Sharp Thinking Cross-Collateralization Clauses in Commercial

No. 91
Perspectives on Developments in the Law from The Sharp Law Firm, P.C.
May 2013
Cross-Collateralization Clauses in Commercial
Mortgages Are Enforceable, 7th Circuit Rules
By John T. Hundley, 618-242-0246, [email protected]
Those cross-collateralization clauses common in commercial mortgages are enforceable and put
subsequent lenders on inquiry notice of other debts brought within the scope of the mortgage by such
clauses, the Seventh Circuit U.S. Court of Appeals ruled last week.
Rejecting an argument that enforcement of the cross-collateralization or “dragnet” clause would
chill second-mortgage lending, the court said that failing to enforce such
clauses would merely transfer the chilling effect from prospective secondmortgage lenders to prospective first-mortgage lenders. In apportioning that
risk, the court said that “only one outcome has the virtue of being consistent
with the plain contractual language that the parties agreed upon, and we think
it more sensible to allow sophisticated parties to contract as they wish. If
cross-collateralization clauses are in the end too costly to borrowers,
they need not agree to them.” Peoples Nat’l Bank v. Banterra Bank, No. 123079, __ F.3d __, 2013 WL 2150820 (7th Cir. May 20, 2013).1
The court added that as a general matter “prudent lenders would do well to
exercise caution before accepting a second mortgage on real property that has
been cross-collateralized.”
In Peoples, Peoples made a commercial loan against certain real estate with a mortgage that said
the property also was to serve as collateral for all other “obligations, debts and liabilities, plus interest
thereon, of Grantor to Lender . . . whether now existing or hereafter arising, whether related or
unrelated to the purpose of the [original] Note” (the cross-collateralization clause). Thereafter,
Banterra Bank took a second mortgage on the same property, but only after Peoples had lent the
debtors an additional $400,000 secured by other property.
Believing that Banterra had no actual knowledge of Peoples’ second loan,
the court said the presence of the cross-collateralization clause in the
mortgage of which Banterra concededly had knowledge put Banterra on
“inquiry notice” with a duty to make reasonable inquiry as to whether any
cross-collateralized loans existed. If the second-mortgage lender “fails to
make (such) 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,” the court said.
The Sharp Law Firm, P.C. represented the successful appellant in Peoples.
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Noting that a name search of Jefferson County land records would have
revealed the existence of Peoples’ second loan and that Banterra offered no
evidence that that loan could not have been discovered upon reasonable
investigation, the court rejected arguments that that siding with Peoples
would impose a duty of endless investigation stretching to the land records of
other states. “[T]he law requires reasonable investigation, not endless
investigation,” the court said. “[W]here to draw that line will be a question
of fact for the trier of fact” in cases where allegedly reasonable inquiry has been made.
The court also rejected arguments that Peoples’ mortgage (a form LaserPro document) had
“inherent contradictions and ambiguities” which did not create a duty of inquiry in the first place, an
argument which had led the District Court to award judgment to Banterra. Peoples Nationals [sic]
Bank, N.A. v. Jones, 482 B.R. 257 (S.D. Ill. 2012). In that regard, the Seventh Circuit specifically
ruled that a maximum lien clause equal in amount to the original note did not create an implication
that only the original note was covered by the mortgage. “The mortgage is not susceptible of two
meanings,” it said in reversing the District Court judgment.
By relying on the doctrine of inquiry notice, the court avoided deciding whether Peoples’
mortgage was insufficient to impart record notice of the second loan under § 11 of the Illinois
Conveyances Act (765 ILCS 5/11). The District Court had ruled that because Peoples’ mortgage
had failed to state the maturity date, interest rate and other terms of the cross-collateralized loan, it
was insufficient to give record notice to third parties under that act. Noting that several Illinois courts
have appeared to rule that the elements set forth in § 11 are mandatory for record notice purposes,
but that the text of § 11 and a recent statutory amendment (P.A. 97-1164 § 20) suggest § 11 is only
permissive, the court said it saw “no need to enter this fray.”
In so ruling, the panel likely was cognizant that two other appeals on the
Seventh Circuit’s docket more directly raised the § 11 issue and had been
stayed pending resolution of Peoples v. Banterra. See Richardson v. Gifford State
Bank, No. 13-1518, and Bruegge v. Farmers State Bank of Hoffman, No. 13-1277.
In both, lower courts have held that the language of § 11 is permissive. See In re
Crane, 487 B.R. 906 (C.D. Ill. 2013); In re Klasi Properties, LLC, 2013 WL 211111
(Bankr. S.D. Ill. 2013). See also Sharp Thinking No. 87 (April 2013); In re HIE
Effingham, LLC, __ B.R. __, 2013 WL 1334282 (Bankr. S.D. Ill. 2013) (similar;
appeal pending before the U.S. District Court for the Southern District of Illinois
(WBCMT 2007 C-33 Mid-America Lodging v. Bruegge, No. 13-cv-00439-WDS)).
Two other observations also might be offered concerning Peoples v. Banterra.
First, the ruling is of doubtful precedent in non-commercial cases – but cross-collateralization
clauses are rare in consumer mortgages anyway.
Second, the court enforced the cross-collateralization clause notwithstanding a provision that the
cross-collateralized debt need not be related to the purpose of the original note. Whether the court
rejected cases which have said the original and cross-collateralized debts must be similar in purpose,
or whether the court accepted Peoples’ arguments that in the instant case they were, is unclear.
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