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

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...