Commercial real estate transactions frequently involve several tranches of secured financing. Where a borrower owns multiple properties, cross-collateralization — a practice in which a lender’s construction loan for one property is secured by liens on one or more of the borrower’s other properties — is often used as a means to enhance the lender’s security. In such transactions, junior lienholders must be especially diligent in their underwriting process to ensure the priority of their liens and identify all senior debt secured by the subject property. This is particularly true where a senior lienholder’s deed of trust contains a cross-collateralization clause – also known as a “dragnet” clause. The Seventh Circuit’s recent decision in Peoples National Bank, N.A. v. Banterra Bank, 719 F.3d, 608 (7th Cir. 2013) demonstrates the consequences facing a junior lender who fails to undertake a sufficiently robust inquiry before providing financing to a borrower.
In that case, the debtors owned a residential subdivision called Windsor Place, the construction of which was first financed by a 2004 loan from Peoples National Bank (“Peoples Loan I”). The debtors granted Peoples Bank a lien on all but two of the parcels in the development. The deed of trust capped the debtors’ indebtedness securing the properties at $214,044.26, the original principal amount of the loan. Importantly, the deed of trust also contained a cross-collateralization clause, whereby it secured, in addition to the note, all obligations, debts and liabilities of the borrowers to People’s Bank, whether related or unrelated to Windsor Place. In August 2008, the debtors obtained another construction loan for Windsor Place, this time from Banterra Bank. This $296,000 loan (the “Banterra Loan”) was secured by a second mortgage on the very same properties that secured Peoples Loan I. Banterra was aware of the prior mortgage that the debtors granted to Peoples. However, Banterra did not know, that in November 2007, the debtors obtained a second loan from Peoples (“Peoples Loan II”). This loan was for $400,000 and was secured by (i) parcels of real property not previously pledged to Peoples Bank and Banterra Bank and (ii) the Windsor Properties pursuant to the dragnet clause in the mortgage securing Peoples Loan I.
On December 21, 2010, the debtors commenced a chapter 11 proceeding. Shortly thereafter, the debtors sold the Windsor Place property for $388,500. There was no dispute that the proceeds generated by the sale should first be applied to satisfy Peoples Loan I, which had an outstanding balance of approximately $115,000. The parties did not agree, however, as to who was entitled to the remaining proceeds. Peoples asserted that, by virtue of the dragnet clause in the 2004 deed of trust, it was entitled to partial payment of Peoples Loan II up to the amount of the secured debt cap. Banterra, argued that the cross-collateralization clause was invalid and ineffective insofar as it purported to secure Peoples Loan II ahead of the Banterra Loan. Peoples Bank filed a complaint in bankruptcy court requesting that the court determine the priority of the parties’ liens. The bankruptcy court found in favor of Peoples Bank. Banterra appealed to the district court, where Banterra prevailed.
On further appeal, the Seventh Circuit ruled that Banterra’s actual notice of the dragnet clause in the 2004 deed of trust put it on inquiry notice as to the potential existence of other obligations, like Peoples Loan II, that may be covered by the security interest granted in connection with Peoples Loan I. The court observed that, on its face, the deed of trust plainly identified Windsor Place as securing Peoples Loan I and any additional loans entered into between the debtors and Peoples Bank (subject to the specific maximum amount of secured indebtedness). The court further noted that the definition of “indebtedness” in the mortgage securing Peoples Loan I clearly encompassed both Peoples Loan I and all other amounts that may be indirectly secured by the cross-collateralization clause. Moreover, the court concluded that a “reasonable investigation” by Banterra would have uncovered Peoples Loan II, and rejected Banterra’s contention that unspecified “inherent contradictions and ambiguities” in the cross-collateralization clause excused Banterra of any duty of inquiry with respect to the dragnet clause. As a result of the foregoing, the court determined that Peoples Loan II took priority over the Banterra Loan, and Peoples Bank was entitled to the remaining sale proceeds.
Senior lenders can take comfort in the fact that the Seventh Circuit has confirmed that cross-collateralization clauses will be enforced even in instances in which subsequent lenders do not have actual notice of all borrowings that are secured by the debt instrument in which the provision is set forth. Nevertheless, the decision leaves some important questions unanswered. For example, it is not clear whether the dragnet clause in People’s Bank would have been enforced if the 2004 deed of trust had not stated a maximum secured amount, as the court’s decision may be read to hold that, absent some stated maximum value, the cross-collateralization clause would have been unenforceable as to Peoples Loan II. Moreover, the Seventh Circuit’s decision requires a subsequent lender to have received actual notice of the contemplated cross-collateralization before it is placed on inquiry notice of additional borrowings that may impact the relative priority of future loans. The Peoples Bank court put great weight on the fact that the dragnet clause in People’s Bank was located on the first page of the 2004 deed of trust. A less prominently displayed cross collateralization clause may not provide future creditors with actual notice. In addition, the question of what constitutes a “reasonable investigation” by a junior creditor on inquiry notice is still an open question, and is subject to a case-by-case determination. Courts may determine that liens that cannot be discovered by a simple records search in the state or county in which the initial mortgage is recorded are not enforceable because they are not discoverable through a reasonable investigation by creditors on inquiry notice.