Saturday, March 25, 2017

Kissing Cousins: MERS and DTC

This semester, I’m teaching a seminar on the financial crisis.  And because my specialty is corporate and securities law, not property, I brought in a ringer – in the form of Chris Odinet of Southern University Law Center – to talk to my class about the Mortgage Electronic Registration System (MERS) and foreclosures.  MERS is a private organization that mortgage bankers have used to track mortgage assignments in the age of securitization, but after the housing bubble burst, it wreaked havoc in the foreclosure process because of sloppy recordkeeping and its inconsistency with the traditional manner in which interests in land have been recorded.  See generally Christopher Lewis Peterson, Two Faces: Demystifying the Mortgage Electronic Registration System's Land Title Theory, 53 Wm. & Mary L. Rev. 111 (2011).

As Chris Odinet described it to my class, MERS was formed when several financial institutions (including, as it turns out, the Mortgage Bankers Association, Fannie Mae, Freddie Mac, the Government National Mortgage Association, the Federal Housing Administration, and the Department of Veterans Affairs) decided that publicly recording mortgage assignments in county property offices was too expensive and cumbersome.  Instead, these institutions decided to form a shell corporation that would “own” all mortgage interests.  Then, instead of formally transferring mortgages from one financial institution to another, MERS would electronically track transfers of ownership.  That way, expensive and anachronistic paper recording systems could be bypassed, and mortgages could be quickly transferred to meet the needs of the age of securitization.

It occurred to me that this is exactly what occurred with stock ownership.  Stock transfers, too, used to be conducted via paper endorsements, which created a literal paper crisis in the 1960s.  See In re Appraisal of Dell.  In response, Congress and the SEC adopted a system of “share immobilization,” namely, that almost all stock today is actually owned by a company called DTC.  DTC is owned by broker dealers, and DTC electronically tracks which shares are allocated to which brokerage.  Those brokerages, in turn, allocate the shares among their clients. 

After class, I looked into the history, and it turns out I wasn’t wrong to draw the comparison: MERS was actually explicitly modeled on DTC.   See Phyllis K. Slesinger & Daniel McLaughlin, Mortgage Electronic Registration System, 31 Idaho L. Rev. 805 (1995).  But – and I suppose hindsight is 20/20 – it’s easy to see why the stock transfer system could not simply be wholesale transferred to mortgages,  which is precisely why MERS has created so many headaches.

For starters, the share immobilization system was mandated by Congress, to deal with a federally-regulated system of stock ownership.  As a result, the regulatory system adapted to the change, and federal rules were created to allow a “look-through” to the beneficial owner of the security instead of focusing on the formal record holder.  See, e.g., 17 C.F.R. § 240.14a-13.  Nothing like that happened with MERS, because it was created without the imprimatur of any legislative or regulatory body.  As a result, there are no formal procedures that permit a look past MERS to the beneficial owner of the mortgage, which is part of the reason why MERS’s legal status has been so uncertain.

Relatedly, MERS often includes only the name of the servicer in its system, and does not require its members to record transfers between mortgagees (although, Chris tells me, MERS recently has tried to improve its practices in this regard).  As a result, MERS records simply do not contain information about who actually owns the mortgage, and these private transfers create opportunities for confusion and mischief.  By contrast, stock transfers are heavily regulated, and settlement is required by SEC rule – within 3 days (soon to become 2).

Beyond these regulatory points, mortgage ownership is simply more complex than stock ownership.  A stock transfer is a personal property transfer.  There is a relatively minimal ongoing relationship with the issuing corporation – more on that below – but for the most part, it’s just property being transferred from A to B.

Mortgages, however, involve transfers between lenders, who must carry on complex and financially significant relationships with borrowers and servicers.  Payments from the borrower must be made and applied to the loan; two-way lines of communication must be maintained; in extreme cases, foreclosures must be managed.  On top of that, arcane rules govern the distinction between the mortgage itself and the note that represent the debt.  It is precisely in these areas that MERS has broken down.

Additionally, America has long had a commitment to creating public, transparent records of interests in real estate, including the chain of title; MERS destroyed that by creating an opaque system that fails to keep track of past transfers.  Stock ownership, by contrast, has never been publicly accessible, and the only area where chain of title is relevant is Section 11 (which, incidentally, has also been undermined by DTC).

That said, even the DTC-share immobilization system has been plagued by recordkeeping and legal problems; it is simply that at the end of the day, these problems are far less devastating to the lives of individual people than are the problems with MERS.

For example, stock ownership does involve an ongoing relationship with the issuing corporation (though one far more attenuated than in the ongoing relationships between borrowers and lenders in a mortgage loan), and errors/gaps in recordkeeping can affect that relationship.  Marcel Kahan and Edward Rock wrote about the “Hanging Chads of Corporate Voting,” detailing how voting procedures may be inadequate to keep up with share immobilization.  Moreover, the DTC system – which operates at the federal level – has created uncertainty with respect to state-level recordkeeping systems.  See In re Appraisal of Dell; Dole Case Illustrates Problems in Shareholder System.

But ultimately, a lost or miscounted shareholder vote, or even lost payments in a merger, are peanuts compared someone losing their home in a legally defective foreclosure, or simply the inability of a homeowner to develop a workout plan.

Perhaps fundamentally, then, the difference is about the power imbalances.  The corporate issuer of stock - the constant at the center of shifting shareholder bases - ultimately is the one with control over resources; shareholders' rights and powers are fairly minimal.  By contrast, the "issuer" of the mortgage note - the individual borrower who remains constant at the center of shifting lenders - is the most vulnerable player in the lending system, at the mercy of a rotating cast of sophisticated mortgagees and servicers.  A trading scheme like DTC/share immobilization, designed to accommodate those with very little power vis a vis the obligor, is not one that will do justice when the power relationships are reversed.

Point being, there were a lot of red flags - that might have been evident earlier - in trying to privately model a mortgage transfer system on the federally-mandated system for transferring stock, but here we are.  The banks weren't wrong about the problems with dealing with local recording systems in today's economy; but a true fix will require public mandates and coordination across all jurisdictions.

Ann Lipton | Permalink


Because "Cede & Co." shows up in case names: "DTC’s nominee name (Cede & Co.) is listed as the registered owner on the records of the issuer maintained by its transfer agent."

Posted by: Stefan Padfield | Mar 25, 2017 9:00:51 AM

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