Part I of this article series analyzes the due diligence investigation to be conducted by a mortgage loan broker (MLB) into a trust deed note available for purchase by their trust deed investor.

For insight into the investor’s and their MLB’s need to investigate and analyze conditions which affect the trust deed note’s and the property’s value, see Part II of this article series.

The history, terms and conditions of a note

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

Buying a note and trust deed, called paper by trust deed dealers, can be a reliable and profitable investment for individuals seeking a flow of income over a fixed period of time. Such an individual is called a trust deed investor, or more commonly a private money lender or hard money lender.

To enforce collection of principal and interest payments called for in a trust deed note, the investor acquiring the note needs to be classified as a holder in due course by assignment of the note and trust deed. Unless they are a holder in due course, they will be subjected to personal defenses against enforcement of the note that the payor owing the money has against the person selling the note. These defenses are more likely to arise in the context of a seller carryback sales transaction. [Calif. Commercial Code §3306]

To qualify as a holder in due course on the assignment of a trust deed note, the investor needs to acquire the note:

  • 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 needs to give something of value to the noteholder in exchange for their assignment of the trust deed note. The investor’s payment of money or transfer of real estate to the mortgage holder in exchange for assigning the trust deed note to the investor is valuable consideration. [Com C §3303]

For the note to be assigned in good faith, it needs to be assigned with honest intentions and in faithful adherence to the common purpose of the seller of the note and the investor acquiring the note by assignment. The assignment of a note automatically assigns the trust deed that attaches the debt owed under the note to a parcel of real estate.

Further, the investor, to be a holder in due course, may not have actual or constructive notice of deficiencies in the note and trust deed, including:

  • a defect on the face of the note, such as irregularities, incompleteness or evidence of alteration or forgery;
  • any misrepresentations made by the person who originated the mortgage with the property owner; or
  • any condition that gives the property owner a claim against the person – lender or carryback seller – who originated the trust deed note.

The mortgage loan broker (MLB) representing the investor in their acquisition of a trust deed note initially needs to investigate the financial condition and legal aspects of the note and trust deed, as well as the assignment documentation. This conduct is all part of fulfilling their agency duty of care and protection owed to their investor.

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

Prudent practice compels the MLB representing the investor to investigate and analyze the circumstances surrounding the trust deed note offered for sale. The purpose of the background check is to gather information sufficient for the MLB to give pragmatic advice about the quality of the note and trust deed.

To do so, the MLB obtains and reviews every document associated with the trust deed note, including:

  • 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 current property profile of the encumbered 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 property owner’s hazard insurance policy; and
  • a copy of the agreement and escrow documents which created the note and trust deed.

Particular attention needs to be paid to the documents which created the note and trust deed and the insurance policies.

For instance, just because title insurance is available to cover the enforceability of the trust deed does not mean the debt evidenced by the note and secured by property under 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 (2009) 177 CA4th 106]

Statutory disclosure statement of the MLB

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

The disclosure statement details, among other items:

Other due diligence aspects beyond the contents of the disclosure statement include:

  • an analysis of the value of the property securing the debt owed on the note; and
  • the risk the property owner will default 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 lender. The owner’s name is misspelled on the note and the note contains a poorly worded provision with a vague meaning. The terms of payment include an unusually high rate of interest and 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 their 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 as stated since the mortgage was only partially funded by the lender and that the investor was on notice to investigate the note’s validity due to irregularities on its face.

The investor claims the note is enforceable since it was purchased for value and in good faith and they had no knowledge of any defects or defenses to payment of the note.

Two questions arise:

1) 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]

2) Is the investor a holder in due course by assignment?

No! The investor did not purchase the note in good faith. They and their MLB were on actual notice of the inconsistencies and errors on the face of the note. Thus, they are charged with the duty to further investigate the note’s condition, which the investor and the MLB failed to do. [Com C §3302]

Here, the investor enforcing payment of the note without being a holder in due course is subjected to the same offsets against the note’s principal debt that the owner has against the lender who sold the defective note. The investor may enforce the note only to the extent it was funded by the lender, since the irregularities in the note put the investor, and their 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 might assert against enforcement, is fully covered by obtaining a trustor’s offset statement from the property owner prior to closing escrow. [See first tuesday Form 414]

Trustor’s offset statement

The trustor’s offset statement is demanded by the investor’s MLB as a condition for their investor accepting an assignment on the purchase of a trust deed note. The statement is first prepared by the noteholder selling the note (or the MLB or escrow), then delivered to the property owner for review and confirmation of the information contained in the statement.

When reviewed and signed by the property owner, it is delivered to escrow for further approval by the trust deed investor prior to closing and acquiring the trust deed note. [See first tuesday Form 414]

The trustor’s offset statement signed and returned by the property owner confirms the:

A property owner who receives a trustor’s offset statement from the noteholder has no duty to respond to a request for the statement, unless they have agreed in writing to do so.

However, regardless of the property owner’s duty to respond, if the owner signs and returns the statement, the information it contains may be relied upon by the trust deed investor. When the owner does not return a signed statement, the broker and the investor need to investigate and confirm the owner has no defenses to payment of the note.

Generally, when the owner does not respond, the broker and investor may conclude a problem exists with the repayment of the debt. Guarantees from the holder selling the note may be a solution when the property owner does not respond.

The trustor’s offset statement is fundamental to the investor’s holder in due course status, imperative on an assignment of the note and trust deed. The sending of the offset statement and the owner’s positive response demonstrates the investor acquired the note in good faith without any known defects in the paper or defenses against its enforcement the property owner may have, except as noted by the property owner in their response to the offset statement.

Part II of this article series discusses the need to investigate factors which affect the trust deed note’s and the property’s value, including the condition of title, past activities, and the note’s terms and its LTV.