Mortgage Loans And UCC: When Article 3 Applies and When Article 9 Applies

Given that a mortgage loan generally consists of two documents, a promissory note and a security instrument (mortgage or deed of trust), and that the security instrument is a mere incident of the note, Article 3 of the UCC seems to apply to most issues related to enforcement and collection of the debt evidenced by the promissory note.

Article 3 of the UCC generally governs promissory notes, including those issued in connection with mortgage loans. Under Article 3, promissory notes (while certainly having many elements of regular contracts) are a special category of an "instrument."  Such an instrument has many similarities to a bank check in that it is payable to an identified payee and may be transferred by physical possession. One of the biggest features is that, just like you can't take a photocopy of a check to the bank to cash it, neither can the payee of the note to rely on a photocopy to collect the debt due on the note.

There is also Article 9 of the UCC, which covers "secured transactions" and which may at times apply to promissory notes secured by a mortgage or deed of trust ("DOT").

When a note is created and is secured by a mortgage or DOT, it may be transferred without a formal assignment contract, but by mere endorsement and transfer of possession.  In allowing such transfers, the law makes the note a more easily transferable type of instrument.  Generally, such transfers of the note will be governed by Article 3 and the security instrument (mortgage or DOT) incident to the note will follow the transfers automatically.

However, what happens if the payee of the note (or the current party to whom the note has been transferred – "holder") will pledge the note as security for yet another loan? What if, instead of transferring the note outright to another party, the holder of the note will borrow against it and will pledge it as a collateral?

In this situation, the note (with its incidental security) is treated as "personal property," and Article 9 applies. The party advancing the loan funds against the note ("new lender") would obtain a security interest in the note and would also have a second-tier security interest in the collateral originally securing the note (i.e., the house).

To explain it further, when the note itself is pledged as security for a new loan (rather than transferred/sold outright), the note's accompanying mortgage/DOT remains incident to the note and follows the note. That mortgage/DOT, in turn, represents an interest in (an encumbrance on) the house that served as collateral at the time the note was issued.  Thus, this situation of a pledged note creates security within security: the house as collateral within the note, with the note itself given as collateral when pledged for a new loan.

The new lender's security interest in the note would be perfected under Article 9 (provided the applicable requirements for perfection are met), but such lender's second tier security interest in the note's collateral (the house) would be unperfected unless recorded specifically against the property. This is what happened, for instance, in Rodney v. Arizona Bank, 836 P.2d 434, 172 Ariz. 221 (Ariz. App. Div. 2 1992).

Bottom line is, there is a key distinction between creating a security interest in real estate (such as when you issue a note payable to your lender and giving the lender security in the house) and creating a security interest in personal property (such as giving a lender security in the note itself, which note may or may not itself be secured with real property).  This is a distinction missed by Judge Sarah S. Curley in In re Zitta.  Don't get me wrong, I like the result in Zitta, but it was reached there for the wrong reasons.

Judge Curley even quotes this passage from a treatise:

B mortgages his real estate to L. L gives B's note and the real estate mortgage to Bank as security for a loan. Article Nine does not apply to the transaction between L and B, but does apply to that between L and Bank.

As can be seen, the transaction between L and Bank does note involve an outright transfer of the note to Bank. Rather L gives the note to Bank "as security for a loan."  There is a difference between selling something outright (without retaining any interest in it) and pledging something as security.  Selling your house to Bank is not the same as pledging your house to Bank as security for a loan.  Same applies to a note instead of a house.

Anyway, when a note is transferred by endorsement and change in physical possession, Article 3 of the UCC generally governs.  When a note is transferred as if it were a regular contract and not a UCC instrument, or when it is pledged as security, Article 9 generally governs.