Assignment of Real Estate Notes and Liens

Topics Covered

Applicable Law: The Business and Commerce Code
Due Diligence by the Buyer-Assignee
Representations and Warranties in the Assignment
Additional Assignment Clauses
Closing the Sale and Assignment of Notes and Liens

Absolute Versus Collateral Assignments

As a general rule, an interest or asset is assignable in Texas unless expressly provided otherwise by law or contract. One must distinguish between absolute assignments (a permanent transfer to a new owner and holder) versus collateral assignments (made to a lender as collateral for a loan). Many interests and assets may be assigned in either way. Our discussion focuses solely on absolute assignments.

Best Practices in the Assignment Process

There is a best-practices process applicable to the sale and assignment of any interest or asset: (1) a non-binding letter of intent setting out a tentative agreement (LOI); (2) a contract to sell the asset that allows for an inspection or option period for due diligence, a cure period for objections, and an unrestricted buyer right to terminate; followed by (3) a formal closing where a final sale and assignment instrument is executed and the interest or asset is delivered to the assignee-buyer.

The assignee-buyer should expect to make three main payments: (1) earnest money plus a non-refundable option fee to cover the inspection period; (2) a second payment due at the end of the inspection period (a more substantial amount), and then (3) payment of the balance of the sales price or assignment fee at closing. This basic payment schedule is subject to variation to suit the circumstances.

Sale and Assignment of Notes and Liens

When investors buy and sell real estate lien notes, either singly or in a package, the principal instrument is known as a Sale and Assignment of Notes and Liens. Two liens may be involved: (1) the vendor’s lien retained by the seller in the warranty deed and (2) the lien for the note amount imposed by the deed of trust against the realty.
Note that our focus in this discussion is on the final assignment instrument that is signed by the parties at closing rather than the preliminary LOI or contract that precedes closing.

APPLICABLE LAW:
TEXAS BUSINESS & COMMERCE CODE

Negotiable Instruments

A properly written and endorsed real estate lien note is a negotiable instrument for purposes of Business and Commerce Code Section 3.201 et seq. There are specific requirements for negotiability:

Bus. & Com. Code Section3.104(a). Negotiable Instrument

Except as provided in Subsections (c) and (d), “negotiable instrument” means an unconditional promise or order to pay a fixed amount of money, with or without interest or other charges described in the promise or order, if it:

(1) is payable to bearer or to order at the time it is issued or first comes into possession of a holder;

(2) is payable on demand or at a definite time; and

(3) does not state any other undertaking or instruction by the person promising or ordering payment to do any act in addition to the payment of money, but the promise or order may contain: (A) an undertaking or power to give, maintain, or protect collateral to secure payment; (B) an authorization or power to the holder to confess judgment or realize on or dispose of collateral; or (C) a waiver of the benefit of any law intended for the advantage or protection of an obligor.

What if the note does not qualify as negotiable?

A real estate note that does not qualify as a negotiable instrument may still be valid and enforceable, and it may still be sold and assigned, but common law rules relating to the assignment of contracts will apply—the negotiable instrument rules of the Business & Commerce Code will not.

The resale value of a note that is non-negotiable is likely to be discounted.

Negotiable Instruments Have Statutory Warranties

The Business and Commerce Code provides minimal warranties for notes that are negotiable instruments. These are automatically in place unless the assignment instrument disclaims them:

Business & Commerce Code Section3.416(a). Transfer Warranties [in Negotiable Instruments]

A person who transfers an instrument for consideration warrants to the transferee and, if the transfer is by indorsement, to any subsequent transferee that:

(1) the warrantor is a person entitled to enforce the instrument;

(2) all signatures on the instrument are authentic and authorized;

(3) the instrument has not been altered;

(4) the instrument is not subject to a defense or claim in recoupment of any party that can be asserted against the warrantor;

(5) the warrantor has no knowledge of any insolvency proceeding commenced with respect to the maker. . . .

Unless contradicted or disclaimed in the assignment, these statutory warranties co-exist with any contractual representations and warranties made the parties.

DUE DILIGENCE BY THE BUYER-ASSIGNEE

The Importance of Buyer Due Diligence

The importance of thorough due diligence prior to buying real estate notes cannot be over-emphasized. A good first step is to ask an attorney to evaluate the validity of the note and enforceability of the loan documents before any substantial funds are committed toward the deal.

Are the note and lien valid?

Determining the validity and enforceability of the note(s) and lien(s) is a core due-diligence task. To do this properly, a prospective buyer should obtain the whole loan file, not just a copy of the note itself. A complete loan file will include (at least) the note; a copy of a recorded deed of trust; a copy of a recorded deed into the name of the property owner (the borrower); and a payment history. Even if only copies are being reviewed, the original note should exist (somewhere) and be available for inspection.

For a note to be valid, there must be consideration extended to the borrower—money that is actually loaned. Hughes v. Belman, 239 S.W.2d 717, 720 (Tex.App.—Austin 1951, writ ref’d n.r.e.) and Bus. & Com. Code Sec. 3.303. Beyond the requirement that funds have been actually loaned, a promissory note offered for sale should:

(1) be correct as to all material information including clearly identifying borrower and lender as well as the security property;

(2) recite an unconditional promise to pay a sum-certain debt (and the numerical portion of the note must match the written portion);

(3) contain authentic signatures of all debtors and be dated;

(4) provide clear terms of repayment;

(5) be secured by a valid, recorded, and unreleased deed of trust;

(6) contain the signature of both spouses if the property is homestead;

(7) not contain any provisions that are illegal such as requiring usurious interest;

(8) not be in default (monetary of technical) or the subject of any actual or potential dispute with the borrower;

(9) not be in litigation or bankruptcy whether existing, threatened, or anticipated;

(10) not be the subject of any interest or claim by third parties; and

(11) not have been previously sold or transferred, in whole or in part, to anyone else.

Due Diligence on the Real Property

A measure of due diligence is also necessary as to the underlying realty. Does the property exist? Is it owner-occupied or leased by a tenant? Are the improvements in good repair or is there damage due to a recent flood? A physical visit (not usually a formal inspection) may be a good idea.

If the parties to the note are registered entities (LLCs, corporations, or limited partnerships) it is important to verify that they are in good standing with the Secretary of State and the Texas Comptroller. If not, they do not have the legal capacity to do business, whether it is selling or buying notes or anything else.

All of the foregoing factors affect the quality of the note or notes being considered—and quality affects price.

REPRESENTATIONS AND WARRANTIES
IN THE ASSIGNMENT INSTRUMENT

Going Beyond the Statutory Warranties

A well-drafted sale and assignment of notes and liens may (and should) go beyond minimum statutory warranties to include additional customized representations and warranties by the parties. It is possible for the assignment to include extensive reps and warranties, limited reps and warranties, or no reps and warranties at all—in which case the assignment is made “as is” and almost always without recourse or warranty, express or implied. These deal points should be expressly stated in the assignment instrument.

A seller-assignor of promissory notes will seek to minimize ongoing liability by limiting the number of its reps and warranties. The buyer-assignee will instead prefer a longer list of assurances that include issues of note quality, completeness of the loan file, and monetary performance.

Core representations and warranties of the seller-assignor include:

(1) assurances that the note and lien(s) contain correct information and are legally valid and enforceable;

(2) assurances that the notes are secured by a lawful vendor’s lien retained in a recorded general or special warranty deed plus a valid first-lien recorded deed of trust against the security property;

(3) assurances that note payments are current and there is no threat of monetary or technical default;

(4) assurances that no adverse litigation is pending or threatened; and

(5) assurances that the assignor is the sole owner and holder of the debt with power to transfer the note and liens.

A legitimate seller of promissory notes should have no hesitation in making these core reps and warranties. However, a prospective buyer will likely want more. For example: if the seller-assignor was the original payee on a real estate note, and the note arose from seller financing, the buyer-assignee may want a specific warranty that the SAFE Act and Dodd Frank were fully complied with when the loan was made.

There is also the question of how long reps and warranties will survive closing (if at all)—30 days? 90 days? For the term of the note?

Obtaining adequate representations and warranties from the note seller is important but does not substitute for thorough buyer due diligence that is undertaken during a specified inspection period.

ADDITIONAL CLAUSES FOR NOTE SALES

Note Sales “As Is”

What if a real estate note is offered entirely “as is” with no representation or warranties? There is certainly a market for this although the sales price will be significantly discounted as a result. The key element for the seller-assignor will be an effective “as is” clause. Drafting this clause can be tricky. A simplistic “as is” clause will not suffice in this case since the seller-assignor needs not only to disclaim warranties regarding the note but also any concerning the condition and value of the underlying real estate.

Disclosure by the Seller-Assignor

Even if an assignment of notes is being made “as is,” a buyer should seek to obtain an agreement by the seller to make full disclosure of all known material facts. A sample clause might be:

Assignor covenants and agrees to fully disclose to Assignee, prior to expiration of the inspection period, any and all known material facts, conditions, and circumstances pertaining to the note(s), the lien(s), and the security property that could reasonably be expected to affect the Assignee’s decision to buy or not buy, even if this assignment is agreed to be “as is,” in present condition with all faults and without recourse.

Recourse by the Buyer-Assignee

Notes can be sold with or without recourse against the seller-assignor. Recourse comes in three varieties: none, full, or limited.

(1) No recourse means what it says: if the borrower defaults then the buyer-assignee is stuck with a non-performing note (a near-worthless asset) and is solely responsible for pursuing the debtor and foreclosing on the security property.

(2) Full recourse means that the buyer-assignee gets to give the note back to the seller-assignor if the debtor defaults. One of two things generally happen: (1) the buyer-assignee gets a credit or refund or (2) the buyer-assignee can substitute another note that is current and performing. There are other variations.

(3) Limited recourse is, contractually speaking, all over the place. There are as many different provisions for limited recourse as there are creative attorneys to write them. Limited recourse provisions may state that there will be some sharing of effort and expense in collection or foreclosure, possibly with a reckoning after foreclosure sale of the security property.

Recourse remedies may be different when a batch of notes is involved: for example, if 100 notes are sold, the assignment instrument might provide that the first 10 problematic notes will be full recourse but the remaining 90 will not. In either case, there may be a hard limit on the total monetary amount of recourse available against the seller-assignor.

The availability of recourse—whether none, full, or limited—may also be constrained within a specific time period. It is seldom infinite.

Indemnity Provisions

If possible, the seller-assignor of promissory notes will want an indemnity clause holding him harmless against issues that may later arise in connection with the legality, enforceability, or collectability of the note. As with sellers of anything, the goal is no comebacks after closing.

Note buyers, on the other hand, resist (1) taking the heat for defects in the notes they are purchasing and (2) also paying the cost of defending themselves against borrower lawsuits arising from those defects. As with so many real estate matters it comes down to quality and price. A seller-assignor may be able to get an indemnity provision included but it may be costly when it comes to the sales price.

Indemnity provisions, although important, may be overrated since they are not self-executing. After all, the terms of an assignment can do nothing to prevent a borrower from suing both the seller-assignor and the buyer-assignee at some later time—an expensive eventuality after which one party to the assignment is left with a claim against the other, often resulting in another lawsuit.

Drafting Considerations

A sale and assignment of notes and liens should be a comprehensive document, easily running ten or twenty pages. All obligations should be express and contained within the four corners of the signed document. Nothing should be implied. Nothing should be assumed. No one should be allowed to rely on anything unless expressly stated in writing. Oral statements should be disclaimed. A poorly-written assignment of promissory notes can easily form the basis for future litigation.

CLOSING THE SALE AND ASSIGNMENT

Endorsement and Delivery of the Note

Any note that will be sold and assigned should be marked or stamped appropriately and the endorsement (or indorsement as it is referred to in the Business and Commerce Code) should be signed by the seller-assignor. The endorsement should include wording appropriate to the circumstances such as “payable to assignee without representations, warranties, or recourse” and would include the effective date.

Where does one place the endorsement? “For an instrument to be negotiable, indorsements must be written on the instrument or on a paper so firmly affixed thereto as to become a part thereof [sometimes called an allonge]. An allonge is a piece of paper annexed to a negotiable instrument or promissory note, on which to write endorsements for which there is no room on the instrument itself.” Failure to properly endorse a note when it is transferred may impair its negotiability, resulting in the recipient being a mere transferee rather than having the superior status of a holder in due course [Bus. & Com. Code Sec. 3.302].” Federal Fin. Co. v. Delgado, 1 S.W.3d 181, 185-86 (Tex.App.—Corpus Christi 1999, no pet.).

The original notes should be physically delivered to the buyer-assignee at closing.

Execution and Recording of the Assignment

Both the seller-assignor and the buyer-assignee should sign the sale and assignment of notes and liens in order to indicate mutual agreement. A properly-drafted assignment is not merely a unilateral transfer but represents a complex contract between the parties. The assigning party’s signature is not enough.

It may be advisable for the buyer-assignee to record the assignment in the real property records of the county where the security property is located, so the assignment instrument should always be drafted in recordable form.

Note Portfolio Strategies

Notes are financial assets and their acquisition can be a part of an investor’s long-term buy-and-hold strategy. Like rents, a portfolio of mixed-age performing notes can produce a stream of income; however, unlike real property, there is no underlying equity that appreciates over time. In fact, the value of note assets depreciates so a stable note portfolio requires continual replenishment. As notes age and mature new notes must be acquired in their stead if the income stream is to be maintained.

It is, of course, possible to acquire real estate notes for other reasons. One aggressive strategy is to buy a secured note in default with the specific intention of foreclosing on the security property. A long-term hold is not the objective; acquiring the property is the objective. Thorough due diligence by the investor will be necessary in order to ensure that both the note and deed of trust are valid and enforceable with no obvious defenses available to the debtor.