This article analyzes the due diligence investigations by a mortgage loan broker (MLB) into a trust deed note available for purchase by his trust deed investor.

The history, terms and conditions of a note

A negotiable instrument, such as a promissory note secured by a deed of trust, contains an unconditional promise to pay an agreed-to dollar amount as scheduled to the holder of the note.  A trust deed note, being a negotiable instrument, may be sold and assigned to others, such as a trust deed investor.

Buying a carryback note and trust deed, together called paper, can be a reliable and profitable investment for trust deed investors, also called private money lenders or hard money lenders.

To enforce collection of the entire principal and interest called for in the note, a trust deed investor, on acquiring the trust deed note, must be classified as a holder in due course of the note and trust deed. If he is not a holder in due course, he will be subjected to any of the personal defenses against his enforcement of the note that the buyer of the property has against the seller of the note, such as exists in carryback transactions. [Calif. Commercial Code §3306]

To qualify as a holder in due course, the investor must be assigned the note and trust deed:

• for value;
• in good faith;
• without notice of defects or defenses to payment of the note; and
• without notice the note is overdue, dishonored, or has an uncured default. [Com C §3302]

The investor purchasing a trust deed note must give something of value in exchange for the assignment of the trust deed note. The investor’s payment of money or transfer of property to the holder assigning the trust deed note to the investor is valuable consideration. [Calif. Commercial Code §3303]

For the note to be assigned in good faith, it must be assigned with honest intentions and in faithful adherence to the agreed common purpose of the seller of the note and the investor taking an assignment.

Also, the investor must not be aware of underlying deficiencies in the note and trust deed, such as:

• a defect in the note, such as irregularities, incompleteness or evidence of alteration or forgery;
• any misrepresentations made by the lender who issued the original  loan to the property owner; or
• any item that would give the property owner a claim against the lender who originally made or carried back the trust deed note involved.

The mortgage loan broker (MLB) representing the investor in his acquisition of the note and trust deed initially needs to investigate the financial and legal aspects of the note and trust deed and the assignment documentation as part of his fulfillment of his agency duty of care and protection owed to his investor.

Comparable to a buyer of real estate entering into a purchase agreement with the advice and assistance of his transaction agent (TA), the trust deed investor buying a carryback note does so with the advice and assistance of his MLB. [See first tuesday Form 241]

Prudent mortgage loan brokerage practice compels the MLB representing the investor to investigate and analyze the note and trust deed offered for sale. To do so, the MLB obtains and reviews every document associated with the note and trust deed offered for sale, such as:

• a copy of the note and trust deed;
• a printout of the note’s amortization schedule;
• a copy of the payment history on the note;
• a property profile of the secured property from a title company;
• copies of all documents recorded on title during the past 24 months;
• a copy of the seller’s current title insurance policy;
• copies of any senior notes and trust deeds;
• a copy of the noteholder’s hazard insurance policy; and
• a copy of the agreement and escrow documents which created the note and trust deed.

The purpose of the background check on the sale or loan transaction which created the note and trust deed, as well as on the insurance policies which cover risks of loss and the conditions of title surrounding the trust deed, is to gather information sufficient for the MLB to give pragmatic advice about the quality of the note and trust deed. Just because title insurance is available to cover the enforceability of the trust deed does not mean the debt secured by the insured trust deed is enforceable.  The debt, being the note, is not insured under a lender’s policy of title insurance. [First American Title Insurance Company v. XWarehouse Lending Corporation (September 1, 2009)__CA4th__]

The MLB prepares and hands his investor the mandatory disclosure statement when submitting a trust deed investment opportunity for the investor’s consideration. [See first tuesday Form 235-2 (DRE 851B)]

Among other items, the trust deed disclosure statement details:

• the terms and conditions of the note and trust deed [See first tuesday Form 235-2 (DRE 851B) Part 3];
• any senior liens encumbrancing the property [See first tuesday Form 235-2 (DRE 851B) Part 9]; and
• the loan-to-value (LTV) ratio. [Calif. Business and Professions Code §10232.5; see first tuesday Form 235-2 (DRE 851B) Part 10]

Other due diligence aspects to be covered in future first tuesday articles include:

• an analysis of the value of the property securing the note; and
• the risk of the property owner defaulting on either the note (payments) or trust deed (use and maintenance of the property).

Notice and the holder in due course

Consider an investor acquiring a trust deed note from a private trust deed lender. The owner’s name is misspelled on the note and the note contains a poorly worded provision with vague meaning. The terms of payment include an unusually high rate of interest over a short period of time before the principal is due. No contingencies placing conditions on the obligation to pay are included in the note. Neither the investor nor his MLB investigate the note or question the uncommonly high rate of interest. Their sole concern is the amount of principal, the rate of interest, the due date and the discount.

When the note becomes due, the investor demands payment of the principal and interest. The owner refuses to pay under the terms of the note, claiming the note is unenforceable since the loan was only partially funded by the lender and that the investor was on notice to investigate the note’s validity due to its irregularities.

The investor claims the note is enforceable since he purchased the note in good faith and had no knowledge of any defects in the note.

Is the note negotiable and thus assignable despite its irregularities?

Yes! The note is a negotiable instrument since it identified the owner and contained an unconditional promise to pay on the terms stated in the note. [Com C §3104]

However, is the investor a holder in due course by assignment as required to enforce the note and avoid the offsets the owner claims he is entitled to due to the lender’s conduct?

No! The investor did not purchase the note in good faith since he and his MLB were on notice of the inconsistencies and errors in the note and thus were charged with the duty to further investigate the note’s condition, which the investor and the MLB failed to do. [Com C §3302]

Thus, the investor enforcing payment of the note is subjected to the same offsets against the note’s principal the owner has against the lender who sold the defective note. The investor can enforce the note only to the extent it was funded by the lender, since the irregularities in the note put the investor, and his MLB, on notice of possible defects. [In re Nusor (1991) 123 BR 55]

The due diligence investigation necessary to uncover defects in the note, which the property owner responsible for paying could assert to defend against enforcement, is fully covered by obtaining a trustor’s offset statement from the property owner prior to closing escrow on the purchase of the note and trust deed. [See first tuesday Form 414]

Trustor’s offset statement

The MLB representing the trust deed investor wants the property owner paying on the note to confirm the terms of the note and trust deed through the use of a trustor’s offset statement. [See first tuesday Form 414]

The trustor’s offset statement is requested by the lender through the trust deed sales escrow and, on receipt, is delivered to the MLB and investor as called for in the purchase agreement the investor entered into for the acquisition of the note and trust deed. [See first tuesday Form 241]

The trustor’s offset statement sent to the owner of the property encumbered by the loan confirms the:

• address and legal description of the property securing the loan [See first tuesday Form 414 §4];
• date of the note [See first tuesday Form 414 §5.1];
• original amount of the note and unpaid balance [See first tuesday Form 414 §§5.2, 5.3];
• periodic payment amount and schedule [See first tuesday Form 414 §5.4];
• interest rate on the note [See first tuesday Form 414 §5.4(a)];
• date through which interest has been paid [See first tuesday Form 414 §5.4(b)];
• date next payment is due [See first tuesday Form 414 §5.4(c)]; and
• due date of any final/balloon payment. [See first tuesday Form 414 §5.4(d)]

The property owner has no duty to respond to the statement unless he has agreed to do so in the trust deed or note.  However, whether or not the property owner has a duty to respond, if the response is not received, the MLB and his investor will need to conduct a further investigation to confirm that no defense to payment of the note exists. Guarantees from the seller of the note may be a solution if contact with the property owner cannot be made or, if made, does not resolve the need for written documentation of the property owner’s confirmation that no defense exists to the note and trust deed.

The trustor’s offset statement is fundamental in establishing the investor’s status as the holder in due course on assignment of the note and trust deed. The sending of the offset statement and the owner’s positive response to it demonstrates the investor acquired the note in good faith without any knowledge of defects in the paper, except as noted by the property owner in his response to the offset statement.

The condition of title and past activity

A property profile downloaded from a title company’s website discloses the trust deed liens of record which were recorded prior to and after the trust deed securing the note was recorded.  Any recorded assignment or subordination of a trust deed will be reflected, including any affecting the trust deed securing the note. A property profile is not a guarantee or warranty that the title is as represented.

The property profile discloses the current vesting, general and special taxes, assessments, bonds, encumbrances and liens of others which are recorded against the property. This is crucial information for the MLB to present to the investor since the risk of the owner’s default increases as the property is further encumbered with liens.  A further check of the county recorder’s general index through the title company, usually done by obtaining a preliminary title report, will disclose any involuntary judgment liens that  have attached to title under this or a prior ownership.  Also, a preliminary title report is not a guarantee or warranty that the title is subject to the liens reported or that the report includes all the liens that might affect title to the property.

The MLB’s review of the title insurance policy held by the seller of the trust deed note confirms the trust deed’s priority on title (but does not insure the investor acquiring the trust deed of that condition on an assignment since he is not a named insured).

A copy of any senior trust deed received from a title company confirms the existence and nature of the senior lender’s due-on rights to challenge the original creation of the junior trust deed being purchased. If the senior lender holding a trust deed with a due-on provision has not entered into a written consent approving the existence of the junior trust deed, the lender on discovery of the junior lien can call the loan due. The senior lender can also call the loan due if the buyer in a carryback financing arrangement did not formally assume the senior loan on the sale of the property and creation of the junior trust deed, or if he did, the junior trust deed was not referenced in the purchase agreement or escrow instructions. Such a conflicting position with the lender requires the trust deed investor to resolve the due-on issue with the seller of the junior trust deed note before proceeding with his purchase of the note.

Due-on waivers

If a due-on clause exists in the senior trust deed, the MLB ascertains whether the senior lienholder has either:

• consented to the recording of the junior trust deed as a further encumbrance on the property; or
• waived his right to call the loan due.

The second trust deed investor must be made aware that the due-on clause in the first trust deed is a time bomb. If the property owner does anything to trigger the first trust deed’s due-on clause before or after the investor acquires the trust deed note, then the investor has to be ready to absorb the risks of funding a payoff or negotiating a modification of the first trust deed if the senior lienholder calls the loan or demands the loan to be recast.

Due-on waivers from the underlying lender/senior lienholder are required documentation to protect the trust deed investor’s junior position on title to the property.

A written waiver of the senior lienholder’s future enforcement of the due-on clause bars the senior lienholder from calling the loan and protects the investor for so long a time as he has an interest in the property. The waiver agreement assures the investor he can protect his security interest in the title without due-on interference from the senior lienholder. [See first tuesday Form 410]

To best protect his trust deed, the investor should have the senior lienholder waive its right to call the loan:

• on the conveyance and further encumbrance of the property;
• for as long a period as the investor has a position on title to the property;  and
• on the investor’s reacquisition of title to the property should the property owner have to complete a foreclosure on the property  or accept a deed-in-lieu of foreclosure.

The waiver must be in writing to be enforceable against the senior lienholder. [12 Code of Federal Regulations §591.5(b)(4)]

Further, a due-on clause in the junior trust deed being acquired protects the investor if the property owner later sells or further encumbers the property. Without a due-on clause, the investor is forced to accept a new owner (one who is potentially less creditworthy) or a further encumbrance of the property by the owner, possibly creating an unacceptable or unreasonable risk of loss by diminishing the owner’s equity in the property.

The note’s loan-to-value ratio

A secured note’s loan-to-value (LTV) ratio indicates the extent of the investor’s risk of loss on the note due to a deficiency in the secured property’s value in the event of a default on the trust deed. A default on the note is a default on the trust deed.  The LTV ratio represents the amount of the loan’s principal, together with amounts of any senior trust deed encumbrances on the property, stated as a percentage of the secured property’s value.

The LTV is calculated as follows:

• add the price the investor intends to pay for the note (not the note’s stated face value) to the total amount of principal unpaid on any senior monetary encumbrances to remain of record on acquisition of the note and trust deed; and
  • divide this total dollar amount by the current fair market value of the property.

For example,  a second trust deed purchased for $50,000  is added to unpaid senior loans totaling $150,000 for total encumbrances of $200,000. This total amount of loans is then divided by the property’s value of $250,000. The result is an LTV ratio of 80%.

MLBs need to take into consideration the LTV percentages mandated to be followed on syndicated trust deed note investments:

• 80% for owner-occupied, single family residences;

• 75% for non-owner-occupied, single family residences;
• 65% for commercial and income-producing property;
• 65% for single family, residential-zoned lots or parcels;
• 50% for undeveloped property zoned for commercial or residential use;
• 35% for other real estate; or
• the percent of value set by any private mortgage insurance (PMI) coverage issued for the note. [Calif. Bus & P C §10238(h)(1); see first tuesday Form 234]

Editor’s note — Unique circumstances may exist allowing the MLB syndicating a trust deed note investment to exceed the statutory LTV ratios if they can justify in writing their reasons for exceeding the limits. However, the LTV ratio must never exceed 80% of improved real property or 50% of unimproved property, except for single family, residential- zoned parcels for which the LTV ratio cannot exceed 65%.

The MLB keeps the statement containing the justification for exceeding the LTV limits in his files. He also provides the trust deed investors with a copy of the LTV statement with the lender disclosure statement. [Bus & P C §10238(h)(2); see first tuesday Form 235-2]

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Tagged as: foreclosure, good faith, hazard, income, insurance, lien, mortgage, purchase agreement, single family residence (SFR), tax, taxes, TIC, title, trust deeds, vesting