Investors often buy and sell real estate lien notes, either singly or in a package, a transaction that is customarily effected by a Sale & Assignment of Notes and Liens. This transfer instrument is referred to in this article simply as an assignment.
The idea of buying or selling a note seems simple until one delves into it. Is the assignment to be made “as is” with all faults that may exist in the note and the lien instrument? Will there be representations and warranties made by the parties and, if so, how extensive? How long will they last? Will recourse provisions apply if the note goes into default, and if so what is the recourse mechanism? Will indemnities be included? The closer one looks the more questions arise.
Our focus in this article is on the final assignment instrument signed by the parties at closing of the transfer rather than preliminary agreements that may come before closing.
The Assignment Process
In the case of real estate lien notes, a completed assignment involves not just a transfer of a note but the liens securing payment as well, which is why the assignment instrument is referred to as an assignment of note and liens. Two liens may be involved: the vendor’s lien retained in the deed from the seller to the borrower and the lien granted by a deed of trust.
One must distinguish between an absolute assignment of a note (a permanent transfers to a new owner and holder) versus a collateral assignment (made to a lender as collateral for a loan). Notes may be assigned in either way.
This discussion addresses absolute assignments. Steps in the process are usually: (1) an initial letter of intent or preliminary contract phase when basic terms are agreed to—similar to an earnest money contract for real estate—with “outs” for the prospective buyer; (2) a due-diligence or inspection period when a prospective buyer studies and evaluates the note (or package of notes) along with the lien instrument(s) and supporting documentation; (3) a cure period for objections, if any, raised by the buyer; (4) a closing document negotiation phase in which the terms of the final assignment instrument are hammered out and agreed to; and (5) a closing where a final sale and assignment of note and liens is executed, the purchase price paid, and the original note and loan file are delivered to the buyer-assignee.
BUSINESS & COMMERCE CODE
A properly written and endorsed real estate lien note is a negotiable instrument for purposes of Business & Commerce Code Section 3.201 et seq. Specific requirements of negotiability are listed in Section 3.104:
Bus. & Com. Code Sec. 3.104(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.
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.
Business & Commerce Code Section 3.416 provides minimal warranties for notes that are negotiable instruments. These are automatically in place unless the assignment instrument disclaims them:
Bus. & Com. Code Sec. 3.416(a). TRANSFER WARRANTIES. 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 contractual representations and warranties of the parties (discussed below).
DUE DILIGENCE BY BUYER-ASSIGNEE
Are the note and lien valid?
Determining the validity and enforceability of a real estate note and the lien(s) securing it is the core due-diligence task of any prospective buyer—who should obtain the whole loan file not just a copy of the note itself. A complete 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 and be available for inspection.
For a note to be valid, there must be consideration extended—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.
Generally, a 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 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 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.
This is a partial list. Sensible note purchasers will also want to perform minimal due diligence as to the value and condition of the security property since such factors may influence future note payment and performance. Does the property exist? Is it owner-occupied or occupied by renters? Is it in a state of good repair or is it underwater as a result of a recent flood?
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.
The importance of thorough due diligence cannot be over-emphasized. A prospective buyer should engage an experienced attorney to assist in determining the validity and enforceability of the loan documents before substantial funds are committed.
Even when a note is being transferred entirely “as is” a prospective buyer-assignee should insist on an adequate due diligence/inspection period before closing.
REPRESENTATIONS AND WARRANTIES
Beyond Statutory Minimum Warranties
A well-drafted assignment may (and should) go beyond minimum statutory warranties to include contractual 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. These terms should be expressly stated in the assignment instrument.
The goal of the seller-assignor is to minimize ongoing liability by limiting the number of reps and warranties. The buyer-assignee will instead prefer a longer list of assurances concerning note quality and completeness of the loan file.
Core representations and warranties of the seller-assignor include assurances that the note and lien(s) contain correct information and are legally valid and enforceable; that they 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; that payments are current and there is no threat of monetary or technical default; that no adverse litigation is pending or threatened; and that the assignor is the sole owner and holder of the debt with power to transfer the note and liens.
There may be many more seller reps and warranties that a careful buyer will want to include. An example: if the seller-assignor was the original payee on a real estate note, and the note arose from seller financing, the buyer-assignee should want a specific warranty that the SAFE Act and Dodd Frank were fully complied with in the course of the original transaction.
There is the question of how long reps and warranties will survive closing (if at all)—30 days? 90 days? Forever?
Obtaining adequate reps and warranties from the seller-assignor does not substitute for thorough due diligence by a prospective buyer-assignee.
OTHER CLAUSES IN THE ASSIGNMENT
Assignments Made “As Is”
What if the transaction is entirely “as is,” with no reps and warranties? There is certainly a market for this although the sales price of the note(s) will be discounted as a result. The key element in the assignment (for the seller-assignor) will be an effective “as is” clause similar to ones found in earnest money contracts and warranty deeds. Drafting these clauses can be tricky. Simplistic, one-liner “as is” clauses will not suffice since the seller-assignor needs not only to disclaim assurances regarding the note being transferred but also any reps or warranties concerning the condition and value of the security property.
Disclosure by the Seller-Assignor
Notwithstanding that an assignment is being made and accepted “as is,” a buyer should seek to obtain an agreement by the seller to make full disclosure of 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 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 are sold with or without recourse by the buyer-assignee against the seller-assignor. Recourse comes in three varieties: none, full, or limited.
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.
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.
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. Remedies may be different when a batch of notes is involved: for example, if 100 notes are sold, the assignment 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 contained within a specific time period. The availability of recourse is seldom indefinite.
If possible, the seller-assignor 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 not only taking the heat for defects in what they are purchasing but also paying the cost of defending against lawsuits arising from those defects. As with so many issues in real estate 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 assignment 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, resulting in inescapable up-front defense costs. One party to the assignment is left with a claim against the other based on the indemnity provision, often resulting in a second lawsuit.
As is the case with many other types of contracts, it is often beneficial to include a mandatory mediation clause in the assignment.
Drafting Considerations Generally
An assignment of note and lien(s) should be a comprehensive document. (If it is one page or less, something is amiss.) All obligations should be express. Nothing should be implied. No one should be allowed to assume anything or rely on anything unless expressly stated in writing. Oral statements should be disclaimed. A poorly-written assignment that involves unwritten assumptions and reliance on oral statements can easily form the basis for future litigation.
The foregoing discussion is by no means intended to be an exhaustive list of possible provisions that can be included in an assignment of note and liens. (Such documents can easily run 10 to 20 pages.) It merely hits the highlights.
CLOSING OF THE ASSIGNMENT
Endorsement and Delivery of the Note
The note itself should be marked or stamped appropriately and the endorsement (or indorsement as it is referred to in the Business & Commerce Code) 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 [see 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 note(s) should be delivered to the buyer-assignee at closing.
Execution and Recording of the Assignment
Both the seller-assignor and the buyer-assignee should sign the assignment in order to indicate mutual assent to its terms and conditions. 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 is usually 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 should be prepared in recordable form.
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 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 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. This scenario contemplates more of an “as is” approach to the note since its price is likely to be heavily discounted. In such cases, thorough due diligence is 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.
Information in this article is provided for general informational and educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. No attorney-client relationship is created by the offering of this article. This firm does not represent you unless and until it is expressly retained in writing to do so. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well.
Copyright © 2023 by David J. Willis. All rights reserved. Mr. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his website, www.LoneStarLandLaw.com.