Enforcing a Lost Note

By Maura O'Connor

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Life used to be simple.  When a bank or insurance company made a real estate loan in California, its borrower signed a note and a deed of trust, our form of mortgage. (Usually, they used blue ink to sign, so you could tell the original signature from copies.)  The deed of trust was recorded.  The lender held the original note in its vault until the loan was repaid.  Then the lender marked the original note "PAID", and delivered it back to the borrower.  End of loan.

If the borrower didn't repay the loan, the lender showed the original note to the deed of trust's trustee, to prove it still was owed money, and the trustee sold the property at a nonjudicial foreclosure sale. (Occasionally lenders foreclosed judicially, but not very often.)   Sometimes, the lender sold a loan, by delivering the original note to the new lender.  The new lender then recorded an assignment of the deed of trust. 

But times changed.  Banks and insurance companies making loans the old-fashioned way were joined by all sorts of new-fangled investors, conduit lenders and others jumping into the business.  These new players originated loans with a lot of Wall Street money, and usually sold them immediately after origination.  Banks and insurance companies starting selling their loans, instead of holding them, as well.    

Pretty soon loans were being traded over and over again, like baseball cards.  Unfortunately, the trades went so fast that the paperwork often was not carefully handled – which gets us to where we are today.  What happens if the original note gets lost?

Lost notes can be a real problem for the lender, if the borrower stops paying, because many trustees require the lender to provide them with the original note prior to beginning nonjudicial foreclosure.  Most courts require the same showing for judicial foreclosures.  How can the lender foreclose if it cannot produce the original note?

There are two established ways to handle this.  (Both assume the borrower has not already repaid the note and the successor lender seeking to foreclose really has the rights to do so.  These two issues need to be settled first, before moving forward.)

The harder way is for the lender to “bond over" the lost note.  California law allows a lender who has lost a note to put up a lost instrument indemnity bond, to back its claim that it has lost the note but is still the owner of the note, and is still entitled to receive payment.  However, the bond is expensive.

The easier way is to persuade the trustee to waive its usual requirement that the lender provide it with the original note.  How can a lender get a trustee to relax its rule?  Beg.  You see, the trustee's rule that a lender provide the original note usually is not a rule imposed not by law:  it's a precaution by trustees, protecting themselves from liability for wrongful foreclosures.  Sometimes they will waive that rule -- if the lender is creditworthy and will indemnify the trustee from any liability arising from the note's loss.  The major risk here is that someone else shows up with the original note and tries to enforce it (which is expensive to defend) and may even win (even more expensive).  Obviously, providing such an indemnity costs the lender nothing, and so is usually preferable – if the risk is low.  But lenders typically hate taking risks by giving indemnities, and may find the extent of the risk hard to figure out.  As a practical matter, whether the risk is high or low frequently depends on whether or not the lost note is a “negotiable instrument”.

Why?  A lost note is more likely to cause trouble if it's a "negotiable instrument" than if it is not.  A negotiable instrument can be enforced by anyone who happens to have it in his or her possession with the right signatures on it.  A note that is NOT a negotiable instrument cannot so easily be enforced separately from the deed of trust,:  so if the deed of trust was properly assigned, and that assignment was recorded, then there's little practical risk that someone holding the lost note can make a claim under it -- provided that the note's not negotiable.

So what’s a negotiable instrument?  Basically, a negotiable instrument is an unconditional promise, in writing, to pay a sum of money at a future date or upon demand to a named payee, or to the bearer (or holder) of the instrument, and to order.  There are many types of negotiable instruments:  a check is one we’re probably most familiar with.  If I make out a check to Jane Doe, and she endorses it to John James, John can deposit the check and get the money I owe out of my checking account. 

Promissory notes are written promises to pay, so they all are “instruments”, but any promissory note may or may not be structured to be “negotiable” – in other words, freely tradeable and enforceable by anyone who has it in his or her possession.

How can you tell if a lost note is a negotiable instrument?  It’s best to check with your lawyer;  the criteria are spelled out in the Uniform Commercial Code. 

Most promissory notes made as part of a real estate loan are not negotiable, usually because they contain too many other promises by the maker.  For example, if a promissory note incorporates by reference all the provisions of the loan agreement, it will generally be deemed non-negotiable.  Also, if a promissory note states that it is payable only out of a certain source or fund, it may be deemed non-negotiable. 

There are other ways that a promissory note can be made negotiable, including through an effective savings clause, so it may be advisable to talk to a lawyer expert in this field to find out, if you are trying to enforce a lost note. 

Lenders designing their loan forms in the first place might want to think twice about using negotiable notes, given the extra risks and issues that arise if they're ever lost. 

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