Promissory Note because the transfer of the Note did not follow the express terms of the Pooling and Service Agreement governing the pooled mortgages.[1] 


Securitization[2] of home loans is the pooling and selling of the cash flow from thousands of mortgages. Mortgages are pooled into an entity, often referred to as a special purpose vehicle, in order to separate them from the banks who originally lent the money.  Real Estate Mortgage Investment Conduits (REMICs) are a type of special purpose vehicle used for the pooling ofmortgage loans.[3]    I use REMIC in this post to identify these special purpose vehicles or trusts because the name reflects their real function as conduits.

REMIC purchases the home loans by selling interests in the REMIC in the form of a security which may be called a bond, a pass-through security or collateralized mortgage obligation (CMO).  Investors[4] in a REMIC buy these securities in order to receive a fairly secure and steady stream of cash from the home owners making their mortgage payments.  Consequently, the mortgages, themselves become the collateral for these securities.  How the money from the collateral is distributed depends on the quality of the underlying collateral and is subject to rules too complicated for this post. Suffice it to say, that the home loans are rated by their risk of non-payment and based on their rating, a price is set for different classes, or tranches, of home loans.  An investor pays more for a higher rated class of home loans and less for a lower rated class of home loans.   

Banks  usually structure asset-backed securities using trusts.[5]  In choosing a trust structure, banks seek to ensure that the transaction insulates the assets from the reach of the issuer’s creditors or are “bankruptcy remote” and that the issuer, securitization vehicle, and investors receive “flow-through” treatment that minimizes the tax consequences.[6]  Simply, the trust is the legal owner of the pool of mortgages. 

The trustee is a third party retained for a fee to administer the trust that holds the underlying assets supporting an asset-backed security.  The trustee is primarily concerned with preserving the rights of the investor.  Generally, the trustee oversees the disbursement of cash flows as prescribed by the indenture or pooling and servicing agreement, and monitors compliance with appropriate covenants by other parties to the agreement.  The trustee also is responsible for declaring an event of default.[7]   

The structure of a transaction is governed by the terms of the pooling and servicing agreement. The pooling and servicing agreement is the primary contractual document between all parties involving the transfer of specific home loans from the originator, servicer and ultimately to the specific trust. The pooling and servicing agreement documents the responsibilities of the trustee.[8]    


Now that you understand how your home loan became collateral in a security sold to the auto workers pension fund, we can dive into how the Alabama court in Horace vs. LaSalle Bank, decided that LaSalle Bank, the trustee of the security allegedly holding Ms Horace’s home loan, could, not now or ever, foreclose on Ms Horace’s home.   Judge Albert L. Johnson made two conclusions in his order: 

“First, the Court is surprised to the point of astonishment that defendant trust (LaSalle Bank National Association) did not comply with the terms of the its own Pooling and Servicing Agreement and further did not comply with New York Law in attempting to obtain assignment of Plaintiff Horace’s note and mortgage. 

Second, plaintiff Horace is a third party beneficiary of the Pooling and Servicing Agreement created by the defendant trust (LaSalle Bank National Association).  Indeed without such Pooling and Servicing Agreements, plaintiff Horace and other mortgagors similarly situated would never have been able to obtain financing.” 

In drawing his conclusion, Judge Johnson accepted Plaintiff’s argument that: 

 “According to the terms of the PSA, all promissory notes transferred to the Trust are required to have a complete chain of endorsements from the original payee thereof to either “Blank” or to the Trustee for the specific Trust.” [9]

The Pooling and Service Agreement stated the following regarding an “unbroken chain of endorsements”: 

“In connection with such sale, the Depositor has delivered to, and deposited with, the Trustee or the Custodian, as its agent, the following documents or instruments with respect to each Mortgage Loan so assigned: (i) the original Mortgage Note, including any riders thereto, endorsed without recourse (A) in blank or to the order of “LaSalle Bank National Association, as Trustee for Certificate holders of Bear Stearns Asset Backed Securities I LLC, Asset-Backed Certificates, Series 2006-EC2,”or (B) in the case of a loan registered on the MERS system, in blank, and in each case showing an unbroken chain of endorsements from the original payee thereof to the Person endorsing it to the Trustee (Emphasis added.) 

And Judge Johnson rejected LaSalle Bank’s  Commercial Code, Article 3, “Negotiable Instruments”[10] argument that: 

“It is black letter law that the holder of a negotiable instrument is entitled to enforce the terms of the instrument (cite omitted).  It is clear that the Note is a negotiable instrument as defined under Alabama law….. Additionally, the Note is endorsed in blank without recourse and is therefore payable to bearer. (Cite omitted).  Therefore, any person in possession of the Note is entitled to enforce its provisions.”[11] 

In declining to follow Alabama law on “negotiable instruments” in favor of New York Trust law as it applies to this particular mortgage backed securities, Judge Johnson understandably found the following argument in the “Memorandum of Law in Support of Plaintiff’s Motion for Summary Judgment and In Response t Defendants’ Motion for Summary Judgment”[12]  (Memo) persuasive.  

1.  The trustee is not an ordinary trustee.  The trustee is a corporate trustee who must adhere to the Pooling and Servicing Agreement. (Page 12, Memo) 

“[t]he corporate trustee has very little in common with the ordinary trustee . . . . The trustee under a corporate indenture . . . has his [or her] rights and duties defined, not by the fiduciary relationship, but exclusively by the terms of the agreement. His [or her] status is more that of a stakeholder than one of a trustee.” (Cite omitted). 

2.  A Trust acquires ownership and control over an asset only when there has been an   effective delivery.  An effective transfer has the name of the trust on the Note as the intended holder. (Page 11, Memo) 

“In the context of mortgage-backed securitization, it is clear that registration of the notes and mortgages in the name of the trustee for the trust is necessary for effective transfer to the trust. Within the Statutes of New York governing Trusts, Estates Powers and Trusts Law (EPTL) section 7-2.1(c) authorizes investment trusts to acquire real or personal property “in the name of the trust as such name is designated in the instrument creating said trust.” (Emphasis added) 

3.  Without the registration of the asset with a specific trust, how does anyone know who is to receive the cash flow from the asset. (Page 13, Memo) 

“Trust property cannot be, as the Defendant argues, held with incomplete endorsements and assignments that do not indicate that the property is held in trust by a trustee for a specific beneficiary trust. In fact, it is clear in the law of New York that an attempt to transfer to a trust which fails to specify both a trustee and a beneficiary is ineffective as a conveyance to the Trust. “The failure to name a beneficiary for the Trustee renders the assignment without merit.”(Cite Omitted) 

4.   New York law expressly requires that for property to be validly delivered to a trust, the property must pass completely out of the control of the donor (and its agents). (Page 13, Memo) 

“It is the consummation of the donor’s intent to give that completes the transaction.  Intention alone, no matter how fully established, is of no avail without the consummated act of delivery. How could one logically argue that delivering a promissory note endorsed in blank (making it bearer paper) into a trustee’s vault is “delivery beyond the authority and control of the donor” when the vault is managed by the agent of the donor? If the donor were to claim that the promissory note were its property, not the trustee’s, there would be no evidentiary basis for the trustee to claim ownership.” (Cite Omitted) 

5.  Trustees are usually large banks who have responsibilities for multiple trusts and therefore it is difficult to know what asset goes into what security without a specific delivery or registration with a specific trust. (Page 14, Memo)

“Trustees for securitizations often occupy many roles simultaneously and conflictingly both as document custodians and trustees for myriad thousands of securitizations as well as for various parties who are active in the securitization process including originators, servicers, sponsors and depositors. Accordingly, it is inconceivable that anything other than registration into “the name of the trust as such name is designated in the instrument creating said trust property” could ever qualify as delivery to any particular securitization trust. Absent such registration, there would be nothing that would indicate which of thousands of trusts in the care of a trustee a particular promissory note might belong to or if it were the personal property of the trustee itself. Absent such registration, a promissory note would simply be bearer paper, and thus the property of anyone who obtained possession of it.” 

6.  The Pooling and Servicing Agreement which set up the trust cannot be altered. (Page 11, Memo) 

“Because the method of transfer is set forth in the Trust instrument, it is not subject to any variance or exception. (Cite omitted) The Trust documents require that the promissory notes and mortgages be transferred to the Trustee, which under New York trust law requires valid delivery.” 

7.  The whole securitization process depends on a complete, fully documented transfer of the home loan mortgages from the bank to the trust in order to comply with the legal objective of being “bankruptcy remote”. (Page 8, Memo) 

“First, all notes sold to the Trust were required to have an unbroken chain of endorsements from the original payee to the person endorsing it to the Trustee.  This requirement stems from the particular business concern in securitization, namely to evidence that there was in fact a “true sale” of the securitized assets and that they are in no way still property of the originator, sponsor, or depositor, and thus not subject to the claims of creditors of the originator, sponsor or depositor.” [13]


Possession of the Note is not enough to give a trustee standing to foreclose according to this case thereby undermining industry arguments relying on the commercial code’s “negotiable instruments” provisions.  Instead, a complete chain of title may be necessary to prove the one foreclosing has standing.     The ramifications for the banking industry would be substantial if this argument gains traction.  The effect may be larger as expressed by Nick Wooten, the Plaintiff’s attorney:  ”My only wish after being in this fight for the three and a half years is that we will get an honest evaluation of what is really wrong, so we can as a country get back on our feet.  If we don’t get control of servicing, they will drive us into a depression that will take 20 years to get out of.”  Housing Wire, Alabama judge denies securtization trustee standing to foreclose, Kerri Panchuk, April 1, 2011.  

As for Judge Johnson’s second conclusion of law – whether a home owner is a third party beneficiary of a Pooling and Service Agreement governing the security holding the home owner’s loan – is subject to conflicting decisions in Alabama.    There are two other Alabama cases that say that a home owner is not a third party beneficiary. They are U.S. v Congress and Wells Fargo Bank v Edward J. Thomas.   This subject will have to wait for another post.  

James Knowlton is a lawyer in Basalt, Colorado.

[1] Horace vs. LaSalle Bank National Association, et al., CV-2008-000362.00, (3/30/11) Circuit Court of Russell County Alabama. 

[2] Asset Securitization: Comptroller’s Handbook, Office of the Comptroller of the Currency, November1997, .  Last viewed 04/6/2011.

[3] Also know as a Collateralized Mortgage Obligation or CMO.

[4] The largest purchasers of securitized assets are typically pension funds, insurance companies, fund managers, and, to a lesser degree, commercial banks. The most compelling reason for investing in asset-backed securities has been their high rate of return relative to other assets of comparable credit risk.  Asset Securitization: Comptroller’s Handbook, Office of the Comptroller of the Currency, November1997,   

[5] The securitization process redistributes risk by breaking up the traditional role of a bank into a number of specialized roles: originator, servicer, credit enhancer, underwriter, trustee, and investor. Banks may be involved in several of the roles and often specialize in a particular role or roles to take advantage of expertise or economies of scale. The types and levels of risk to which a particular bank is exposed will depend on the organization’s role in the securitization process. Id.

[6]  Id.

[7] Id.

[8] Id.

[9]  “Plaintiff Phyllis Horace’s Motion for Summary Judgement pursuant to Rule 56 of the Alabama Rules of Civil Procedure and Response to Defendant’s Motions for Summary Judgment”, Page 20.  

[10] See my previous post on “MERS and the Evolution of Foreclosure” for an explanation of UCC Article 3, “Negotiable Instruments”.

[11]  Horace vs. LaSalle Bank, Defendants’ Motion for Summary Judgment, page 10.

[12] Horace vs. LaSalle Bank,  Memorandum of Law in Support of Plaintiff’s Motion for Summary Judgment and In Response to Defendants’ Motion for Summary Judgment”.  

[13]  Id.

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