United States: Mortgagee Stay Relief: Wending A Path Through Adequate Protection And Dragnet Clauses

Last Updated: March 19 2014
Article by Vicki Harding

Magnolia Portfolio, LLC v. Dye (In re Dye), 502 B.R. 47 (Bankr. M.D. Pa. 2013) –

A mortgagee sought relief from the automatic stay in order to pursue its state law remedies against properties securing seven defaulted loans.  The chapter 11 debtors contended that cause did not exist and the mortgagee was not entitled to relief since they had proposed a confirmable plan of reorganization under which the mortgagee's claims would be satisfied in full.

The debtors were a married couple who managed a variety of properties, including three trailer parks, a drag strip, a car wash, and several apartments.  The husband also operated a septic service, and the wife was employed in her father's business.

As of the bankruptcy filing, the balance due on the seven loans was ~$1.7 million.  At the time the court considered the stay motion, some of the properties securing the loans had been or were in the process of being sold, leaving the mortgagee's request for relief with respect to several emaining properties.  The properties in question included a 2.5 story two-family dwelling, 3-story brick row house that had been converted into two apartments and was attached to an abandoned furniture finishing shop, a manufactured home park, a single manufactured home on a 1.23 acre parcel, and a single-family dwelling that was not habitable.

The mortgagee contended that the debtors had failed to make loan payments, failed to pay property taxes and failed to maintain casualty insurance on the properties.  Further it contended that the debtors allowed the collateral to deteriorate such that they had no equity in the properties.  The mortgagee also claimed that the debtors' projections confirmed that the collateral could not generate sufficient funds to cover debt service.

After conducting a detailed review of the somewhat sporadic payments by the debtors, the court concluded that four of the seven loans were in default, two appeared to be current, and it was impossible to determine the status of the final loan.  Turning to the mortgagee's request, the court noted that relief could be granted for cause, which includes a lack of adequate protection of the mortgagee's interest in the collateral.  Adequate protection can take various forms.  Typically it is provided through periodic payments, but sometimes an "equity cushion" will be sufficient.

Before considering whether the debtors had an equity cushion, the court first considered cross-collateralization provisions in the mortgages.  All of the mortgages except one included a traditional dragnet clause:

In addition to the Note, this Mortgage secures all obligations, debts and liabilities, plus interest thereon, of either Grantor or Borrower to Lender, or any one or more of them, whether now existing or hereafter arising, whether related or unrelated to the purpose of the Note, whether voluntary or otherwise, [and] whether due or not due...

Notwithstanding the literal terms of the dragnet clauses, the court concluded that (1) for cross-collateralization to be enforceable under applicable state law (Pennsylvania), later advances must be related to the purposes of the original loan agreement, and (2) dragnet clauses are disfavored in real estate transactions since they "cloud title."  Thus, the subsequent advances must be "of the same class as the primary obligation... and so related to it that the consent of the Debtor to its inclusion must be inferred."

After raising this issue, the court acknowledged that the mortgagee's contention that all of the loans were cross collateralized was not disputed.  However, notwithstanding the debtor's lack of challenge, the court declined to find cross collateralization for the loan that was missing the standard dragnet clause.  It held that the collateral for this loan did not secure the remaining loans.  And with respect to this standalone collateral, the court concluded that the mortgagee's interests were adequately protected because the property securing the loan was sufficient:  the balance due on the loan was ~$67,000, while the collateral was valued at $148,000.

As to the cross-collateralized loans, at least four were delinquent and consequently the collateral for all six loans secured delinquent loans.  The combined value of the properties securing the cross-collateralized loans was ~$1.475 million, while the outstanding amount due was ~$1.7 million.  Thus, the debtors did not have an equity cushion.  In addition, the projections did not support the debtor's assertions that they could generate sufficient income to retire the debt.  Thus the court determined that the debtors failed to establish that the mortgagee's interests were adequately protected.

In addition, another basis for relief from the automatic stay is "if a debtor has no equity in the property and the property is not necessary to an effective reorganization."  As the Supreme Court has made clear:

What this requires is not merely a showing that if there is conceivably to be an effective reorganization, this property will be needed for it; but that the property is essential for an effective reorganization that is in prospect.  This means... that there must be "a reasonable possibility of a successful reorganization within a reasonable time."

The debtors had filed a series of disclosure statements that had not yet been approved by the court, the pending proposed plan did not take into account the loss of assets, and the projections did not support that reorganization would be possible.  Consequently, the court found that the mortgagee was entitled to relief from the stay with respect to the cross-collateralized properties on this basis as well.

In addition to reviewing the typical grounds for relief from the automatic stay, this decision includes a particular focus on dragnet clauses.  The court's description of state law suggests a significantly narrower scope of enforceability than one would expect based solely on the language of the typical dragnet clause.  Although the court did not apply this test to call into question the scope of the mortgagee's dragnet clauses due to the debtor's failure to raise the issue, the court on its own declined to allow cross-collateralization where the mortgage did not include appropriate language.  The moral of this story appears to be (1) you better include appropriate language if cross-collateralization is intended, but (2) that does not guarantee that it will be effective.

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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