The MERS Mess

This Kansas Supreme Court decision is the latest to expose the flaw affecting lenders’ ability to foreclose “securitized” mortgages:

In a unanimous opinion, the Kansas Supreme Court has ruled that, under the facts presented, a second mortgage holder who was not given notice of a foreclosure performed by the first mortgage holder on the same property could not set aside the judgment of foreclosure obtained by the first mortgage holder, due to the complex legal relationship among the holder of the second mortgage, the holder of the underlying promissory note, and an intermediary company.¹

While not binding in any state other than Kansas, this decision is the latest indication that a flaw exists in the way millions of “securitized” mortgages were structured, a flaw that gives millions of borrowers a legal argument that may allow them to avoid foreclosure of their mortgages.

Kesler was the borrower on two loans secured by the same parcel of real property located in Kansas. The lender on the first loan was Landmark National Bank. The original lender of the second loan was Millenia Mortgage Company (Millenia). The mortgage documents for the second loan named Kesler as the Borrower and the Mortgagor, and named Millenia as the lender, but also named Mortgage Electronic Registration Systems (MERS) as the mortgagee, as “nominee” for the lender. This means that while Millenia was the original holder of the promissory note for the loan, MERS was intended to be the original holder of the mortgage by which the loan was secured.

MERS is a private corporation that administers the MERS System, a national electronic registry that tracks the transfer of ownership interests and servicing rights in mortgage loans. Through the MERS System, MERS becomes the mortgagee of record for participating members through assignment of the members’ interests to MERS. MERS is listed as the mortgagee (as nominee for the lender) in the official records maintained at county register of deeds offices. The lenders retain the promissory notes, as well as the servicing rights to the mortgages. The lenders can then sell these interests to investors without having to record the transaction in the public record. MERS is compensated for its services through fees charged to participating MERS members.²

If the borrower were to default on the loan, MERS would bring a foreclosure action in its own name. By taking over the role of mortgagee MERS is in position to administer the loans and to conduct any necessary foreclosure proceedings. By providing this service, MERS made it easier for lenders to sell their loans, and for these loans to be bundled together as mortgage-backed securities to be offered for sale to investors, who did not wish to have to be involved in the administration of the loan or in foreclosure process. In this way MERS became the mortgagee on millions of mortgages taken out by Americans over the part decade.

In this case it appears that Millenia sold its interest in the second loan to Sovereign Bank. Later, Kesler became insolvent and filed for bankruptcy. Landmark filed a foreclosure proceeding under Kansas law. Kesler and Millenia were given notice of the foreclosure action, but MERS and Sovereign Bank were not given notice. (No record of the transfer of the underlying promissory note from Millenia to Sovereign had ever been recorded in Kansas.) The property was then sold at auction as a result of this foreclosure. The auction sale produced cash proceeds in excess of the amount required to pay off the loan, and Kesler and Landmark filed a motion in the foreclosure proceeding to determine how the excess proceeds should be divided.

At this point Sovereign and MERS attempted to intervene in Landmark’s foreclosure proceeding and to overturn the judgment for foreclosure on the grounds that they, as junior lienholders, had not received notice of Landmark’s foreclosure. The trial court denied MERS’ and Sovereign’s motion and refused to allow either of them to participate in the foreclosure action; they appealed to the Kansas Court of Appeals which upheld the decision of the trial court.

The Kansas Supreme Court rejected Sovereign’s and MERS’ appeal. Sovereign was not entitled to notice of Landmark’s foreclosure because no document had ever been recorded, or any other notice given to Landmark or to the public that Sovereign was the owner of the second loan.

As to MERS, the court found that the trial court was correct in not setting aside the Landmark foreclosure sale and allowing MERS to participate because, the court said, even if MERS participated in the foreclosure action, it would not have had a meritorious defense to it. The court found that MERS’ true role in the loan transaction did not give it standing to participate as a party to a foreclosure action as a mortgagee, or in any other way. The court said:

“The mortgage instrument states that MERS functions “solely as nominee” for the lender and lender’s successors and assigns. The word “nominee” is defined nowhere in the mortgage document, and the functional relationship between MERS and the lender is likewise not defined. In the absence of a contractual definition, the parties leave the definition to judicial interpretation.

“What meaning is this court to attach to MERS’s designation as nominee for Millennia? The parties appear to have defined the word in much the same way that the blind men of Indian legend described an elephant–their description depended on which part they were touching at any given time. Counsel for Sovereign stated to the trial court that MERS holds the mortgage “in street name, if you will, and our client the bank and other banks transfer these mortgages and rely on MERS to provide them with notice of foreclosures and what not.” He later stated that the nominee “is the mortgagee and is holding that mortgage for somebody else.” At another time he declared on the record that the nominee is more like a trustee or more like a corporation, a trustee that has multiple beneficiaries. …”

The court then found that “[t]he relationship that MERS has to Sovereign is more akin to that of a straw man than to a party possessing all the rights given a buyer.” Further, the court said:

“What stake in the outcome of an independent action for foreclosure could MERS have? It did not lend the money to Kesler or to anyone else involved in this case. Neither Kesler nor anyone else involved in the case was required by statute or contract to pay money to MERS on the mortgage. … If MERS is only the mortgagee, without ownership of the mortgage instrument, it does not have an enforceable right.’

This finding that MERS really possessed no enforceable right in the second mortgage formed the basis of the courts finding that MERS need not be included as a party in the Landmark foreclosure. The Landmark affirmed the decisions of the lower courts and the Landmark foreclosure was allowed to stand, without any participation of, or compensation to, the holders the second loan.

In so ruling the Court rejected an amicus brief filed by ALTA which argued that the role of MERS should be recognized on the basis that “MERS provides a cost-efficient method of tracking mortgage transactions without the complications of county-by-county registration and title searches,” and that the existing recording scheme stems from “seventeenth-century property law that is entirely unsuited to twentieth-century financial transactions.” The court found that it was not the court’s role to usurp the legislature’s role of making laws regarding the recordation of documents or “to substitute its view on economic or social policy.” The court further stated that the system advocated by MERS and ALTA had serious problems of its own:

“One such problem is that having a single front man, or nominee, for various financial institutions makes it difficult for mortgagors and other institutions to determine the identity of the current note holder.

“‘[I]t is not uncommon for notes and mortgages to be assigned, often more than once. When the role of a servicing agent acting on behalf of a mortgagee is thrown into the mix, it is no wonder that it is often difficult for unsophisticated borrowers to be certain of the identity of their lenders and mortgagees.'”³

As noted above MERS, as part of its business, brings many foreclosure actions in its own name as against borrowers who default on mortgages and deeds of trust in which MERS is named as the “nominee.” There are millions and millions of such mortgages on which MERS appears. The Landmark decision is important because it indicates, although it does not expressly decide, that MERS will have a great deal of trouble bringing foreclosure actions in its name because, based on the reasoning of Landmark, MERS is not a proper party in a foreclosure action, having no substantive interest in the ownership of the loan or in the security for the loan.

But if MERS cannot bring the foreclosure action, who can? As noted above, the original lender has almost always sold the loan to other parties long before the borrower’s default occurs, and thus has no interest in the transaction on which it could base a foreclosure. The party who has purchased the loan has in fact usually purchased only the underlying debt obligation such as the promissory note, and has not purchased the mortgage security or deed of trust which was designed under the MERS system to remain with MERS, as nominee. Thus the holder of the debt is also not in a legal position to bring the foreclosure action.

It is certain that attorneys for borrowers will use the findings of this case and others like it4 to challenge MERS’ right to bring foreclosure actions against their clients. This could potentially result in a situation where millions of delinquent loans can not be foreclosed upon under the current MERS system. Such a situation could create a serious impact on the U.S. financial system. This situation will continue to develop as more such cases work their way through the legal system. It is an area of law bears watching by all involved in the real estate industry, either as investors or as professionals.

1 The case reviewed is Landmark National Bank v. Kesler (August 2009) (No. 98,489); 2009 Kan. LEXIS 834.
2 Mortgage Elec. Reg. Sys., Inc. v. Nebraska Depart. of Banking, (2005) 270 Neb. 529, 530, 704 N.W.2d 784
3 Citing In re Schwartz, 366 B.R. 265, 266 (Bankr. D. Mass. 2007).
4 See, e.g., Bellistri v. Ocwen Loan Servicing, LLC, 284 S.W.3d 619, 623 (Mo. App. 2009); Mortgage Electronic Registration System, Inc. v. Southwest Homes of Arkansas (No. 08-1299, Arkansas Supreme Court, March 2009) 2009 Ark. LEXIS 121.