United States: Mortgagees Beware: Your Dragnet May Have A Hole In It

Last Updated: January 23 2013
Article by Vicki R. Harding

Peoples Nationals Bank, N.A. v. Jones, 482 B.R. 257 (S.D. Ill. 2012)

In Jones, the district court reversed the bankruptcy and held that a standard dragnet clause in a mortgage was not sufficient to secure an advance made by the mortgagee in connection with other real estate.

Peoples Nationals Bank, N.A. made an initial loan to the debtors in the original principal amount of $214,044.26 that was secured by a mortgage on a number of lots in a residential subdivision known as Windsor Place. The mortgage contained a statement that it secured a maximum principal amount of $214,044.26 (exclusive of protective advances). The mortgage also defined "Indebtedness" in terms of the note and related documents evidencing the initial loan, together with amounts that "may be indirectly secured by the Cross-Collateralization provision of this Mortgage."

The cross-collateralization provision stated that, in addition to the note evidencing the initial loan, the mortgage secured all obligations, debts and liabilities plus interest owed by the mortgagors to the mortgagee, as well as all claims of the mortgagee against the mortgagors, now existing or hereafter arising, liquidated or unliquidated, etc.

The bank subsequently made a $400,000 loan to the debtors secured by a mortgage on additional real estate that was not subject to the first mortgage. The debtors also obtained a $296,000 loan from a second lender that was used to build a spec home in the Windsor Place subdivision (which the debtors lived in).

After the debtors filed a voluntary chapter 11 petition, the spec home was sold for $388,500. The parties agreed that the bank was entitled to payment of the balance of the initial loan. However, the bank also argued that it was entitled to partial payment of its second loan (i.e., so that it received a total of $214,044.26 in principal payments on the first and second loans from the proceeds), while the second lender argued that it was entitled to the remaining proceeds after payment of the bank's initial loan.

The bankruptcy court agreed with the bank that the cross-collateralization clause in its mortgage was sufficient to support payment on the second bank loan. However, the district court reversed.

The district court quoted an Illinois statute as providing that a mortgage should "recite the nature and amount of indebtedness, showing when due and the rate of interest, and whether secured by note or otherwise." It also cited an 1883 Illinois Supreme Court case for the principle that "the policy, though not the letter, of Illinois statutes requires, in all cases, a statement upon the record of the amount secured." (The statute addressed in the 1883 case required that the mortgage recite the nature of the amount of indebtedness, which is still required under the current statute.) Otherwise, according to the 1883 case, the mortgage does not provide notice to bona fide purchasers. The district court further cited 1892 and 1964 Illinois appellate decisions for the proposition that when a mortgage fails to state the amount of indebtedness or maturity date it does not provide constructive notice that it secures the debt.

The district court acknowledged that cross-collateralization or "dragnet" clauses can be enforceable under Illinois law. However, it noted that they are not favored, and must be clear and unambiguous. The district court contended that the bank's mortgage was ambiguous since it contained "contradictory" language in that only the initial loan was described in the mortgage.

In sum, the district court concluded that, based on the Illinois statute and case law, the failure to describe any debts other than the first loan with particularity was fatal and prevented the bank from securing any debt other than the balance due on the initial note; and further that the mortgage did not provide record notice of any debt other than the initial loan. Consequently, the second lender was entitled to all proceeds remaining after payment of the bank's initial loan.

Although the debtors in this case were individuals, this decision was issued in a chapter 11 bankruptcy case in connection with commercial loans, and there is nothing particularly unusual about the cross-collateralization provision. Since a dragnet clause is intended to cover future loans that have not been made, by definition the standard set by the district court cannot be met in many cases.

One might conclude the significance of this case is limited to mortgages governed by Illinois law. However, the cited statute is also not that unusual. There are a variety of other states that include similar provisions. Specifically 765 ILCS 5/11 provides (emphasis added):

Sec. 11. Mortgages of lands may be substantially in the following form:

The Mortgagor (here insert name or names), mortgages and warrants to (here insert name or names of mortgagee or mortgagees), to secure the payment of (here recite the nature and amount of indebtedness, showing when due and the rate of interest, and whether secured by note or otherwise), the following described real estate (here insert description thereof), situated in the County of ...., in the State of Illinois.

Dated (insert date).

(signature of mortgagor or mortgagors)

A potential issue of even greater concern is whether a court might read this section as requiring that a mortgage include all of the specified information in order to be valid, notwithstanding the use of "may." It seems safe to say that very few mortgages include everything from amount to rate of interest to due date even when specifically identifying the debt secured.

Not surprisingly, the bank is appealing the district court's decision to the 7th Circuit.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Vicki R. Harding
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