Buying and Selling Real Estate Notes
by David J. Willis J.D., LL.M.
Real estate 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 Note(s) and Lien(s),” which is akin to a bill of sale for personal goods. We will refer to this document simply as an assignment.
The notion of buying or selling a note seems simple until you delve into it. Is the assignment made “as is?” Are there representations and warranties made by either party and, if so, how extensive? Are there recourse provisions and, if so, what is the recourse mechanism? Will an indemnity provision be included? This chapter will deal with these considerations.
For purposes of this discussion, we will address absolute assignments rather than assignments made as collateral for a loan (“absolute assignments” versus “collateral assignments”). Further, comments on the contents of the assignment itself will be limited to the final document to be signed by the parties, not to executory contracts contemplating a due diligence period followed by a closing. Another assumption made in this chapter is that there is no separate loan agreement that accompanies the note.
A properly written and endorsed real estate lien note is a negotiable instrument for purposes of Texas Business & Commerce Code Section 3.201 et seq. Specific requirements of negotiability are listed in Section 3.104:
Sec. 3.104. NEGOTIABLE INSTRUMENT. (a) 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 the usual common law rules relating to the assignment of contracts will apply. Caution is in order, however; the resale value of a note that is non-negotiable will likely be deeply discounted.
Due Diligence by the Assignee
Determining the validity and enforceability of a real estate note is the basic due-diligence duty of anyone considering buying one.
What are issues the assignee should be looking for? Look at the basics. As is the case with any contract, there must be consideration extended (i.e., money loaned) for a note to be valid. Hughes v. Belman, 239 S.W.2d 717, 720 (Tex.App.-Austin 1951, writ ref’d n.r.e.); also Tex. Bus. & Com. Code §3.303. The note should identify the parties, recite an unconditional promise to pay a sum certain (the numerical portion must exactly match the written portion), be signed by the debtor and dated, and provide clear terms of repayment (upon demand or at a fixed time). It should not (obviously) contain any provisions that are illegal, such as requiring the payment of usurious interest. The note should be currently performing (no monetary or non-monetary defaults), with no lawsuit or bankruptcy filing anticipated from the debtor, whose payment history should also be examined. If the lien(s) securing the note are against a homestead, both husband and wife must have signed the note and the deed of trust securing its payment. The deed of trust should be filed and otherwise properly do its job.
Clearly, there are many factors that need to be considered, both legal and in terms of risk assessment. Sensible purchasers of real estate notes (and the liens accompanying them) will ask an experienced attorney for assistance in evaluating the validity and enforceability of such documents before committing substantial funds toward their purchase. Accordingly, any executory contract for the purchase and sale of a real estate note should include an adequate due diligence or inspection period before a final closing. The purchase of any note that does not meet the minimum standards of this paragraph should be avoided.
If the parties 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 transferring notes or anything else.
The Basics of an Absolute Sale and Assignment of Note and Lien(s)
Buying and selling a real estate note involves transferring not only the debt but also the lien(s) that go with it, making it advisable to record any such assignment in the real property records where the security property is located. Two liens are usually involved: the vendor’s lien retained in the deed to the payor, and the deed of trust lien granted to a trustee to secure payment.
It goes without saying that the payee on the note should also be given notice of the transfer along with the name of the new payor and the address to which payments will now be sent.
A sale and assignment of note and liens (for the remainder of this chapter we will use the term “assignment”) should clearly indicate the parties-the assignor-owner-holder of the note along with the identity of the assignee. Assignment may be made with or with representations, warranty, or recourse, and the instrument should make these variables clear. The assignment should also include the legal description of the security property, exactly tracking the legal description found in the general or special warranty deed. As with all real property instruments, it is useful to also include the property’s street address. Both assignee and assignee should sign the assignment in order to indicate unconditional mutual assent to its terms and conditions.
Representations and Warranties (“Reps and Warranties”) by Assignor
The assignment may 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. It should be obvious that issues like these need to be made clear in the instrument, but often they are left unarticulated or muddled (Internet junk forms are particularly deficient in this respect). A poorly-written assignment can form the basis for later litigation, what lawyers refer to as “an invitation to a lawsuit.”
Business & Commerce Code Section 3.416 provides minimal warranties for notes that are negotiable instruments. These are automatically in place unless the assignment disclaims them:
Sec. 3.416. TRANSFER WARRANTIES. (a) 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. . .
What are other examples of reps and warranties? There are many. The core of these would include assurances that the note and liens are legally valid and enforceable; that they are secured by a lawful vendor’s lien retained in a general or special warranty deed plus a lawful first-lien deed of trust against the security property; that payments are current and there is no threat of default; and that the assignor is the sole holder and owner of the debt with power to enforce and transfer the note and liens. Many more reps and warranties can (and should, from the buyer’s point of view) be included. These can vary and are generally the result of negotiations between the parties. Clearly, the assignor’s goal will be to minimize ongoing liability by either transferring the note entirely “as is” or including as few reps and warranties as possible; the assignee will instead want a long and specific list (the inclusion of a couple of dozen reps and warranties is not uncommon). Here’s an example of one you might not expect at first: if the assignor was the original payee, and the note was generated from seller financing, the assignee would logically want a specific warranty that the SAFE Act and Dodd-Frank were fully complied within the course of the sale.
From the point of view of the assignee-buyer, due diligence is still required to assure the accuracy of reps and warranties by the seller. The existence of reps and warranties in the assignment does not eliminate this duty. Despite some inroads, the doctrine of “buyer beware” is alive and well in real estate.
Lastly, with respect to reps and warranties, there is the question of how long they will survive-30 days? 90 days? Forever?
“As Is” Assignments
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 or notes will likely be discounted as a result. The key element in the assignment will be an effective “as is” clause, similar to ones found in earnest money contracts and warranty deeds although specifically tailored to the context of promissory notes. Drafting these clauses can be a bit tricky; simplistic, one-liner “as is” clauses simply will not do in this context, since the assignor will want not only to expressly disclaim assurances regarding the transferred note but also any reps or warranties concerning the condition and value of the property pledged as security.
An Indemnity Clause: Additional Protection for the Assignor
If possible, the assignor will want a clause that holds him or her harmless and indemnifies against any issues that may later arise in connection with the legality or collectability of the note. Buyers of anything, however, understandably resist not only taking the heat for defects in what they’ve purchased but also paying the seller’s bills for defending against claims and lawsuits arising from those defects. As with so many issues in real estate, it comes down to price. A seller-assignor may be able to get an indemnity provision included, but it will likely be costly when it comes to the sales price of the note.
Indemnity provisions may be overrated, since they are not self-executing. After all, the terms of an assignment can do nothing to prevent a debtor from suing both assignor and assignee at some later time, resulting in inescapable up-front defense costs. The assignor is then left with a claim against the assignee on the indemnity, often resulting in a second lawsuit.
Notes are sold with or without recourse against the assignor. Recourse comes in three varieties: none, full, or limited. “No recourse” means what it says-if the debtor defaults, then the assignee is stuck with a non-performing asset and is solely responsible for pursuing the debtor and foreclosing on the security property.
Full recourse means that the assignee gets to give the note back to the assignor if the debtor defaults. One of two things generally happens: the assignee gets a credit or refund or, alternatively, the assignee can substitute another note that is current and performing. There are quite a few variations on this theme.
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 the foreclosure sale. 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 assignor.
The availability of recourse-whether none, full, or limited-may also be contained within a specific time period (It seldom lasts forever).
Endorsement 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 assignor. The endorsement should include wording appropriate to the circumstances such as “payable to assignee without representations, warranties, or recourse” and would include the 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 [which is 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 §3.302]. “Federal Fin. Co. v. Delgado, 1 S.W.3d 181, 185-86 (Tex.App.-Corpus Christi 1999, no pet.).
Miscellaneous Clauses in the Assignment
As is the case with most contracts involving the sale of an item, it is advisable for the seller (the assignor, in this case) to insist on an alternative dispute resolution clause that requires a good-faith mediation before the filing of suit. A venue clause, a merger clause, a no-representations clause, and a no-reliance clause are all advisable inclusions, particularly if one is the assignor. Good drafting principles apply, so consult a real estate attorney.
Notes are 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 realty, there no underlying equity to sell at the end of the rainbow. Value depletes over time, it does not increase, so a note portfolio requires continual management. 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. The property is the objective. This scenario contemplates more of an “as is” approach to the note, since its price is often heavily discounted. In such cases, it is essential to perform thorough due diligence in order to ensure that both the note and the 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 © 2019 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.