Part II of this article series discusses the escrowing the assignment of a trust deed note.
For insight into methods of investing in trust deed notes and the due diligence investigation and documentation needed for the purchase of an existing trust deed note, see Part I of this article series.
Escrowing the note sale
Buying a trust deed note, such as a carryback mortgage, can be a reliable and profitable investment for trust deed investors. When an investor purchases a trust deed note, their broker prepares a note and trust deed purchase agreement. Along with the terms of the trust deed note purchase and assignment, an escrow holder is also agreed to for the assignment in the note and trust deed purchase agreement. [See first tuesday Form 241]
The trust deed note sale may be escrowed by:
- the broker involved;
- an escrow company;
- a title company; or
- an attorney.
Before preparing the escrow instructions, the person opening escrow provides the escrow officer with:
- the names of the parties to the transaction;
- the terms of the transaction;
- the trust deed involved; and
- the conditions to be met for the assignment/endorsement and funding to occur.
Further, to avoid confusion when dictating the instructions, the broker or the principals involved inform escrow of the:
- type of transaction;
- scheduled dates for the elimination of any contingencies; and
- final date for the close of escrow.
The escrow officer performs only as instructed, preparing the written instructions from oral dictation by the broker, or one or both principals involved. Some will accept a copy of the purchase agreement and figure out what they need to do to process the closing of the transaction.
Preferably, the person who dictates the instructions is the same person who collected the information the escrow officer used to prepare the instructions. They are then able to answer any question posed by the escrow officer related to the transaction.
When escrowing the transaction, the escrow officer has no obligation to notify the brokers or their principals of any suspicious fact or circumstance short of fraud detected before the close of escrow if it does not affect the closing instructions. Thus, the investor and their broker need to make sure their due diligence and investigations are completed prior to finalizing the transfer of the note and trust deed. [Lee v. Title Ins. and Trust Co. (1968) 264 CA2d 160]
The written escrow instructions are delivered to all persons involved in the transaction for their review, approval, and signatures. Typically, assignments and other customary documents that escrow prepares are included with the instructions to be signed by both principals.
Precision is essential
It is essential for the escrow instructions to be complete and precise. Any inconsistencies between the note and trust deed purchase agreement and the escrow instructions are superseded by the purchase agreement, unless the inconsistencies are stated in the instructions to be a modification. [Karras v. Title Ins. and Guaranty Co. (1953) 118 CA2d 659]
Any broker involved in the transaction is responsible for ensuring the escrow instructions, whether dictated by them or others, conform to the purchase agreement.
If the broker discovers any aspect of the escrow instructions conflict with the intentions expressed in the purchase agreement before closing, they are duty-bound to bring them to the attention of their client and the escrow holder.
On notification of an error, the close of escrow needs to be delayed by the escrow officer until the error is clarified or corrected by signed amended escrow instructions. [Diaz v. United California Bank (1977) 71 CA3d 161]
Title insurance
The investor purchasing a trust deed note needs to be insured against financial loss arising out of defects in title to the secured property and from the invalidity or unenforceability of the trust deed. Thus, the investor may either:
- demand a new policy of title insurance; or
- simply accept an endorsement (an “assignee” or “104.1” endorsement) of the noteholder’s existing policy.
However, the disadvantage of obtaining an assignee endorsement is the policy provisions are not updated. An endorsed policy reflects the condition of title exactly as it was when the seller’s policy was written and does not include any junior liens that have since attached.
In addition, the investor needs to review a preliminary title report during escrow to assure the priority and title conditions of the trust deed.
Transfer of the note
On the close of escrow, the note is transferred from the noteholder to the investor in one of three ways:
- assignment;
- endorsement; or
- guarantee.
The seller assigns the trust deed to the investor at the close of escrow. To assign the trust deed, the seller signs an assignment form prepared by escrow. [See first tuesday Form 445 and 446]
The completed and fully executed assignment form is forwarded by escrow to the title company insuring the trust deed. The assignment is recorded with the county recorder to give constructive notice of the assignment.
On the close of escrow, the investor receives the original note from escrow. The document assigning the trust deed (and note) is returned to the investor by the county recorder.
Avoiding or assuming liability
The sale and transfer of a trust deed note is comprised of two independent but interwoven activities:
- the assignment or endorsement of the promissory note; and
- an assignment of the trust deed.
Editor’s note — The promissory note is the primary document since it evidences the debt owed. The note on an assignment remains secured by the real estate even if the trust deed securing it is not assigned. Apart from the note, the trust deed has no value. [Calif. Civil Code §2936]
The seller of a trust deed note avoids liability for any future default by the property owner when the transfer of the note is by an absolute assignment of the note, a nonrecourse situation.
Conversely, a recourse situation occurs if the seller of a trust deed note is liable to the investor for their losses on the note when the note is transferred by:
- an endorsement of the note; or
- a guarantee of the note.
Absolute assignment
An assignment of a trust deed note to an investor divests the seller of the note of all proprietary interest in the note without guaranteeing the investor against future defaults or losses. The investor accepting a note transferred by assignment (with the trust deed) has fully stepped into the shoes of the seller.
Consider a seller of real estate who carries back a note executed by the buyer and secured by a junior trust deed on the property sold.
An investor purchases the trust deed note by an assignment of the note and trust deed from the seller. Since the note is carryback paper secured only by the property sold, the note is purchase money paper. Thus, the carry back note is subject to anti-deficiency rules barring recovery by way of a money judgment due to the debt against the maker of the note — the buyer of the real estate securing the note. [Calif. Code of Civil Procedure §580b]
Later, the senior mortgage holder forecloses on the property and wipes out the investor’s junior trust deed, eliminating it from the title position which was the security for the carryback note.
The investor is now both unsecured and without recourse to collect on the note. The note was signed by the buyer of the real estate as part of the purchase price paid for the property.
Is the investor allowed to recover their losses from the seller who sold and assigned them the carryback note, since the investor is not able to recover from the maker of the note?
No! The seller, having assigned the note without a separate guarantee agreement, is not liable to the investor for any default on the note sold. [Calif. Commercial Code §3415(b)]
The seller’s absolute assignment of a promissory note occurs when:
- the seller signs the back of the note and add words such as “endorsed without recourse” [Kinsel Ballou (1907) 151 C 754]; or
- the note is transferred by the same form used for the assignment of the trust deed, with no notation of an assignment or endorsement on the note itself, the acceptable common method used by escrow to transfer notes and trust deeds unless advised to the contrary. [See first tuesday Form 445]
Endorsements
Now consider a seller who carries back a note and trust deed. The seller later sells the note and trust deed to an investor. To transfer the note to the investor, the seller endorses the note by placing their signature on the back of the note. Words of “assignment” or “without recourse” are not included with the endorsement.
The buyer of the real estate defaults on the note. Without first completing a foreclosure on the real estate under the trust deed, the investor makes a demand on the seller of the note to pay the full amount of the note.
The seller claims the investor needs to first foreclosure and sell the real estate before making a demand on the seller. However, the seller, as an endorser, is liable to the investor separate from any borrower liability on the note itself. The investor may recover from the endorser of the note without first foreclosing on the real estate which secured the note. [Kinsel, supra]
In essence, the seller of the note by endorsement has agreed to repurchase the note on:
- a default in payments on the note; or
- nonpayment on acceleration of the note based on a default in the trust deed.
Even if the note was purchased at a discount by the investor, the liability for repurchasing the note is for the full amount due on the note.
Signature without limitation
A note is endorsed whenever the holder who sells the note signs its back and delivers the note to the buyer. A signature alone, or a statement such as “pay to the order of…” accompanied by a signature, are effective as endorsements when placed on the back of a note — the note is transferred giving the buyer recourse to the seller of the note.
Now consider a seller of a trust deed note and a trust deed investor who orally agree to the terms for the sale of the note. Escrow is opened.
The escrow office is given no instructions on the type of transfer to be prepared. On closing, the escrow officer prepares an assignment of trust deed form. The seller signs both the:
- assignment of trust deed form, which states the note and trust deed are being assigned; and
- back of the note, as an endorsement with no words of “assignment” or “without recourse.”
Later, the borrower defaults on the note, and the investor makes a demand on the seller of the note, as an endorser, to pay the full amount of the note. The carryback seller claims they are not liable to the investor since they assigned the note and trust deed and did not intend to establish any liability for the repurchase of the note.
However, when the seller of a note transfers the note by endorsement without words limiting the seller’s signature on the note to an assignment of the note, the seller becomes personally liable to the investor, unless the seller can show the signature was not an endorsement. [Com C §3204(a)(3)]
For example, consider the seller and investor who enter into an agreement for the sale of a note and trust deed. The purchase agreement for the note and trust deed states the note will be transferred to the buyer through escrow by way of an assignment.
On closing, the seller signs, upon escrow’s request, both the:
- assignment of deed of trust form, assigning the note and trust deed; and
- back of the note.
Here, the seller’s signature on the note is not enforceable as an endorsement. The seller can show the signature on the back of the note was not for the purpose of establishing recourse liability as an endorser of the note. The underlying purchase agreement for the note and trust deed states the seller is transferring the note by an assignment. [Com C §3204(a)(3)]
Endorser’s liability
The seller of a note by endorsement is liable for the entire amount due on the note and trust deed.
The endorsements of the note need not be on the note itself. A note is also endorsed if a separate sheet of paper containing the signature and any words of endorsement is attached to the note, called an allonge. [Com C §3204(a)]
If the note has been transferred by endorsement several times, the present noteholder may recover only against their immediate endorser, unless prior endorsers have agreed otherwise. Endorsers may agree to endorse as joint payees, in which case both agree to be jointly liable to the noteholder.
Generally, endorsers are liable to one another in the same order in which they endorsed the note. This is presumed to be the order in which their signatures appear by endorsement on the note. [Com C §3415(a)]
Notice to borrower
Any change in the collection agent on transfer of a trust deed note secured by one-to-four residential units needs to be communicated to the borrower paying on the note. Thus, if the borrower continues to make payments to the seller of the trust deed note or their collection agent after the transfer, the borrower is not liable to the investor for payments made if they were made:
- on time, according to the payment schedule; and
- prior to receipt of the investor’s transfer notice. [CC §2937(f)]
NOD/NODq
The investor as beneficiary of the trust deed note will receive a notice of default (NOD) or notice of delinquency (NODq) from the senior mortgage holders if a request for each is recorded and served on the mortgage holders. [See first tuesday Form 412]
The noteholder’s recorded right to receive an NOD and NODq is transferred to the investor on sale of the note. However, the investor needs to file renewals of each request to reflect the investor’s name and address. The senior mortgage holder’s charge for receiving each renewal request is $15. [CC §2924e(b)]
Any person who signs the back of the note without indicating the signature is for another purpose is considered an endorser, such as a broker who does not guarantee the note they sold for another, but assumes liability for repayment of the note by endorsing the note on its transfer.
For further discussion on various methods of investing in trust deed notes and the due diligence investigation and documentation needed for the purchase of an existing trust deed note, see Part I of this article series.
