United States: Cross-Collateralization: Your Dragnet Clause May Have At Least A Little Hole In It

Last Updated: August 13 2013
Article by Vicki R. Harding

In this case, the district court had reversed the bankruptcy court – holding that a standard dragnet clause in a mortgage was not sufficient to secure a loan made by the mortgagee that was secured by other property in the face of a claim by a junior mortgagee.  The mortgagee appealed and the 7th Circuit reversed the district court.

As described in a prior blog ( Mortgagees Beware: Your Dragnet May Have a Hole In It):  A bank (Peoples) made an initial loan to the debtors in the original principal amount of $214,044.26 secured by a mortgage on a number of lots in a residential subdivision known as Windsor Place.  Although the principal amount secured by the mortgage was capped at $214,044.26, the obligations secured included both the original loan and amounts that "may be indirectly secured by the Cross-Collateralization provision of this Mortgage."  The reference was to a standard dragnet provision which stated that the mortgage secured not only the initial loan, but also all other claims of the mortgagee against the mortgagors, now existing or hereafter arising, liquidated or unliquidated, etc.

Peoples subsequently made a $400,000 mortgage loan to the debtors secured by other property.  The debtors also obtained a $296,000 loan to build a spec house in the Windsor Place subdivision from a second lender (Banterra) that was secured by a mortgage on part of the collateral for Peoples' first loan.

After the debtors filed bankruptcy, the spec home was sold for $388,500.  All parties agreed that Peoples was entitled to payment of the outstanding balance of its initial loan, which had been paid down.  Peoples argued that it was also entitled to partial payment of its second loan to the extent that the ~$214,000 cap exceeded the then outstanding balance of the initial loan, while Banterra argued that it was entitled to the remaining proceeds after payment of the initial Peoples loan.

In reversing the bankruptcy court, the district court relied on an Illinois statute that it read as providing that mortgages 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 relied on an 1883 Illinois Supreme Court case to the effect that there is a requirement that there be "a statement upon the record of the amount secured."

In reversing the district court, the 7th Circuit began by noting that on the face of the mortgage the property secured other obligations, and the second Peoples loan appeared to come within that category.  Although there was a cap that initially would have prevented any other loans from being secured, as the debtors paid down the initial loan, that was no longer true.

With respect to the Illinois statute relied on by Banterra and the district court, the 7th Circuit acknowledged that the statute appeared to provide a checklist of information to include in a mortgage.  However, the statute stated that mortgages "may" be in substantially the form in the statute, which suggested that the information was not required. (As a side comment, shortly after the appeal to the 7th Circuit was filed, the Illinois legislature modified the statute to make it clear that the provisions regarding the form of a mortgage "are, and always have been, permissive and not mandatory.")

Banterra also relied on several cases (including two dating back to the 1800's) to support the proposition that a mortgage that does not at least list the amount of the debt secured by the collateral does not provide record notice of the debt to a subsequent creditor without actual notice.  However, the 7th Circuit distinguished those cases on the basis that not only was the second party without actual notice of the prior interest, there was no indication that it had knowledge of facts that would put it on inquiry notice.

As described by the court, inquiry notice is essentially a form of constructive notice similar to record notice.  Record notice treats a creditor as having actual knowledge of a prior interest if the prior interest is properly recorded.  Similarly:

Inquiry notice describes the situation where the transferee has been made aware of facts or circumstances from which the existence or possibility of a prior claim might reasonably be inferred.  If so, the purchaser then has a duty to verify or dispel the inference through further inquiry.  If he fails to make inquiry, he is nonetheless chargeable with knowledge of facts that a diligent inquiry would have disclosed, the same as if he had acquired actual knowledge of those facts.

In this case it was agreed that (1) Banterra did not have actual notice of the second Peoples loan, and (2) it did have actual notice of (i) the initial Peoples loan, (ii) the Peoples mortgage securing the initial loan, and (iii) the cross-collateralization provision in that mortgage.  The 7th Circuit agreed with the bankruptcy court that actual notice of the cross-collateralization clause gave rise to inquiry notice as to whether other obligations exist.

It went on to add that "it is clear that a reasonable investigation would have disclosed this prior claim."  A footnote suggests that the court was referring to the fact that a name search in the land records of the county where the mortgaged property was located would have revealed the second loan.  Banterra questioned whether this could be interpreted to require investigation to include not just other Illinois counties but even counties in neighboring states.  The court brushed this concern aside by asserting that the "law requires reasonable investigation, not endless investigation ... Ultimately, where to draw that line will be a question for the trier of fact."

In analyzing the distinctions between this case and the Illinois cases cited by Banterra, the court reiterated that Banterra had actual knowledge of the cross-collateralization clause:

The clause may well have been insufficient to impart record notice of Peoples Loan 2 on a subsequent creditor who did not have actual knowledge of that loan – that is Bullock.  But it is clear that the clause does impart inquiry notice on a subsequent creditor who had actual knowledge of the clause – a  point not reached by Bullock.

While many will breathe a sigh of relief that the 7th Circuit reversed the district court, it is troubling that the court required that Banterra have actual notice of the dragnet clause in order to trigger inquiry notice with respect to the additional loan.

Although this may vary by jurisdiction, generally I would expect that a properly recorded mortgage would provide constructive notice of its contents.  Taking things to the next logical step, I would expect that constructive notice of a dragnet clause in a mortgage would be sufficient to give inquiry notice as to potential additional obligations.

However, under the 7th Circuit's approach, there will be uncertainty about the effectiveness of a dragnet clause since the mortgagee will have to prove that a subsequent creditor had actual knowledge of the provision. This uncertainty is exacerbated by the fact that the cross-collateralization provision in this case was conspicuously placed on the first page of the mortgage and discoverable with just a cursory review.  If the dragnet clause is buried somewhere in the mortgage – perhaps in describing the obligations secured by the lien or in a definition of secured obligations – will a subsequent creditor be able to argue that it did not have actual notice of the dragnet clause since it did not read the mortgage, and consequently did not have inquiry notice of potential additional obligations?

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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